In our last article, we discussed how buy-sell agreements help business owners maintain control over their ventures until they exit and ensure a smooth transition to the remaining owners, heirs, or a third party. We also highlighted that funding, often provided by life insurance policies, is the key to making these agreements work. Traditionally, life insurance proceeds have been excluded from taxable estates, making them an attractive option. But a recent Supreme Court ruling in Connelly v. United States could change that, potentially subjecting these proceeds to estate taxes. Here’s what you need to know.

The Connelly Brother’s Case

The Connelly v. United States case involved a family business owned by two brothers, Michael and Thomas Connelly. To ensure the continuity of their venture, the duo created a buy-sell agreement allowing one brother to either purchase the other's shares upon death or have the company buy the shares using life insurance proceeds. The company, therefore, took out life insurance policies on both siblings.

After Michael passed away, Thomas chose not to buy his brother’s shares. As a result, the business used $3 million from Michael’s life insurance policy to purchase his stock. As the executor of Michael’s estate, Thomas filed a federal estate tax return, including the value of Michael’s assets at the time of his death.

Thomas excluded the life insurance proceeds from the company’s valuation, relying on a previous court ruling that allowed life insurance proceeds used to buy back a deceased owner's shares to be exempt from estate taxes. However, during an audit, the IRS challenged this, arguing that the life insurance proceeds should be included in the company’s valuation for tax purposes. Thomas ended up paying the taxes but later sued the IRS for a refund.

The case eventually reached the Supreme Court, which ruled unanimously in favor of the IRS. The Court determined that life insurance proceeds used to buy a deceased owner's shares must be included in the company's valuation for estate taxation.

How the Supreme Court Ruling Affects Succession Planning for Business Owners

The Connelly v. United States ruling means that businesses using life insurance policies to buy back shares when an owner passes away may face higher estate taxes. As a result, entrepreneurs might need to rethink their succession planning strategies. One option is to consider more tax-efficient avenues options like cross-purchase agreements, where the individual business partners, rather than the business itself, own the life insurance policies. This approach could help mitigate the impact of the ruling and reduce potential tax burdens.

Conclusion

The Connelly Brothers case will change how business owners plan for succession, especially considering taxation. Companies taking out life insurance policies on their owners to fund their buy-sell agreement may not be as tax efficient as before, as the proceeds will now be considered part of the taxable estate. Join us next time as we discuss the importance of life insurance plans in business succession planning.

Are you wondering about any of the issues mentioned above? Please email us at info@wilkinsonlawllc.com or call (732) 410-7595 for assistance.

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