Buy-Sell Agreements, Life Insurance and the United States Supreme Court

By: Randall A. Denha, J.D., LL.M.

In a landmark ruling, the Supreme Court unanimously decided in Connelly v. U.S. that for estate tax valuation purposes, the value of a life insurance policy held by a closely held business must now be included in the company’s fair market value. This pivotal decision alters the landscape for valuing closely held businesses when life insurance proceeds are used to buy back shares from a deceased shareholder’s estate. Importantly, the Court clarified that a company’s contractual commitment to repurchase shares from a deceased does not reduce the value attributed to life insurance policies. This ruling has profound implications for buy-sell agreements, potentially affecting estate tax liabilities, redemption values, and other financial considerations. Companies with existing buy-sell agreements that include life insurance components are strongly advised to seek counsel from tax and estate planning experts to mitigate any adverse effects on their operations and tax obligations.

To illustrate the impact of Connelly, consider the following facts. A business has two shareholders, Alan and Bob. The business has a fair market value of $3M and has taken out a $2M life insurance policy for each of its shareholders. Assume Alan dies, and his shares in the business are included in his taxable estate. Pursuant to a buy-sell agreement, the business is required to purchase the shares of Alan for fair market value. Prior to Connelly, the fair market value of his interest would be $1.5M ($3M business fair market x 50%). Following Connelly, the fair market value of the business would be $5M ($3M plus $2M life insurance policy), and Alan’s interest would have a value of $2.5M ($5M x 50%). These differences in fair market value may impact:

Estate Taxes. For business owners with taxable estates, this decision may increase the value of their gross estate. Using the above example, Alan will include $1M more in his taxable estate after the Connelly decision because the life insurance policies are included in the business fair market value. If the value of Alan’s estate exceeds the federal estate tax exemption, this will cause an increase in estate taxes. While the federal estate tax exemption is currently $13.61M for an individual and $27.22M for a married couple, these are set to expire at the end of 2025, which will likely result in significantly lower exemption amounts.

Redemption Prices. The decision may create discrepancies between the life insurance proceeds received and the higher redemption price required to purchase a deceased shareholder’s shares, necessitating alternative financing strategies for businesses. Using the facts from the example, prior to Connelly the $2M life insurance proceeds for Alan would cover the entire $1.5M redemption price for its shares. After the decision, however, the business is left with a $500K deficit ($2M life insurance proceeds less $2.5M redemption price) it will need to cover to redeem Alan. As a result of Connelly, businesses may need to consider other sources of funds for redeeming owners (ex., reserves, promissory notes) or implementing cross-purchase buy-sell arrangements. While cross-purchase buy-sell arrangements with owners taking out life insurance policies on other owners can be administratively more burdensome, that structure does not impact the fair market value of the business (i.e., no redemption price issues) and life insurance proceeds are still received tax-free. What if life insurance was held withing an LLC created for this purpose? Here are some of the benefits of this structure:

• Holding life insurance policies within an LLC can streamline management, protect against creditors, and provide tax benefits. The LLC must have a business purpose so consider forming an equipment leasing company or use an existing LLC to meet the requirements.
• The LLC structure allows for tax-efficient distribution of policy proceeds and can align with the terms of buy-sell agreements.
• Crafting an LLC operating agreement requires careful planning to address premiums, proceeds distribution, and policy rights.
• Legal guidance is essential to navigate the complexities and ensure IRS compliance and optimization of tax outcomes.

Basis and Loss. Setting a redemption price below the updated fair market value could lead to basis and loss complications, affecting the deceased’s estate’s tax position. Put another way, if the redemption price is set at a lower amount than the fair market value of a decedent’s interest, this may give rise to basis and loss issues given a decedent’s estate receives a step-up in basis equal to the fair market value of an interest. Assume that instead of a redemption price set at fair market value, the business must redeem Alan for the value of its life insurance policy under the buy-sell agreement ($2M). Alan’s estate receives a step-up in basis for Alan’s shares equal to $2.5M. When the business redeems the shares, Alan’s estate will realize a $500K capital loss ($2M redemption price less $2.5M basis). While the capital loss may be used to offset capital gain, the loss may pose problems to the estate executor, who wants the estate to have full value.

While Connelly involved related shareholders, its principles likely extend to unrelated parties, suggesting all shareholders in similar arrangements should reassess their positions.

The Connelly decision underscores the need for strategic planning around buy-sell agreements and life insurance policies. Businesses must carefully consider the structure of these arrangements to prevent unforeseen tax consequences and ensure alignment with estate planning objectives. Consulting with professionals to revisit and possibly revise existing agreements is essential for maintaining compliance and optimizing financial outcomes. Any business with company-bought life insurance should revisit their buy-sell agreements to understand its redemption obligations and consult with tax and/or estate planning advisors to update such agreements as needed.