On June 6, 2024, the U.S. Supreme Court issued its much-anticipated decision in Connelly v. United States, a case with significant implications for owners of closely held businesses and their estate planning strategies. The Court’s ruling clarifies how life insurance proceeds used to fund a stock redemption agreement should be treated for federal estate tax purposes and raises important questions around estate and business succession planning and potential pitfalls for business owners.
Background of the Case
Connelly involved two brothers who were the owners of a closely held corporation. The brothers entered into a stock redemption agreement pursuant to which the company would redeem a deceased shareholder’s interest using the proceeds of a life insurance policy owned by the company. When one brother died, the company received $3.5 million in life insurance proceeds and used those funds to buy the deceased brother’s shares from his estate. The IRS argued that the insurance proceeds should increase the value of the company (and thus the value of the deceased brother’s shares) resulting in a higher estate tax liability.
The estate disagreed, arguing that because the company was obligated to use the proceeds to redeem the shares, the proceeds did not enhance the value of the company for estate tax purposes. The Court, however, sided with the IRS and held that the life insurance proceeds should be included in the company’s value when determining the value of the deceased brother’s shares.
Four Potential Concerns for Business Owners
This ruling raises four practical and legal concerns for business owners, particularly those using buy-sell agreements as part of their succession and estate plans:
1. Valuation of Closely Held Business Interests
The Court’s decision emphasizes that life insurance proceeds received by a company, even if used for a stock redemption, can increase the value of the company for estate tax purposes. This means business owners may face a higher estate tax burden than previously expected.
2. Funding Buy-Sell Agreements
Many business owners rely on corporate-owned life insurance to fund buy-sell agreements. After Connelly, such arrangements may unintentionally increase estate tax exposure. Business owners should evaluate whether cross-purchase agreements (in which owners buy insurance on each other individually) might be a better solution in some circumstances.
3. Estate Liquidity Concerns
If the redemption is intended to provide the decedent’s estate with the liquidity necessary to pay estate tax on the shares, then an increase in the value of the shares without a corresponding increase in the redemption price may create liquidity issues for the estate.
4. Need for Updated Planning
Business owners should review their current operating agreements, shareholder agreements and estate plans with competent legal counsel given the Court’s decision. Attorneys, working with financial advisors, can help determine whether the structure of existing life insurance-funded buy-sell agreements is still tax-efficient and achieves planning goals.
Conclusion
The Connelly ruling highlights the complexity of coordinating business succession planning with estate tax planning. Business owners should proactively review their arrangements to avoid unintended tax consequences. A thoughtful restructuring of buy-sell agreements and an understanding of how life insurance affects business valuation can mitigate risk and preserve more wealth for the next generation.
If you have questions about how this ruling might affect your business or estate plan, our team is here to help.
For a customized estate planning strategy developed for your closely held business’s needs, including succession planning, contact the attorneys in our Private Client Services practice at WCN to assist you.
Brendan McGrory, an attorney in our Private Client Services practice, concentrates his practice on trust and estate planning and business succession planning. Learn more about Brendan.
This article is not legal advice and should not be taken as such or relied upon as legal advice.