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Much has already been said about the June 6, 2024, case of Connelly v. Internal Revenue Service, where the U.S. Supreme Court held that a corporation’s contractual obligation to redeem shares was not a liability that reduced the value of the shares for federal estate tax purposes.
In Connelly, two brothers and shareholders of a closely held corporation entered into a redemption arrangement where the entity purchased insurance policies on their lives. At the first brother’s death, the corporation used a portion of the proceeds to redeem the decedent’s shares. When the IRS audited the decedent’s estate, it augmented the entity’s value by the insurance proceeds used in the redemption. This determination resulted in nearly $1 million in additional estate taxes to the deceased brother’s estate.
The Supreme Court sided with the IRS and held that the decedent’s shares should have been valued at the time of death before the redemption occurred. Since the brothers used redemption arrangement and made the corporation the owner and beneficiary of the life insurance policies, the life insurance proceeds were an asset of the corporation. The court noted that the brothers could have used a cross-purchase arrangement to avoid this result.
Key Takeaways
Following the ruling, some business owners may feel compelled to limit themselves to a cross-purchase structure. However, as with all things legal, the devil is in the details.
In a cross-purchase, the individual business partners are the owners and beneficiaries of the insurance policies, and each partner purchases a life insurance policy on other partner(s). In a redemption structure, the entity administers the policies and pays the premiums.
What are the pros of the cross-purchase arrangement? The value of the life insurance stays out of the corporation, and the surviving owners receive a full step-up in basis on the deceased owner’s interest. The cons? Each owner must purchase a policy on all other owners and pay the insurance premiums. Thus, three partners in a business would hold six policies collectively. The administration of six independent policies is complex, and the risk of nonpayment and potential coverage lapses are very real. Additionally, differences in the health and age of the owners may lead to premium disparities among the partners.
Many businesses favor redemption as a more practical arrangement, even though a step-up in tax basis may not always be achievable, and the policy value may be exposed to the creditors of the business. Now, the Supreme Court’s decision in Connelly v. Internal Revenue Service casts an additional shadow on its utility.
Several factors influence the choice of a buy-sell structure and the end result, including the size of the deceased owner’s estate, the state in which deceased had resided, whether the buy-sell agreement has conclusively established the fair market value of the owner’s interest and whether the buy-out involved family members or unrelated business owners. Other types of buy-sell arrangements, such as ones involving a trust or an “insurance-only” LLC may offer more flexibility.
A well-structured, properly funded buy-sell agreement offers peace of mind for the owners by providing a mechanism for buying out the deceased partner’s interest. Closely held businesses should consult with their legal and tax advisors to ensure that their buy-sells are technically sound and up to date. However, those with company-held insurance policies should resist the temptation to amend their agreements until their advisors carefully review owners’ personal circumstances and offer tailored advice.
