A new Supreme Court decision may significantly change how buy-sell agreements are structured for closely held companies and the way life insurance is used to support these arrangements.

In the recent case of Connelly v. U.S., the Supreme Court examined whether life insurance proceeds received by a closely held company upon a shareholder’s death should be included as a company asset when valuing the shareholder’s shares for federal estate tax purposes.

The court ruled unanimously that “a corporation’s contractual obligation to redeem shares is not necessarily a liability that reduces a corporation’s value for purposes of the federal estate tax.” This means that life insurance proceeds received by the company increase its fair market value because they are considered an asset. The company cannot offset this asset with the liability associated with the repurchase obligation.

Case Background: Connelly v. U.S.

Michael and Thomas Connelly were brothers who owned Crown C Supply, a roofing and siding materials business in St. Louis, Missouri. In 2001, they made an agreement that allowed the surviving brother to purchase the deceased brother’s shares, with Crown required to repurchase the shares if the surviving brother declined.

Crown took out $3.5 million in life insurance policies for each brother, intending for Crown to reacquire the shares of the brother who died first. When Michael Connelly passed away in 2013, Crown received $3.5 million in life insurance proceeds.

At the time of Michael’s death, he held about 77% of Crown’s stock, while Thomas held about 23%. Following Michael’s death, Crown negotiated with Thomas and Michael’s son to purchase Michael’s estate’s shares for $3 million, using the remaining $500,000 for operating expenses.

Thomas Connelly filed an estate tax return valuing Michael’s shares at $3 million. The IRS audited the estate and issued a notice of deficiency, determining that Michael’s shares were worth $2,982,000 but that the $3 million in life insurance proceeds should be included as an additional non-operating asset. This adjustment increased the value of Crown’s shares by almost 80%, resulting in a new valuation of about $5.3 million for the estate’s shares.

Thomas Connelly then sued the IRS in the United States District Court for the Eastern District of Missouri, seeking a refund of over $1 million in estate taxes. The district court ruled in favor of the IRS, and the United States Court of Appeals for the Eighth Circuit upheld the decision. The Supreme Court affirmed the appeals court’s ruling.

Avoiding Similar Issues

Jay Judas of Life Insurance Strategies Group noted that this issue could have been avoided through a cross-purchase buy-sell agreement. In such an arrangement, shareholders are responsible for purchasing the shares of the deceased, and each shareholder obtains life insurance policies on the others to fund these purchases.

However, the court mentioned that cross-purchase agreements have their drawbacks compared to entity-redemption arrangements:

• Shareholders, rather than the company, pay the premiums.
• Shareholders may face tax consequences.

Shareholders must ensure continuous premium payments and maintain the policies to guarantee payment for the shares to their heirs.

Recommendations for Business Owners

Judas advises owners of closely held businesses with buy-sell agreements to consult their advisors to review and potentially revise their agreements and funding methods. This is especially important given the possible changes to federal estate and gift tax exemption amounts.

“If you are an advisor working with clients who have these arrangements, you should proactively inform them about this development, address their questions, and guide them through any necessary changes,” he said.