In the recent case, Connelly v. United States, 602 U.S. (2024) (slip op.) the U.S. Supreme Court unanimously ruled that life insurance proceeds received by a closely held corporation which is used to fund the redemption of a deceased shareholder’s stock should be taken into account when determining the value of a deceased owner's stock for estate tax purposes. The case also is significant to other forms of business entities including limited liability companies.
BUY-SELL AGREEMENTS FOR SMALL BUSINESS OWNERS
Small businesses use Buy-Sell agreements to prevent conflicts when an owner leaves. Triggering events like death, divorce, or disability lead to the sale of shares of the exiting owner at an agreed-upon price.
There are two types of agreements used to purchase an exiting shareholder’s interest: Cross-Purchase Agreements and Redemption Agreements. Cross-Purchase Agreements involve shareholders being personally obligated to purchase the exiting shareholder’s shares, while Redemption Agreements involve the corporation redeeming the exiting shareholder's shares. In many instances, the purchase of a deceased shareholder’s shares is funded with insurance on the deceased shareholder’s life.
It was commonly believed that both of these agreements are treated the same for estate tax purposes. However, this no longer appears to be the case following the recent Connelly decision handed down by the U.S. Supreme Court last month.
In Connelly, two brothers, Michael and Thomas, each owned 50% of a closely-held family business, a Roofing Company. There was a shareholders’ agreement in place to provide for the purchase of shares if either shareholder died. Under that agreement, the surviving brother would have the option to purchase the deceased brother’s shares. If he declined, the company itself would be required to redeem (i.e., purchase) the shares.
The purchase price for a deceased shareholder’s shares was to be fair market value which the brothers agreed was $3 million. To ensure that the corporation would have enough money to redeem the shares if required, it obtained $3.5 million in life insurance on each brother.
After Michael's passing in 2013, Thomas, his surviving brother, chose not to purchase Michael's shares. Instead, the company used $3 million from the life insurance proceeds to buy out Michael's shares. Michael's estate did not include this amount in the company's valuation for estate tax purposes. The IRS disputed this, leading to the Supreme Court considering whether the $3 million from the life insurance should be included in the company's valuation.
The Court held that the proceeds of $3 million in life insurance should have been included in the business' valuation for purposes of reporting the value of the stock for estate tax purposes. In other words, the Supreme Court unanimously decided that the proceeds from the life insurance policy used to buy out the deceased owner's share of the business were not offset by the redemption obligation. In effect, the Court found that the deceased brother made a post mortem gift to the surviving brother equal to 50% of the insurance proceeds used to fund the redemption.
THE WAY YOU STRUCTURE THESE AGREEMENTS CAN AFFECT YOUR ESTATE'S VALUE AND ITS IMPACT ON YOUR HEIRS
The tax issue in Connelly could have been avoided if the brothers had used a cross-purchase agreement instead of a redemption agreement. In a cross-purchase agreement, the insurance is paid to the surviving shareholder, and the proceeds are not included in the corporation's value for estate tax purposes. The holding of the case therefore has significant ramifications for taxpayers with significant estates subject to federal estate tax (currently $13.86 million).
The Connelly case is especially significant for New Jersey Inheritance Tax purposes. New Jersey imposes an inheritance tax on transfers made to beneficiaries other than a surviving spouse, parent, or lineal descendants (“Class A Beneficiaries”) for amounts exceeding $500. Based on the Supreme Court’s holding in Connelly, a New Jersey Inheritance Tax could be triggered whenever there is a redemption agreement funded with life insurance in a business owned by shareholders other than Class A beneficiaries.
WHAT DOES THIS MEAN FOR YOU?
Businesses, especially closely held entities like the brothers' roofing company, need to consider the tax implications of their buy-sell agreements and recognize that the death buy-out terms under the agreement are particularly important. It's crucial to understand how life insurance proceeds, used for share redemptions, are treated for estate tax purposes. If your company has a redemption agreement funded by life insurance, it is essential to review the agreement and consider making changes to avoid unintended results or additional tax issues. This not only applies to corporations, but also to limited liability companies and to partnerships.
If you would like further details or would like to discuss your business’ structure and its tax implications, please contact the author, Ken Cohen.
The author thanks Bressler Summer Law Clerk, Adam Auerbach, for his contributions to this article.