A Big Change in Estate Planning and Business Valuation
The recent Supreme Court case Connelly v. United States (2024) made an important ruling that affects business owners who use life insurance to fund buy-sell agreements. The Court unanimously agreed with the IRS that when a company receives life insurance proceeds to buy out a deceased owner’s shares, those proceeds must be included in the company’s value for estate tax purposes. This decision may significantly impact how businesses handle succession planning and taxes.
What is a Buy-Sell Agreement?
A buy-sell agreement is a legally binding contract that determines what happens to a business owner’s share of the company if they pass away, become disabled, or leave the business. These agreements help ensure a smooth transition of ownership and often prevent disputes among remaining owners and the deceased owner’s family.
One common way to fund a buy-sell agreement is through life insurance. Each business owner is insured, and if one owner dies, the proceeds from the insurance policy are used to buy their shares from their estate. This arrangement provides liquidity to the business and helps prevent the need for sudden asset sales to cover the cost of the buyout.
Why This Matters
Before Connelly, many business owners assumed that life insurance proceeds used to buy out a deceased owner’s shares wouldn’t increase the company’s taxable value. However, the ruling confirms that the insurance payout does count toward the company’s value, which could increase estate taxes owed by the deceased owner’s estate.
This means that, instead of just counting the company’s market value, the IRS now requires estates to include life insurance proceeds that the business receives in its valuation. For business owners, this could mean a significantly higher taxable estate value.
An Example to Illustrate the Impact
Imagine John and Tom each own 50% of Widget, Inc., a company worth $4 million. The company has a $2 million life insurance policy on both owners.
- Before Connelly: If one owner passed away, the deceased owner’s estate would report a 50% share of the company’s $4 million value—meaning a $2 million valuation.
- After Connelly: The estate must now include the life insurance proceeds, increasing the company’s total value to $6 million. The deceased owner’s estate must now report their 50% share of $6 million, or $3 million, which could result in higher estate taxes.
What Business Owners Should Do Now
If you have a buy-sell agreement funded by company-owned life insurance, it’s time to review your estate plan. Here are some strategies to consider:
- Sinking Fund (Cash Reserves): Setting aside money for a future buyout instead of relying on insurance. However, this may still lead to the same valuation issue as in Connelly.
- Seller Financing: The company or remaining owners could purchase the deceased owner’s shares over time using promissory notes instead of life insurance.
- Cross-Purchase Buy-Sell Agreements: Instead of the company owning the insurance policies, each owner buys life insurance on the other. This way, proceeds go directly to the surviving owner rather than increasing the company’s value.
- Irrevocable Life Insurance Trust (ILIT): This trust holds life insurance policies outside of the taxable estate, providing liquidity to cover estate taxes without increasing company value.
- Special Purpose Life Insurance LLC (Use Caution!): Some businesses consider transferring life insurance policies into a separate LLC. However, the IRS may scrutinize this approach, so expert guidance is essential.
The Bottom Line
The Connelly decision is a wake-up call for business owners who use life insurance in their succession planning. If you rely on company-owned life insurance to fund buyouts, now is the time to reevaluate your strategy to minimize tax burdens and protect your heirs.
Need Assistance?
We’re here to help you navigate these complex issues. Contact Steven Nofar, Esq., CPA at steve@spartanwealth.com or at 248-297-6600.
