A recent court decision has sent ripples through the world of business succession planning. The Eighth Circuit's ruling in Connelly v. United States raises significant concerns for business owners who rely on buy-sell agreements to fund succession plans with life insurance proceeds. This case is a wake-up call for closely held businesses, particularly those structured as corporations, to reexamine their planning strategies.

Background: The Connelly Case

The case revolved around two brothers who were the sole shareholders of a corporation. They had a buy-sell agreement in place, funded by a life insurance policy on each other. When one brother passed away, the corporation used the life insurance proceeds to redeem his shares. However, the IRS took the position that the life insurance proceeds should be included in the valuation of the company for estate tax purposes, significantly increasing the estate tax liability.

The Eighth Circuit upheld the IRS's position, finding that the buy-sell agreement did not fix the value of the company for estate tax purposes and that the insurance proceeds increased the company's value. This decision complicates the use of corporate-owned life insurance in buy-sell agreements and could lead to higher estate tax exposure for business owners.

Key Takeaways for Business Owners

1. Corporate-Owned Life Insurance Can Inflate Estate Tax Valuations

   • The ruling clarifies that life insurance proceeds held by a corporation can increase the company's valuation for estate tax purposes, creating a larger tax burden on the deceased owner's estate.

2. Buy-Sell Agreements May Not Control Valuation for Tax Purposes

   • Many business owners assume that a properly structured buy-sell agreement establishes the value of a business for estate tax calculations. Connelly shows that the IRS may not respect these agreements if they do not meet stringent requirements.
     
     

3. Alternative Structuring May Be Necessary

   • Owners may need to consider alternative structures, such as cross-purchase agreements or the use of irrevocable life insurance trusts (ILITs), to keep life insurance proceeds outside the corporate balance sheet.

Cross-Purchase vs. Entity-Purchase Buy-Sell Agreements

Business owners have two primary ways to structure buy-sell agreements: cross-purchase and entity-purchase (redemption) agreements. Each has distinct implications for tax treatment and business continuity.

• Cross-Purchase Agreements: In a cross-purchase agreement, each owner buys a life insurance policy on the other owners. When an owner dies, the surviving owners use the insurance proceeds to purchase the deceased owner's shares directly. This structure keeps the life insurance proceeds out of the company's valuation, potentially avoiding the issue raised in Connelly.

  • Pros: Avoids increasing corporate valuation, potential for a step-up in basis for surviving owners.
  • Cons: Requires multiple policies in multi-owner businesses, can be administratively complex.
    
    

• Entity-Purchase (Redemption) Agreements: In an entity-purchase agreement, the business itself buys life insurance policies on each owner. When an owner dies, the company uses the proceeds to redeem the deceased owner's shares. This was the structure in Connelly, which led to the IRS increasing the company's valuation and estate tax liability.

  • Pros: Simplifies administration, business retains control of transaction.
  • Cons: May increase corporate valuation for estate tax purposes, as seen in Connelly.

Given the Connelly ruling, business owners should strongly consider whether a cross-purchase structure or another alternative better aligns with their estate and succession planning goals.

What Should Business Owners Do Now?

• Review Existing Buy-Sell Agreements: Business owners should work with their legal and tax advisors to ensure that their agreements are structured in a way that minimizes estate tax exposure.
• Consider Cross-Purchase Agreements: Unlike redemption agreements, cross-purchase agreements keep life insurance proceeds out of the business's valuation.
• Explore the Use of ILITs: These trusts can own life insurance policies without increasing the taxable estate or company value.
• Stay Informed on Potential IRS Challenges: The IRS may continue scrutinizing these arrangements, so proactive planning is essential.

Final Thoughts

The Connelly decision is a stark reminder that estate and business succession planning must be regularly reviewed and adjusted in light of evolving tax law interpretations. Business owners relying on corporate-owned life insurance should take this opportunity to revisit their buy-sell agreements and consider alternatives to avoid unexpected tax liabilities.

If you own a business and have concerns about how this decision might impact your succession planning. Thoughtful planning today can help protect your business and legacy for the future.