The Supreme Court’s recent decision in Thomas A. Connelly et al. v. United States has significant implications for certain closely held business owners. The decision is important especially for those with, or planning to buy, life insurance policies reserved to buyout or redeem their interests after death.
As detailed in this alert, the Supreme Court ruled that life insurance proceeds received by a company to buy or redeem an owner’s shares must be included in the company’s value for estate tax purposes, and that redemption obligations do not reduce the company’s value for estate tax purposes. This situation can cause unintended or adverse tax consequences for a business owner’s estate as occurred in this case. The outcome underscores the need for careful structuring of these policies and agreements, which for some this may mean changing the policy owner and listed beneficiary.
Background and the Connelly Decision
The U.S. estate tax is a federal tax on the transfer of a deceased person’s property. It applies to estates valued over $13.61 million in 2024, with deductions allowed for certain expenses and transfers to spouses or charities. Without further legislation, the exemption amount will drop to $5 million, adjusted for inflation, at the end of 2025. Executors must file an estate tax return if the estate exceeds the exemption amount. The return essentially requires an executor to disclose the value of all estate assets valued as of the date the decedent died.
In Connelly, brothers Michael and Thomas Connelly were the shareholders of Crown C Supply before Michael’s death. They had an agreement that upon the first of them to die, the surviving brother could buy the deceased’s shares or have the company redeem those shares using company-owned life insurance. When Michael passed away, Thomas did not buy Michael’s shares from his estate so the company used the life insurance proceeds to redeem Michael’s shares. Michael’s estate tax return did not include the life insurance proceeds in the valuation of the company. Michael’s estate relied on the Eleventh Circuit court decision in Estate of Blount which held that life insurance proceeds paid to the entity can be excluded from the computation of the company’s fair market value for estate tax purposes.
The IRS audited Michael’s estate and determined that Michael’s estate had undervalued the shares by not reporting the fair market value of the shares. The IRS asserted that the valuation of the company must include the life insurance proceeds in its valuation and that the valuation could not offset the proceeds by that of the redemption obligation. The Supreme Court agreed with the IRS, rejecting the previous Eleventh Circuit decision. The Court held that the fair market value of the company must include the life insurance proceeds and that the contractual obligation to redeem shares does not reduce the date-of-death valuation of shares held by the deceased shareholder. For Michael’s estate, the increased company value resulted in more estate tax paid.
Implications for Succession Planning
The decision highlights the importance of careful succession planning in closely held companies, particularly for those with owners that may have estates subject to estate taxes. This Court acknowledged concerns about the impact of this ruling on succession planning but noted that these concerns stem from the specific structuring of the Connelly brothers’ agreement. The ruling suggests that business may need to reconsider how they structure buy-sell agreements and the use of life insurance or promissory notes to fund share redemptions to avoid unintended tax consequences.
To avoid an outcome seen in Connelly, closely-held business owners should review their buy-sell or similar agreements and consider changing ownership of each policy and the listed beneficiary as needed. It is important to note the “transfer-for-value” rule under Section 101(a)(2) of the Internal Revenue Code. This rule generally provides that if a company transfers the policy to a new owner in exchange for proper consideration, that new owner is subject to income tax on the policy proceeds unless the new owner is generally either the insured, a partner of the insured, a partnership in which the insured is a partner, a corporation in which the insured is a shareholder or officer, or anyone whose basis is determined by reference to the original transferor’s basis. But, choosing the best transferee depends on the company structure, number of owners, and the desired result.
It also is noteworthy that the issue presented to shareholders in the Connelly case may be avoided if more than 50% of the value of the property subject to the buy-sell agreement is owned directly or indirectly by individuals who are not members of the deceased shareholder’s family. Section 2703(b) of the Internal Revenue Code provides a safe harbor provided the buy-sell agreement is a bona fide arrangement, is not a device to transfer property to members of the decedent's family for less than full and adequate consideration, and has terms that are comparable to similar arrangements entered into by persons in arm's-length transactions.
Additional Options Going Forward
There are other options that if implemented correctly can be effective in preventing a Connelly outcome for closely held businesses with taxable estates. These alternative options include: purchase of additional life insurance, a cross-purchase agreement, insurance trusts, a special purpose LLC, and use of promissory notes.
One option is simply to have the company buy more life insurance to offset the additional estate tax liability that results from the Connelly decision.
A second option is a cross-purchase agreement structure which involves having each shareholder own a life insurance policy of each of the other shareholders. The proceeds from the life insurance policies are used to purchase the deceased shareholder’s interest from the estate of the deceased shareholder. The purchasing shareholder receives a step-up in basis for the shares purchased. The Court in Connelly referenced to cross-purchase agreements for an alternative structure that the Connelly brothers could have implemented to avoid the risk of the insurance proceeds increasing the fair market value of the shares held by the deceased shareholder. The drawback to this option is if the company has many shareholders, this would require each shareholder to obtain several life insurance policies on the other shareholders.
An insurance trust is similar to the structure of the cross-purchase agreement, with the main difference being the insurance trust is the policy holder and the recipient of the life insurance proceeds.
Another option is to use a special purpose LLCs to fund the buy-sell agreement. The special purposes LLC, taxed as a partnership, is used to own life insurance policies insuring the lives of multiple owners of a company and will also be the beneficiary of these policies. This structure can be useful in the case of a closely-held business that has multiple shareholders and is far simpler than cross-purchase agreements. This structure would not require shareholders to obtain several policies like a cross-purchase agreement. However, in light of the Connelly decision, there is uncertainty as to whether the IRS will continue to allow these LLCs to go unchallenged.
If life insurance is not an option due to the age or health of a shareholder or otherwise, it is possible to fund the buy-sell agreement entirely with a promissory note payable over an extended period of time. Using a promissory note to fund the purchase of business interests offers flexibility and immediate transfer of ownership while allowing payments to be spread over time. It, however, creates a long-term financial obligation for the buyer and involves risk for the selling party.
Conclusion
Connelly underscores the necessity for closely held companies to carefully consider the structure of their life insurance policies and redemption agreements. The inclusion of life insurance proceeds in the company’s value for estate tax purposes can significantly impact the estate tax liability. Clients should review their current agreements and estate plans to ensure they are aligned with this new legal precedent.
We recommend that clients consult with their tax advisors and legal counsel to understand the full implications of this decision and to explore potential strategies for mitigating any adverse tax consequences.
