Financial Planner Corner: Supreme Court Decision Impacts Business Owners

Jarrett E. Hindrew, CFP®, ChFC®, CLU®
Financial Advisor, Creative Financial Group

Business owners, particularly those with closely held businesses who may have a taxable estate, should revisit their buy-sell agreements post the recent Connelly v. United States Supreme Court ruling. The decision mandates that the valuation of stock in closely held companies within a deceased shareholder's estate must include the value of life insurance proceeds obtained by the company on the shareholder's life. This valuation is crucial for federal estate tax purposes, regardless of the company's obligation to use the life insurance for redeeming the deceased shareholder's interest. It's essential to reassess buy-sell agreements to align with these legal changes.

Case Overview:

In Connelly v. United States, Michael and Thomas Connelly were Crown C Supply's sole shareholders, a building supply corporation. Following Michael's death, Thomas, the surviving brother, opted not to purchase Michael's shares, triggering Crown's obligation to redeem them per their buy-sell agreement. Thomas had a valuation that was submitted to the IRS that excluded the life insurance proceeds received by Crown that were then used to purchase Michael’s shares from his estate. The Internal Revenue Service (IRS) disputed the valuation, arguing that the life insurance proceeds didn't offset the redemption obligation, leading to a tax deficiency. The courts upheld the IRS' position, requiring the estate to pay additional taxes.

Key Takeaways and Tips:

If estate taxes are not a concern, then an entity-redemption agreement can still be a viable option. However, the ruling poses challenges for businesses that rely on entity-owned life insurance to fund their buy-sell agreements for succession planning. The facts and circumstances of each business entity and its shareholders must be considered when determining the appropriate type of buy-sell agreement. Key considerations and tips include:

Review Existing Agreements:

• Is there a clear method to value the business?
• Is the purchase an obligation of the business entity?
• Is the obligation funded with life insurance?
• Consider Alternative Structures: Explore alternative agreement structures and life insurance ownership models with tax implications in mind.
  • Cross-Purchase Agreement: Shareholders own life insurance policies on each other to buy out deceased shareholders' interests. Note that should permanent insurance be used as a funding vehicle, the cash values are subject to creditors of the individual shareholder.
  
  
  • Buy-Sell Using Trust or Escrow Agent: Life insurance is managed by a trust or escrow agent for distributing shares post a shareholder's demise.
  
  
  • Special Purpose/Insurance LLC: An LLC owned by shareholders can manage life insurance policies and distribute proceeds upon a shareholder's death for share. Under this approach, the business owners would still execute a cross-purchase agreement but would form an LLC to own a life insurance policy on the life of each owner(s). Using an LLC to own and administer the insurance policies can combine the benefits of redemption and cross-purchase agreements.