Many co-owners of closely held businesses will employ life insurance as a tool for funding the transfer of ownership in the business upon the death or retirement of an owner. In these cases, planning involves the use of insurance proceeds to acquire the interests of a deceased shareholder or partner.
As a simple example, if Smith and Jones are the equal owners of a corporation, and they agree that value of a fifty percent interest is $10 million, they could proceed to enter into a buy-sell arrangement under which the business would agree to purchase a $10 million policy on Smith’s life with the proceeds used to redeem Smith’s shares at his death. Smith and Jones, and their estate planners, all expect that (i) the $10 million of insurance proceeds received by the corporation would be received tax free; (ii) Smith’s estate would not pay income taxes on the sale of the stock to the corporation, and (iii) Smith’s estate would report the value of his shares at $10 million for estate tax purposes.
This approach has been used by thousands of businesses and their owners for several decades. On June 6, 2024, the Supreme Court changed the rules. In Connelly, as Executor of the Estate of Connelly v. United States (602 US ___,2024), the Supreme Court ruled that the estate of a shareholder in Smith’s position must include fifty percent of the Corporation’s insurance proceeds in the value of his stock for federal estate tax purposes, even though he will not be entitled to that value. As a result, even though Smith’s estate is paid only $10 million to redeem the shares, the estate would be required to treat the value of the shares as $15 million for federal estate tax purposes. Assuming a 40% federal estate tax applies, Smith’s estate will be forced to pay $6 million of federal estate taxes on the shares, even though the estate received only $10 million for the shares.
Not only did the Court rule that a portion of the insurance proceeds received by a corporation (or other business entity) must be included in the deceased shareholder’s estate but that the shareholder agreement in that case would not determine value for federal estate tax purposes. Many shareholder agreements set the terms for the valuation of shares upon the death of the shareholder, which may include a fixed price, appraised value, or a formula approach. These agreements aim to ensure a smooth transition of ownership and can help resolve disputes among shareholders. Shareholders know what they will receive for their shares, and insurance planning revolves around that value.
The courts have long ruled, and the Internal Revenue Service (“IRS”) has long recognized that shareholder and other restrictive agreements effectively determine value for estate tax purposes where the agreements are entered into for a legitimate business purpose and restrict transfers during life as well as transfers upon death. See e.g. Brodrick v. Gore, 224 F.2d 892 (10th Cir. 1955); Estate of Bischoff v. Commissioner of Internal Revenue, 69 T.C. 32 (1977); and Estate of Lionel Weil, Deceased v. Commissioner 22 T.C. 1267, 1954 WL 31 (T.C. 1954), acq., 1955-2 C.B. 3.[1]
In Connelly, the Supreme Court considered the valuation method stipulated by the shareholder agreement in a closely held business. The case revolved around two brothers, Michael and Thomas, who were the sole shareholders of a corporation. The brothers and the corporation executed a shareholder agreement allowing the surviving brother to buy the deceased brother’s shares. If the surviving brother chose not to buy the shares, the corporation was required to redeem them for a proportionate share of the fair market of the corporation. The corporation took out life insurance policies on each brother so that it could use the proceeds to redeem the shares if one of them died.
When Michael (a 77% shareholder) died, Thomas elected not to purchase the shares. As a result, the corporation, which had received $3 million of insurance on Michael’s life, was required to redeem the shares using the $3 million of life insurance proceeds. The estate’s tax return reported Michael’s shares’ value at $3 million. However, the IRS audited and determined the $3 million of life insurance proceeds to be used to pay for the redemption, which should be considered a corporate asset when calculating the value of the shareholder’s shares for purposes of the federal estate tax. Thus, for valuation of the shares, the value of the company was increased by the $3 million of life insurance proceeds, with 77% of such total amount required to be included in the estate, resulting in an additional estate tax liability.
