Many privately held businesses use life insurance in their succession planning to provide for liquidity in the event of an owner redemption requirement. A critical component of private company succession planning is buy-sell agreements, which my colleague Brian Sharkey recently wrote about.
In this article, we’ll take a fresh look at life insurance and buy-sell agreements in light of the recent Supreme Court ruling on Connelly v. United States (No. 23-146). This decision should prompt all business owners to revisit their succession plans and how they are using life insurance as part of their buy-sell agreement.
General Background on Using Life Insurance in a Buy-Sell Agreement
Using life insurance in a buy-sell agreement is generally intended to create a vehicle which provides immediate liquidity to fund all or a part of an owner’s redemption. It also strives to maintain continuity of business operations and looks to safeguard a tax-efficient estate plan.
There are two common ways to insert life insurance into a buy-sell agreement:
- Cross-Purchase Agreement: Each owner buys a life insurance policy on the other owner(s)
- Entity-Purchase Agreement: The business entity buys life insurance policies on each owner
Life insurance proceeds are generally income tax-free to the recipient in situations where the beneficiary of the policy is either the entity or the owner.
Implications of the Connelly v. United States Supreme Court Ruling
The issue at hand in Connelly v. United States was how to properly value a deceased business owner’s business interest.
The case involved two brothers – Michael and Thomas Connelly – who were the sole shareholders of a small, family-owned business. The brothers entered into a buy-sell agreement and the business obtained life insurance on each brother (entity-purchase agreement). When Michael died, the business redeemed his shares using his life insurance proceeds.
The IRS included the life insurance proceeds for Michael’s stock redemption when assessing taxes on his estate. Michael’s estate argued that the life insurance should not be included and sued for a tax refund.
Generally, when a business owner dies, his or her business interest must be valued as part of the calculation of the taxable estate. Prior to Connelly, most business valuations in this context would exclude any potential corporate-owned life insurance proceeds in the calculations. To that point, in Connelly, the business valuation of the deceased owner’s interest was done excluding the proceeds of the policy. This caused the estate to be undervalued for estate tax purposes, and thus, created additional estate tax.
The Supreme Court upheld two lower court rulings that the life insurance proceeds were an asset of the company, and therefore, should be included in the valuation of the company for estate tax purposes.
Impacts on Estate and Succession Planning for Business Owners
One item to note from the Court’s decision is that a valuation can be impacted by a mandatory repurchase/redemption obligation. This would decrease the company’s valuation and create an opportunity to mitigate the impact of the life insurance proceeds being includible in the calculation.
Business owners should evaluate their succession plans and buy-sell agreements, especially those with life insurance policies in place, to ensure the most tax-efficient approach is considered in light of this ruling. You may even want to consider the option of cross-purchase arrangements instead of redemption arrangements. Working with your tax advisor is important to ensure that your corporate agreements are properly structured and they align with current laws and court rulings.
Please contact me or any member of our Tax Strategies team if you have any questions about this topic or would like to discuss your company's transition plans.