On June 6, 2024, the U.S. Supreme Court issued a pivotal decision in Connelly v. United States, affecting how life insurance proceeds are treated in buy-sell agreements for closely held corporations. The ruling states that life insurance proceeds received by a corporation to fund the purchase of a deceased stockholder’s shares must be included in the corporation's value for federal estate tax purposes and are not offset by the contractual purchase obligation, leading to significant additional estate tax liability.
The case revolved around the estate of Michael Connelly, who had set up a cross-purchase buy-sell agreement with his brother, funded by life insurance policies. The life insurance proceeds were payable to the business and the business had a contractual obligation to redeem the deceased owner shares upon death. Upon Michael Connelly's death, the cross-purchase agreement triggered a redemption of Mr. Connelly’s shares by the company using the $3.5 million life insurance payout. The estate valued the business excluding the insurance proceeds based upon the understanding that the death benefit of the life insurance policy was offset by the company’s obligation to pay those proceeds to Mr. Connelly’s estate in redemption of the shares, but the IRS disagreed.
The Supreme Court sided with the IRS, ruling that life insurance proceeds payable to a corporation must be included in the valuation of the deceased owner’s business interest. The Court emphasized that such proceeds are integral to the business arrangement and cannot be excluded from the overall value of the ownership stake. The Court's ruling confirms that life insurance proceeds payable to the company are considered corporate assets notwithstanding any offset buyout agreement, which increases the corporation’s fair market value.
This change mandates careful consideration of how life insurance policies are structured and used within buy-sell agreements. A cross-purchase agreement on the other hand, where shareholders purchase each other’s shares, as opposed to the company itself redeeming the shares, may mitigate the impact of increased share value due to corporate-held insurance. However, this structure requires careful management of insurance premiums and policies between the shareholders and the business.
The Connelly decision may result in higher estate tax liability for decedent-stockholders due to the inclusion of life insurance proceeds in the taxable estate and emphasizes the importance of careful consideration and structuring of buy-sell agreements. Moving forward business owners should consult with their attorneys and tax professionals to review the structure of their business succession plans, and where appropriate consider restructuring the use of life insurance policies to avoid adverse tax consequences.