In Connelly, the court ruled that the fair market value of a corporation on the date of a shareholder’s death should include the life insurance proceeds used to fund redemption of the shareholder’s stock even though the shareholder held no incident of ownership over the shares.[2] This result has long been viewed as incorrect by practitioners and by various courts. In Estate of Blount, the Eleventh Circuit held that insurance proceeds are to be ignored when offset by a corresponding redemption obligation. Estate of Blount v. C.I.R, 428 F.3d 1338 (11th Cir. 2005). In so doing, the Eleventh Circuit court joined the Ninth Circuit, which reached a similar conclusion in Estate of Cartwright v. Commissioner, 183 F.3d 1034, 1038 (9th Cir. 1999). Both courts followed the theory that a third party seeking to purchase shares in a corporation would certainly take into account both the fact that the corporation was set to receive insurance proceeds and that it was obligated to redeem the decedent's shares.
However, in Connelly the Court rejected the reasoning of both the Eleventh and Ninth Circuit’s decision to offset corporate assets with a redemption obligation. The court ruled that the proceeds of a life insurance policy taken out by a closely held corporation on a shareholder should be considered a corporate asset when calculating the value of the shareholder’s shares, even though those assets are dedicated to the redemption of the shareholder’s stock.
In Connelly, the taxpayers noted that this was a wide standing practice in the wealth planning industry and would lead to additional costs for insurance funded buy-sell agreements. Justice Thomas responded that if the shareholders had just used a different approach, the cost could have been avoided.
“True enough, but that is simply a consequence of how the Connelly brothers chose to structure their agreement. There were other options. For example, the brothers could have used a cross-purchase agreement—an arrangement in which shareholders agree to purchase each other’s shares at death and purchase life-insurance policies on each other to fund the agreement. . . . A cross-purchase agreement would have allowed Thomas to purchase Michael’s shares and keep Crown in the family, while avoiding the risk that the insurance proceeds would increase the value of Michael’s shares.”
Impacts on Insurance Funded Buy-Sell Arrangements
Justice Thomas’s words ring true. In most cases, the estate tax cost imposed by the Connelly ruling can be avoided by simply using a different structure. But this ability to keep an existing plan in place by making a simple change in structure makes it critical now to re-evaluate life insurance funded business succession planning.
Connelly not only affects future estate planning, but also may affect a number of existing estate plans. In evaluating any estate plan using life insurance funding for a closely held business, estate planners should consider the following:
- Consider holding policies outside of the business entity and using the proceeds to fund cross purchase agreements. (This should be given particular consideration in family-owned businesses.)
- In any shareholder agreement, clearly define the method of determining the value of the Company and the shares to be redeemed and set forth the business purposes for the agreement.
- While recently falling out of favor, practitioners should consider the use of split dollar arrangements, where the business might bear premium costs with the net death benefit payable to shareholders and used to fund a cross purchase shareholder agreement.
- Whenever existing policies are moved, plan to avoid taxability issues under the IRC Section 101(a)(2) transfer for value rules.
For tailored advice on drafting or reviewing your shareholder agreements, or reviewing your estate plans, please contact our legal team.
[1] In Connelly, Justice Thomas discusses the effect of shareholder agreements on estate tax valuation. He states, “Although such an agreement may delineate how to set a price for the shares, it is ordinarily not dispositive for valuing the decedent’s shares for the estate tax. See 26 U. S. C. §2703.” However, it is clear that Bischoff still lives. Section 2703(b) provides such agreement or contractual restriction will be respected if it satisfies three requirements: (1) is a bona fide arrangement; (2) the restriction is not a device to transfer property to a family member for less than full and adequate consideration; and (3) the terms of the restriction are comparable to other arm’s length transactions. In Part II of his opinion, where he suggests the problem in Connelly could have been avoided with a cross-purchase agreement, Justice Thomas appears to concede that the outcome in Connelly was not dictated by Section 2703.
[2] See Treas. Reg. Section 20.2042-1(b)(6), which provides that the incidents of ownership of life insurance held by a corporation will not be attributed to the sole or controlling shareholder where the corporation receives the policy proceeds.
