The recent U.S. Supreme Court decision in Connelly v. United States has sent ripples through the world of closely held businesses, particularly those that rely on stock redemption agreements funded by life insurance policies. The June 2024 ruling clarified the treatment of life insurance proceeds used for share redemption in the context of federal estate taxes, overturning longstanding assumptions and practices.
Background of Connelly v. United States
The Connelly case involved brothers Michael and Thomas Connelly, who owned all the shares of Crown C. Supply, a closely held corporation in St. Louis, Missouri. The brothers entered into a stock purchase agreement in 2001 to ensure the company remained within the family upon the death of either brother. This agreement stipulated that the surviving brother could purchase the deceased brother’s shares. If the surviving brother declined, the company was obligated to redeem the shares, using proceeds from life insurance policies taken out on each of the brothers.
When Michael Connelly passed away in 2013, Crown C Supply used $3 million from the life insurance proceeds to redeem his shares, effectively making Thomas the sole shareholder. However, when Michael's estate was filed for federal tax purposes, the estate’s valuation excluded the life insurance proceeds used for the redemption, a common practice based on prior case law. The IRS disagreed with this exclusion, arguing that the full life insurance proceeds should be included in the valuation of Michael’s estate, which led to a significant tax assessment.
The Supreme Court's unanimous decision upheld the IRS's position, ruling that the life insurance proceeds used to redeem shares must be included in the estate's taxable value.
The court ruled that a decedent’s shares should be valued before redemption and that Crown's valuation must account for the policy proceeds as a non-operating asset. For estate tax purposes, the valuation is determined at the time of death, not after the redemption payment. Therefore, the court dismissed the argument that Crown's redemption obligation reduces the life insurance benefits.
This ruling overturns prior interpretations that allowed such proceeds to be excluded, dramatically altering the tax landscape for closely held businesses with similar buy-sell agreements.
Impact of Connelly on Business Owners
The Connelly ruling has significant implications for business owners, particularly those who rely on life insurance-funded buy-sell agreements. The verdict effectively increases the taxable value of estates, leading to potentially higher estate taxes and reducing the net value passed on to heirs.
For businesses, this ruling may result in reevaluating their current buy-sell agreements. Previously, businesses could rely on the expectation that life insurance proceeds used in stock redemptions would not be included in the estate’s taxable value. Now, however, these proceeds must be considered, leading to higher valuations and, consequently, higher estate taxes. This may place financial stress on the business or heirs, particularly if liquidity is an issue.
How Business Owners Can Take Action in Light of the Connelly Ruling
In light of this ruling, business owners need to take proactive steps to review and possibly revise their existing estate planning strategies:
- Review Your Buy-Sell Agreements: Business owners should review their current buy sell agreements, particularly those that involve life insurance-funded redemptions. It’s crucial to understand how the Connelly ruling might impact the valuation of the business and the tax implications for the estate.
- Utilize Cross-Purchase Agreements: In a cross-purchase agreement, shareholders will directly own the life insurance policies on the other shareholders. As a result, the proceeds of the insurance policy will not be included in the value of the company upon death and can still be used to purchase the ownership interest of the deceased shareholder from their estate.
- Consider Alternative Funding Mechanisms: Since life insurance proceeds are now included in the estate's taxable value, business owners may want to explore alternative funding mechanisms for buy-sell agreements. Options such as sinking funds, installment sales, or third-party financing might offer more tax-efficient ways to achieve the same objectives.
- Educate Successors: The ruling underscores the importance of clear communication with successors about the financial and tax implications of the business's estate plan. Preparing them for the possible tax consequences can prevent future disputes and ensure a smoother transition of ownership.
- Consult with Tax and Legal Advisors: Given the complexities involved in the Connelly ruling, consulting with experienced tax and legal professionals is essential. Advisors at Kreischer Miller can help reassess the company’s valuation strategies and explore alternative structures that might mitigate the impact of the ruling.
Next Steps for Reassessing Your Estate Planning Strategy
The Connelly v. United States ruling represents a pivotal shift in how life insurance proceeds are treated for estate tax purposes in closely held businesses. Business owners should act soon to reassess their estate plans and ensure they are not caught off guard by any increased tax liabilities that this ruling may bring. By consulting with professionals at Kreischer Miller and considering alternative strategies, they can mitigate the impact of this ruling and protect the long-term viability of their businesses.