In a landmark decision, the U.S. Supreme Court has affirmed the Eighth Circuit Court of Appeal’s decision in Connelly v. United States, creating significant waves in the realm of buy-sell planning for business owners. The decision, delivered on June 6, 2024, upheld the inclusion of life insurance proceeds in corporate valuations, a decision that could alter the financial landscape for many business owners with taxable estates. Let’s dive into the case's facts, the court's decision, and the potential implications for business owners across the United States.
Case Overview
The Connelly case involved brothers Michael and Thomas Connelly, who were the sole shareholders of their family-owned corporation. To ensure a smooth transition and maintain corporate control upon the death of either brother, the corporation had purchased life insurance on each brother's life. The proceeds from these policies were intended to redeem the shares of the deceased brother, thereby allowing the surviving brother to retain full control of the business.
When Michael Connelly passed away, the IRS assessed additional taxes on his estate. The key point of the dispute was whether the life insurance proceeds, which were intended for a stock redemption, should be included in the corporation's fair market value for estate tax purposes. Michael's estate argued that these proceeds should not be included, while the IRS maintained that they should be, as they significantly increased the corporation’s value.
The District Court ruled in favor of the IRS, a decision that was subsequently upheld by the Eighth Circuit. The case finally reached the U.S. Supreme Court, which, in a unanimous 9-0 decision, sided with the IRS. Justice Clarence Thomas, delivering the majority opinion, stated that "a corporation's contractual obligation to redeem shares is not necessarily a liability that reduces a corporation's value for purposes of the federal estate tax." This decision resulted in an additional $889,914 in estate taxes for Michael Connelly's estate.
Challenges and the Path Forward
The Connelly decision creates several challenges and key steps moving forward to analyze how this affects business owners with redemption buy-sell agreements.
1. Increased Estate Tax Liability
Business owners with taxable estates must now consider the potential inclusion of entity owned life insurance proceeds in their estate valuations. If your estate is near or above the estate tax threshold, it's crucial to project your estate tax liability to understand the potential impact of the Connelly decision.
The inclusion of life insurance proceeds can significantly increase the taxable estate, leading to higher estate taxes and potentially putting a financial strain on the surviving owners or heirs.
2. Evolving Buy-Sell Agreements
The Connelly decision requires a thorough review of your existing buy-sell agreements. With the sunset of several provisions in the Tax Cuts and Jobs Act (TCJA) scheduled for January 1, 2026, now is the time to meet with legal or financial advisors and life insurance professionals to determine if updates to your agreement are needed.
For those with both a stock redemption buy-sell agreement and a taxable estate, alternative buy-sell structures like cross-purchase agreements might be more appropriate. However, if you are well below the exemption threshold, a stock redemption may still be a viable option.
3. Navigate Policy Transfers
It’s essential to avoid breaking the transfer-for-value (TFV) rule. Transferring existing policies out of a corporation to someone other than the insured, without an applicable exception, can result in death benefits becoming taxable income. Additionally, transferring policies out of a corporation could trigger other income tax consequences that need to be considered.
It’s especially important to keep in mind that the estate tax exemption will be significantly decreased when many of the provisions of the TCJA sunset. If you don’t use the excess estate tax exemption before January 1, 2026, you lose it.
4. Increase life insurance coverage
Another potential solution is to purchase more life insurance to cover the anticipated estate tax shortfall. Meeting with life insurance professionals can determine if this is the appropriate course of action.
The Connelly decision has introduced significant complexities into estate planning for business owners. To navigate this new landscape, review your buy-sell agreements with your financial and legal advisors and consult with the experts at NFP Insurance Solutions today. By working closely with an advisor team, you can explore strategies to mitigate these effects, protect your assets, and ensure a smooth transition of ownership. Take control of your financial future and safeguard your business from unexpected tax liabilities.
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