How Your Buy-Sell Agreement Could Impact Your Personal Federal Estate Tax

In June of 2024 the Supreme Court unanimously decided in Connelly v. United States that a corporation’s contractual obligation to redeem shares is not necessarily a liability that reduces a corporation’s value for purposes of the federal estate tax. Further, the Court stated that the value of a decedent’s interest in a closely held corporation reflects the corporation’s fair market value, which includes life insurance proceeds payable to the company.

While it is always important for business owners to understand the specifics of their buy-sell agreement, it is especially important in the wake of the Connelly ruling given the major estate tax implications of the case. Although the Court’s decision primarily impacts C and S Corporation shareholders, business owners of all types should familiarize themselves with the Connelly ruling as the fact pattern could be applied to other entity types more broadly in the future.

What is a Buy-Sell Agreement, and Why Do You Need One?

A buy-sell agreement is a legally binding contract used to transfer ownership and ensure business continuity in the event of death, departure or incapacitation of an owner. An effective buy-sell agreement mitigates the risk of costly disputes among partners, surviving spouses and their estates. Common elements of an agreement include:

• Specific events that will trigger a buyout, which may include retirement, voluntary departure, disability or death.
• How the business is valued when the agreement is triggered, such as formulaic valuation or third-party appraisal.
• Who has the right or obligation to buy the interest in question, and the ability of owners to transact with third parties before offering shares to existing owners or the business.
• A timeline for executing the buyout.
• Methods for funding the buyout, such as life insurance, liquidation of assets or bank financing.

Financing a Buy-Sell Agreement with Insurance
Life insurance is one of the most popular methods for financing a buy-sell agreement, because it provides immediate liquidity upon death of an owner and generally prevents remaining owners from liquidating assets or taking on debt.

When a buy-sell is funded by life insurance owned at the individual level, it is referred to as a “cross purchase agreement.” Under this arrangement, each owner purchases life insurance on the other owners. When a buy-sell is funded by life insurance owned by the company, it is referred to as an “entity-purchase agreement.” Prior to Connelly, owners often preferred entity agreements, especially by large businesses, due to the associated cost savings and administrative simplicity.

Facts & Circumstances of the Connelly v. United States Case

Michael and Thomas Connelly were the sole shareholders of Crown C Supply, a C Corporation. The brothers had a buy-sell agreement in place with the following stipulations:

• If either brother died, the surviving brother had the right to purchase the deceased’s shares. If the right was not exercised, Crown C Supply was required to redeem the shares.
• Crown C Supply purchased a $3.5 million life insurance policy on each brother to fund the redemption obligation. When Michael passed and Thomas did not exercise his purchase right, Crown used the insurance proceeds to purchase the shares.
• The buy-sell specified the redemption price for each share would be based on an outside appraisal of Crown’s fair market value; however, Crown simply purchased the shares for $3 million dollars without obtaining a third-party appraisal.
• When the estate tax return of Michael Connelly was filed, the value of Michael’s interest in Crown was reported at $3 million. Under audit, the taxpayer obtained a valuation that placed the value of Crown at $3.86 million. However, this amount excluded $3 million in life insurance proceeds on the company books, under the pretense that insurance proceeds are deductible from the value of a corporation when offset by a redemption obligation, as established previously in Estate of Blount v. Commissioner.

The IRS’ Interpretation of Connelly, and What It Means for Owners

The IRS argued the total value of Crown was $6.86 million at Michael’s passing, therefore his 77.18% interest was valued at $5.3 million instead of $3 million. This resulted in the estate owing nearly $900,000 more in taxes than originally estimated. The IRS argued a third-party buyer or seller would have viewed the insurance proceeds as a net asset on the books of Crown. Further, the Court argued a redemption of shares at fair market value would not reduce the value of a shareholder’s economic interest — making it clear that a redemption obligation is not a liability (unlike in the Blount case referenced above).

Considering this ruling, owners have an increased responsibility to review buy-sell agreements to understand the estate tax implications of the agreement’s structure. Four areas of particular importance include the economic impact, transfer for value rules, cost basis, and state law:

1. Economic Impact: Michael Connelly’s heirs received a $3 million payment per the terms of the agreement. However, following the inclusion of the insurance proceeds in the valuation of the business, the estate owes roughly $2 million of estate tax related to the business despite only receiving $3 million of cash. Rather than receiving proceeds net of estate tax paid at a 40% rate, the heirs receive proceeds net of an effective 67% tax rate. This was an extremely poor economic result for the taxpayer, but it could have been avoided by properly structuring the agreement.
2. Transfer-for-Value Rules: Generally, life insurance death benefits paid to a beneficiary are income tax-free. Under transfer-for-value rules, death benefit proceeds can become partially or fully taxable if the policy is transferred for “valuable consideration,” such as money or property. Due to the complexities of the law and individual circumstances, it is best to engage a tax professional to review contemplated transfers in advance; certain attempts to unwind an insurance policy could bring about negative income tax consequences.
3. Cost Basis: The Connelly ruling could also impact business owners who do not have a federal taxable estate in two ways. The inclusion of life insurance proceeds in the corporate valuation may result in a larger step-up in basis to fair market value. Depending upon the ultimate redemption price, this could result in a capital loss for the business owner’s heirs.
4. State Law: Consider state estate and inheritance taxes. Laws vary widely, and many jurisdictions have estate tax thresholds that are below federal levels.

The Connelly ruling highlights the importance of monitoring legislative changes, and proactively and periodically reviewing buy-sell agreements as well as your life insurance policies to ensure they still meet your needs. Your tax advisers and attorneys can help you navigate the complexities related to estate and business succession planning.

Contact Holly McCartney, Joe Falbo or a member of your service team to discuss this topic further.

Cohen & Co is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law with your professional advisers.