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On June 6, 2024, the Supreme Court delivered a landmark ruling in Connelly v. United States, affirming the Eighth Circuit’s opinion with a unanimous 9-0 decision.
This monumental verdict has sent ripples through the buy-sell system, and significantly impacts buy-sell planning.
Centered on a flawed stock purchase agreement between brothers Michael and Thomas Connelly, the case highlights critical issues in valuing life insurance proceeds and underscores the urgent need for businesses to reevaluate their buy-sell agreements to avoid unexpected tax liabilities.
Here’s what we'll cover in this post:
Michael and Thomas Connelly were brothers who owned Crown C Supply, a C Corporation. The brothers entered into a stock purchase agreement allowing either brother to buy out the other upon the death of one.
If a brother chose not to purchase the shares of the deceased brother, the company was obligated to redeem the shares. To ensure a smooth ownership transition, the corporation purchased a $3.5 million life insurance policy for each brother.
The buy-sell agreement provided two mechanisms for determining the redemption price of the shares: a certificate of agreed value and fair market value appraisals. Unfortunately, the brothers never executed a certificate of agreed value or obtained appraisals.
When Michael died in 2013, the company received the life insurance proceeds and redeemed Michael’s shares for $3 million without obtaining appraisals. The redemption resulted from an agreement between Thomas and Michael’s son, with the additional $500,000 in proceeds used for operating expenses.
Michael’s estate tax return valued his shares at $3 million, the redemption value. However, the IRS concluded that the life insurance proceeds should be included in the company's total fair market value, assessing the estate value at $5.3 million.
The estate argued that the proceeds used to redeem shares should not be included, referencing the 2005 case, Estate of Blount v. Commissioner. While the 11th District Court sided with the estate, the 8th District Court sided with the IRS.
Every business owner with a stock redemption buy-sell agreement must reevaluate it. If the agreement states that the deceased partner gets the fair market value of their shares, the required payout may not be what is anticipated. Consider a company worth $1 million owned 50/50 by two brothers without any insurance payable to the company.
They agree the estate of the first to die should be paid half the value of the company, or $500,000. However, if the company receives $1 million in insurance when the first brother dies, the company would be worth $2 million. Hence, the deceased brother’s estate should get $1 million, not $500,000.
Even if the mechanism for determining the redemption price does not refer to fair market value, ignoring it, as in the Connelly case, can jeopardize the desired outcome. There is even more reason to reevaluate the stock redemption agreement for business owners with a taxable estate.
A different buy-sell design selected from those listed below may prevent the additional estate tax owed due to the company's increased valuation.
A cross-purchase plan is an agreement where business owners personally buy each other's interests upon a triggering event, such as death, disability, or retirement. Each owner purchases a policy on the lives of each co-owner.
For example, if Mike and Mary each own 50% of a business and enter into a cross-purchase agreement, upon Mike’s death, Mary will buy Mike’s shares from his estate. This arrangement prevents the business's value from increasing and offers tax advantages, but it can be complex with more than two or three owners.
In a trusteed arrangement, a trustee purchases life insurance on each owner's life. The trustee collects the proceeds, purchases stock from the deceased owner's estate, and distributes the shares to surviving owners. Care must be taken to follow the transfer-for-value rules.
In this plan, business owners form a partnership (e.g., LLC) that purchases life insurance on each owner's life. This method helps avoid the transfer-for-value problem, ensures compliance with the buy-sell agreement, and keeps policy proceeds from the insured’s creditors.
Each business owner purchases and owns a life insurance policy on their own life, endorsing a portion of the death benefit to the other owners. This arrangement provides flexibility and satisfies both personal and business needs.
However, the rental costs (economic benefit costs) increase with age, and it may run afoul of the transfer-for-value rules for C and S corporation owners.
Asset-based valuations are best for businesses with significant tangible and intangible assets.
Market-based valuations are determined by what a knowledgeable buyer is willing to pay for the business.
Income-based valuations, used primarily for service-based businesses with few physical assets, are determined solely by the business's earnings. A combination of these methods can also be used.
While costly, independent appraisals can help determine a business's value and prevent future disputes. Additionally, considering the timing of the valuation is crucial, as annual or seasonal fluctuations can impact the business's value.
Life insurance can be a cornerstone of estate planning, providing instant cash upon the insured's death. However, the transfer-for-value rule can make the life insurance proceeds taxable as ordinary income.
There are exceptions to the transfer-for-value rule, such as transfers as a gift or to certain parties (e.g., the insured, a partner, a partnership, or a corporation).
Common scenarios where the transfer-for-value rules come into play include changing from a stock redemption to a cross-purchase structure. One solution is for shareholders to be partners in another enterprise to avoid transfer-for-value issues.
Given the importance of the Connelly case, business owners with existing buy-sell agreements or those looking to enter into one are urged to review their situation and plan carefully. Cross-purchase plans will be the way to go if manageable. Partnership Cross-Purchase plans are likely to become prevalent when there are many owners.
Expert advice from the attorney is needed to draft the agreement. Unfortunately, many business owners, like Connelly, do not update their valuation or follow the valuation mechanism in their agreement. Now is an excellent time to update values and ensure the agreement will function as intended.
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Louis has been in the insurance business for over 30 years. He specializes in “high risk” cases as well as more complex coverages for long term care, disability, and estate planning.
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Cliff is a licensed life insurance agent and one of the owners of JRC Insurance Group. He has helped thousands of families of businesses with their life insurance needs since 2012 and specializes with applicants who are less than perfect health. In his spare time he enjoys spending time with family, traveling, and the great outdoors.
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