On June 6, 2024, the Supreme Court of the United States ruled in a 9-0 decision that life insurance proceeds from a company-owned policy used to redeem a deceased owner’s interest in a closely held business must be included when calculating the value of that owner’s interest for federal estate tax purposes. The Court’s ruling represents a significant departure from established law and likely will have a substantial impact on business owners and their estates and families.
Factual Background
Michael and Thomas Connelly were the sole owners of a small, successful business. To protect their interests in the business and ensure that it remained with the family following one of their deaths, the two brothers entered into a buy-sell agreement, a common agreement for many small businesses and their owners.
Under the terms of the buy-sell agreement, Michael and Thomas had the option to purchase the other’s interest following their death. In the event that option was not exercised, the company was required to redeem the deceased brother’s interest at the fair market value, which was to be established by an outside appraisal. To fund the potential redemption, the brothers caused the company to take out life insurance covering both of their lives.
In 2013, Michael died, and Thomas declined to exercise his option to purchase Michael’s shares. Thus, the company was required to purchase Michael’s shares, which it did using the life insurance proceeds it received following Michael’s death. Thomas then filed a federal estate tax return for Michael’s estate that reported the value of Michael’s interest in the company without regard to the life insurance proceeds. Following an IRS audit, the estate was assessed a deficiency, which it paid. The estate then sued the United States for a refund claiming that the life insurance proceeds should not have been included when calculating the value of Michael’s interest for estate tax purposes.
The Supreme Court’s Holding
The United States Supreme Court sided with the IRS and the lower courts that heard this case that life insurance proceeds from a company-owned policy used to redeem a deceased owner’s interest in a closely held company must be included when calculating the value of that interest for estate tax purposes. Specifically, the Court held that the contractual obligation for a company to redeem an interest at fair market value does not offset life insurance proceeds set aside for the redemption because such redemption does not affect any owner’s economic interest.
Justice Thomas provided an example to illustrate the Court’s point: in a corporation with two owners, A and B, where A owns 80 shares worth $8 million and B owns 20 shares worth $2 million, A’s shares would still be worth $8 million following a redemption of B’s shares. This is true because the value of the corporation would be reduced by the redemption amount ($2 million), but since A would own the whole corporation, A’s interest is still worth $8 million, the value of the business following the redemption. Similarly, B’s economic interest is not affected because B would walk away with $2 million in cash instead of $2 million in shares. Thus, according to Justice Thomas, the contractual obligation to redeem an interest at fair market value does not affect the value of that interest. Ultimately, the Court concluded that because the redemption obligation did not affect the value of Michael’s interest, a willing buyer would pay the value of Michael’s interest accounting for the life insurance proceeds, and not the value of Michael’s interest discounting the life insurance proceeds.
Thomas argued that the value of Michael’s interest should not include life insurance proceeds because a willing buyer would not consider them since they would leave the company immediately after entering it to fund the redemption. However, the Court rejected the argument stating that it was looking at the wrong point in time for the value of the interest. In other words, the correct time to establish the value of Michael’s interest for estate tax purposes was immediately before the redemption, when the value of the life insurance proceeds were held in the corporation.
Thus, the Court held that life insurance proceeds from a company-owned policy used to redeem a deceased owner’s interest in a closely held company must be included when calculating the value of that interest for estate tax purposes.
The Impact of the Supreme Court’s Holding
The Court’s holding will impact how business owners structure their buy-sell agreements and plan for the deaths of owners. Specifically, the holding could result in higher estate taxes for owner’s estates following their deaths, which could, in turn, lead to liquidity issues for estates that had not planned for or anticipated the increased burden. The higher estate tax value will also lead to a larger step up in basis for the estate’s heirs. Finally, business valuations will become more complex as appraisers will have to consider buy-sell agreements that are funded by company-owned life insurance. Because of these impacts many businesses will need to consider revising their current buy-sell agreements.
Emerging Strategies
To avoid the negative consequences of the Connelly decision, companies may have to restructure their buy-sell agreements. Potential alternatives to buy-sell agreements funded by company-owned life insurance may include:
- Using cross purchase agreements, where each owner is responsible for maintaining life insurance on the other owners to fund a post-death cross purchase.
- Using split dollar arrangements, where the company pays the premiums, but the owners get the death benefits of a life insurance policy, to fund a cross purchase agreement.
- Gifting ownership interests during the life of the owner, potentially through non-voting interests.
- The remaining owners loan or contribute additional capital to the company following an owner’s death to fund a redemption.
- Using other estate planning vehicles such as irrevocable life insurance trusts, limited liability holding companies, or escrow agents to hold and maintain life insurance policies to fund redemptions.
- Using a buy-sell agreement that requires liquidation of company assets to fund a redemption instead of life insurance proceeds.
In addition to the above, it is important for business owners to regularly obtain valuations according to the terms of a buy-sell agreement to properly account for the value of each owner’s interest and avoid surprises.
The team at Rhoades McKee will continue to monitor changing strategies in light of the Connelly decision and stands ready to assist businesses and their owners with all their estate and succession planning needs.
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