Most closely held businesses, whether organized as a C or S corporation, LLC or partnership, have (or should have) a buy-sell agreement. A buy-sell agreement addresses what happens to an owner’s interest in the business when the owner dies.

Many of these agreements provide that the business may or must purchase the deceased owner’s interest. The business frequently purchases life insurance on each of the owner’s lives, the proceeds of which, upon the death of an owner, will be used to purchase the decedent’s interest in the business from his or her estate.

A decedent’s gross estate includes the fair market value of interests he or she owned in a business as of the decedent’s date of death. Before a recent ruling by the United States Supreme Court, the life insurance proceeds received by the business would not be included in determining the value of the decedent’s interest in the business for estate tax purposes. On June 6, 2024, however, the Supreme Court issued a decision that changed that. The Court determined that business-owned life insurance proceeds used to redeem a decedent’s interest in his or her business must be included when valuing the decedent’s interest in the
business for estate tax purposes.

The results of the Supreme Court’s decision are an increase in the value of the decedent’s estate and, thus, higher estate taxes. For example, a business owned by two people is worth $2 million. The business buys two $1 million life insurance policies, one on each of the two owners’ lives. One owner dies. Since the business will receive $1 million in life insurance proceeds, the business is now worth $3 million. Under the Supreme Court ruling, the value of the decedent’s interest in the business for estate tax purposes is not $1 million but $1.5 million.

What does this mean for business owners? Owners should carefully review their existing buy-sell agreements and their estate plans, taking into consideration whether and how life insurance policies are used. Owners should then contact their professional advisors to determine the most tax-efficient way to transfer life insurance policies owned by the business to the business owners individually. There could be significant negative income tax consequences if this transfer is not structured properly. In lieu of business redemption agreements, cross-purchase agreements funded with life insurance owned by one owner on the life of the other owner should be considered.

This article appeared in the September 2024 issue of Stroll Lloyd Harbor.