In a landmark ruling, the U.S. Supreme Court changed the landscape for business owners relying on life insurance proceeds to fund buy-sell agreements. On June 6, 2024, the Court sided with the IRS in Connelly v. United States, clarifying how these proceeds can affect estate tax calculations and business valuations.
The Court’s decision has far-reaching implications, particularly for companies with multiple owners who use company-owned life insurance policies to fund entity stock redemptions dictated by buy-sell agreements. Such agreements are commonly used to ensure liquidity when purchasing the shares of a deceased business owner. In these agreements, the business owns, pays the premiums for, and is the beneficiary of the life insurance policies for its owners.
There are lessons to be learned from the ruling and what it means for your business.
Connelly Case Background
Michael Connelly and Thomas Connelly were the sole shareholders of Crown C Supply, a St. Louis-based building supply corporation. Michael held 77.18% of the shares, while Thomas held the remaining 22.82%. Before Michael’s death, the business was valued at $3.86 million.
To ensure the business remained within the family if either brother passed away, they entered into a buy-sell agreement. This agreement required the company to purchase the shares of the brother who died if the surviving brother and shareholder chose not to buy them. To fulfill this obligation, the business held a $3.5 million life insurance policy on Michael.
When Michael died, Crown C Supply used $3 million of the life insurance proceeds to purchase his shares. His estate argued that for estate tax purposes, Michael’s ownership interest should be valued at $3 million, calculated at 77.18% of the business’s $3.86 million value. The estate assumed that the stock redemption agreement liability offset the value of the life insurance proceeds when calculating the business value.
Supreme Court Decision
After Michael Connelly’s death, the IRS challenged the estate tax value of his shares, arguing that the life insurance proceeds increased the business’s value, thereby raising the estate tax value. The IRS determined that Crown C Supply’s total value was actually $6.86 million, consisting of $3.86 million plus the $3 million in life insurance proceeds. The IRS then calculated the value of Michael’s shares as $5.3 million, which is $6.86 million times his share percentage of 77.18%.
In a unanimous 9-0 ruling, the U.S. Supreme Court sided with the IRS on how life insurance proceeds and redemption obligations should be treated for federal estate tax purposes. The Court found the original buy-sell agreement lacked a clear buy-out price, which left the business’s value for estate tax purposes undefined. Additionally, the eventual buyout price appeared inconsistent with the agreement’s terms. The Court’s decision resulted in an additional estate tax of nearly $900,000.
Lessons Learned from the Connelly Case
The Connelly case highlights the importance of having clear and well-structured buy-sell agreements with determinable buy-out prices, and business owners should proactively revisit their succession plans to prevent unexpected tax burdens. It also underscores the need to seek expert guidance from legal and tax advisors to align the structure of such agreements with your financial goals. Now is a good time to evaluate your life insurance policies to minimize potential tax liabilities, and there are strategies you can implement to do so. For help, consult the experts at 1RDG by calling 585-673-2600.