In a unanimous decision, the Supreme Court of the United States recently determined in Connelly v. U.S. that the value of a life insurance policy must be included in the fair market value of a closely held business for purposes of determining the value of a decedent’s interest. Further, the Court stated that any contractual obligation of the business to re-purchase a decedent’s interest does not create an offsetting liability to a life insurance policy. This decision is significant for buy-sell arrangements, and raises issues related to estate taxes, redemption prices, basis and loss, and more. Businesses that have buy-sell agreements in place should consult with tax and/or estate planning advisors for review of such agreements in conjunction with any life insurance policies to avoid any unwanted tax or business consequences.

To illustrate the impact of Connelly, consider the following facts. A business has two shareholders, Shareholder A and Shareholder B. The business has a fair market value of $3M and has taken out a $2M life insurance policy for each of its shareholders. Assume Shareholder A dies, and their shares in the business are included in their taxable estate. Pursuant to a buy-sell agreement, the business is required to purchase the shares of Shareholder A for fair market value. Prior to Connelly, the fair market value of Shareholder A’s 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 Shareholder A’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, Shareholder A will include $1M more in their taxable estate after the Connelly decision because the life insurance policies are included in the business fair market value. If the value of Shareholder A’s estate exceeds the federal estate tax exemption or an applicable state 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. Many states, such as Maryland and D.C., have estate tax exemptions that are significantly lower than the federal estate tax exemption threshold ($5M and $4M, respectively), making Connelly a material consideration for state estate tax purposes as well.

Redemption Prices. Redemption price issues may arise for a business due to the fair market value of a decedent’s interest exceeding the amount of life insurance proceeds received. Using the facts from the example, prior to Connelly the $2M life insurance proceeds for Shareholder A 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 Shareholder A. 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. Again, using the facts from the example, if instead the shareholders utilized a cross-purchase life insurance structure, both the fair market value of Shareholder A’s shares and redemption price would be $1.5M, which would be covered by the $2M policy without the need for other funding sources.

Basis and Loss. If a 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 Shareholder A for the value of its life insurance policy under the buy-sell agreement ($2M). Shareholder A’s estate receives a step-up in basis for Shareholder A’s shares equal to $2.5M. When the business redeems the shares, Shareholder A’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.

Note that the shareholders in Connelly were related, and the Court did not explicitly address whether the holding extends to unrelated shareholders. Given the Court did not limit its analysis to related shareholders, however, it is prudent to assume unrelated shareholders are subject to the same rules.

The Connelly decision highlights that buy-sell arrangements require careful structuring and should take into account any life insurance policies and estate planning goals. Without careful structuring, any transfer or distribution of company-bought life insurance policies can have significant tax consequences, including tax recognition on the transfer or the loss of exemption for future proceeds received with respect to the policy. 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.

Opinions and conclusions in this post are solely those of the author unless otherwise indicated. The information contained in this blog is general in nature and is not offered and cannot be considered as legal advice for any particular situation. The author has provided the links referenced above for information purposes only and by doing so, does not adopt or incorporate the contents. Any federal tax advice provided in this communication is not intended or written by the author to be used, and cannot be used by the recipient, for the purpose of avoiding penalties which may be imposed on the recipient by the IRS. Please contact the author if you would like to receive written advice in a format which complies with IRS rules and may be relied upon to avoid penalties.

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