Connelly Vs. United States: Impact on Company-Owned Life Insurance Proceeds and Buy-Sell Agreements

Written by Ian C. Perry and Roman A. Basi | Published September 2024

On June 6, 2024, the Supreme Court released its much-anticipated decision in Connelly v. United States. The court sided with the IRS and held that life insurance proceeds a corporation received to fund a share redemption agreement increased the corporation’s estate tax value, and the corporation’s obligation to redeem the shares was not a liability that decreased the corporation’s value. With the statement being held true, the value of a deceased shareholder’s shares must reflect the corporation’s fair value, including insurance proceeds meant to fund a redemption of shares.

The Connellys, Michael and Thomas, were two brothers who were sole share-holders in Crown. They established a buy-sell agreement funded by a company-owned life insurance policy. The intention of the buy-sell agreement was to keep the corporation in the family. When either brother died, the surviving brother would have an option to purchase the deceased brother’s shares. If that option was declined, Crown would be obligated to purchase the shares, which Thomas Connelly did when his brother died in 2013. Per the buy-sell agreement, the corporation used the life insurance proceeds to redeem the shares.

Michael’s estate filed a federal tax return that listed the value of his estate at $3 million, the amount that Crown paid to redeem the shares. The IRS disagreed by saying that Crown’s redemption obligation did not include the life insurance proceeds. This went on to set Crown’s total value at $6.86 million based on the $3 million and a $3.86 valuation of crown based on the redemption amount paid and Michael’s ownership percentage (77 percent) in Crown. This made Michael’s value in Crown $5.3 million, resulting in an additional estate tax liability of $889,914.

The Connelly decision impacts shareholders who use corporate-owned life insurance to fund equity purchase and buy-sell agreements. This ruling by the Supreme Court resolved a split that was between the Tax Court and some Courts of Appeals. Business owners are going to have to consider the following:

• Reviewing Buy-Sell Agreements— Make sure agreements are structured in the most tax-efficient manner.

• Planning for Future Tax Obligations—Have a strategy to cover potential tax liabilities arising from corporate obligations or share redemptions.

• Cross-Purchase Agreements— These agreements can avoid complications by ensuring insurance proceeds go directly to purchasing shares without inflating estate tax values.

• Evaluating Life Insurance Policies—Review your life insurance policies to make sure they are structured to avoid unexpected tax liabilities.

• Seeking Professional Valuations—Obtain professional valuations to comply with current market values as well as tax regulations.

• Consulting Legal and Tax Experts— Obtain estate planning attorneys as well as tax advisors to review and update corporate structures and agreements to ensure they align with current regulations. This court case highlights how critical it is to have careful estate planning, understand potential tax implications of corporate agreements, and select the right insurance products. By reviewing and structuring your buy-sell agreements and life insurance policies, and consulting with professionals, you will be able to ensure a smooth ownership transition and minimize tax liabilities.

Ian C. Perry is a staff accountant for The Center for Financial, Legal & Tax Planning. Roman A. Basi is an expert on closely held enterprises. He is an attorney/cpa and the president of The Center for Financial, Legal & Tax Planning. At The Center for Financial, Legal & Tax Planning, Inc. (The Center), our M&A team is equipped with attorneys and CPAs to guarantee you are properly prepared for the exit of a business partner. If you need a buy-sell agreement prepared or would like your current buy-sell agreement reviewed, please feel free to reach out at our website, www.taxplanning.com, or by phone at 618-997-3436.