Life insurance is commonly used in both estate planning and succession planning for closely held businesses. Life insurance proceeds can provide liquidity to assist in payment of estate taxes without liquidation of assets, and they can also be used to pay the estate itself or any heirs of a deceased shareholder or partner. However, the recent ruling of Connelly v. United States could indicate that business owners may need to revisit any shared redemption agreements as well as the use of life insurance to help fund succession and estate planning.
Connelly v. Unites States – A Background
Two brothers, Michael and Thomas Connelly, co-owned a thriving building supply company called Crown C. Supply (Crown). They had a shared redemption agreement, which stipulated that if Michael died, Thomas could either buy Michael’s shares or Crown itself would be obligated to purchase them. To fund this potential buy-out, Crown secured a $3.5 million life insurance policy on Michael’s life.
After Michael passed away, Thomas, acting as the estate executor, filed tax returns valuing Michael’s stake in Crown at $3 million, a figure previously agreed upon by the brothers. The Internal Revenue Service (IRS), however, disagreed. They argued that the life insurance proceeds used to redeem Michael’s shares should be included in the valuation, significantly increasing the estate’s tax burden.
Thomas countered with an independent appraisal valuing Crown at $3.86 million. Since Michael owned a majority share, this translated to a $3 million value for his portion. This valuation aimed to offset the life insurance proceeds by the buy-out obligation. The IRS rejected this approach, placing a higher value of $6.68 million on Crown (including the life insurance). This resulted in an additional $889,914 in estate taxes.
Thomas challenged the IRS assessment in court, but both the district court and the 8th Circuit Court of Appeals sided with the government. Determined, Thomas appealed to the Supreme Court, which ultimately agreed to hear the case and upheld the lower courts’ decisions.
Impacts to Estate and Succession Planning
The Supreme Court upheld that Crown’s contractual obligation to redeem Michael’s shares at fair market value did not offset the value of the life insurance proceeds committed to funding the redemption. The Court also stated that a corporation’s life insurance proceeds used to redeem a decedent’s shares must be included in any federal estate tax calculation, as the life insurance proceeds are considered an asset that would increase the company’s fair market value (and that the IRS may tax life insurance proceeds as a corporate asset, regardless of their use). This undoubtedly could impact succession plans of any corporation, particularly those with shareholder life insurance provisions and buy-sell agreements. Closely held corporations, much like Crown, are perhaps most impacted if they are using life insurance and redemption obligations to make sure ownership remains within the family upon the death of a shareholder, and also how to avoid additional federal estate tax.
Review Succession Plans That Include Life Insurance Policies
Moving forward, taxpayers and businesses owners should carefully review their succession plans with a qualified team of advisors, especially those that have life insurance policies in place to provide liquidity or for redemption agreements. As the Court noted, there are instances where redemption obligations can reduce the value of a business; thus, a team of qualified advisors is needed to also develop strategies to allow for life insurance or other mechanisms to be used to achieve a desired result. Closely held businesses, family-owned businesses and other small business owners should also consult their advisor to assess any additional estate tax obligations, reconsider the right structure for any buy-sell arrangements and make a proactive plan for determining fair market value. Such businesses could even consider the option of cross-purchase arrangements instead of redemption arrangements – even though these arrangements still increase the individual cost to owners, they can help avoid additional tax that would be imposed as a result of the Court’s decision.
Develop Personalized Tax Strategies
Windham Brannon’s Tax Practice can help you understand the specific needs of your tax situation as well as your succession and estate plans, helping you develop personalized strategies for your desired results. To understand how the Connelly v. United States ruling impacts your business, contact your Windham Brannon advisor today, or reach out to Doug Neal.
*This article was authored in conjunction with Roger Lang, Experienced Tax Associate.
