/>iOwners of closely held businesses take note: A recent U.S. Supreme Court decision might impact estate tax strategies related to buy-sell agreements and life insurance proceeds. Now is a good time to review your buy-sell agreements in an effort to avoid a potential increase in estate tax.
Background
It is often desirable to have an agreement requiring a decedent’s estate to sell the decedent’s ownership interest in a company upon death and requiring the other shareholders of the company to buy such interest. There are many ways to structure these agreements. One method is to impose an obligation on the company to redeem the decedent’s shares. To minimize the economic burden, the company frequently obtains insurance on the shareholders’ lives to be used to fund the redemption obligation.
Connelly v. United States
The U.S. Supreme Court issued a decision on June 6, 2024 affirming a recent Eighth Circuit decision and reversing prior court holdings. The decision will have a significant adverse effect on the estate tax valuation of a decedent’s interest in a closely held business that is subject to a corporate redemption agreement on death funded by life insurance (Connelly v. United States, 602 U.S. ___ (2024)).
When insurance proceeds on a decedent’s life owned by a corporation are used to fund a corporate redemption obligation upon a shareholder’s death, courts had previously ruled that the redemption obligation offset the insurance proceeds received by the company. Effectively, the value of the decedent’s shares for estate tax purposes was reduced.
This U.S. Supreme Court reversed the prior court holdings and held that when valuing a company upon a decedent’s death for estate tax purposes, life insurance proceeds received by the company increase the date of death value of the company by the amount of the insurance proceeds received, and that there is no offsetting liability for the redemption liability. Effectively, the value of the decedent’s shares for estate tax purposes is increased, and the value received by the decedent’s estate per the agreement may be less than its fair market value for estate tax purposes.
This is a significant reversal on how life insurance used for a corporate redemption is treated for estate tax purposes. Because of the potential significant increase in estate tax that can then be due – which may not have been anticipated when the agreement was structured – it is recommended that any such agreements be reviewed.
Alternative Structures
There are alternative structures that can be used to achieve buyout objectives of both a decedent’s estate and the company that could avoid the Connelly result. One such alternative would be to structure the agreement as a shareholder cross-purchase agreement rather than a corporate redemption. Any life insurance to be used to fund the shareholder purchase obligations would then be structured with the shareholders owning the insurance rather than the company owning such policies. While the shareholders would then be responsible for paying the premiums and maintaining the policy(ies), as the company would not own the life insurance, the proceeds would not be included in the company value for estate tax purposes. As always, any change in strategy should be carefully evaluated and consider the tax, structural, and other practical ramifications.
