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Navigating the Connelly Decision: Buy-Sell Agreements Funded with Life Insurance

In business succession planning, buy-sell agreements funded with life insurance have long been a cornerstone strategy. These agreements provide a mechanism to ensure business continuity in the event of an owner's death, offering financial stability to the remaining partners and the deceased owner's family. However, the recent Supreme Court decision in Connelly vs. United States has introduced significant changes that business owners must carefully consider. This blog explores the implications of the Connelly ruling, provides strategic insights, and offers guidance on how businesses can adapt to these new legal landscapes.


Understanding the Connelly Decision


On June 6, 2024, the United States Supreme Court issued a unanimous opinion in the Connelly vs. United States case involving two brothers, Michael and Thomas Connelly, who owned a building supply company. The Court ruled that the proceeds from a life insurance policy purchased by a business to fund the buyout of a deceased brother must be included in the value of the business stock redeemed. This decision means that the value of such interests must now be included for federal estate tax purposes, potentially resulting in significantly higher estate tax liabilities for the decedent's estate.


The Traditional View vs. The Connelly Decision


Before the Connelly decision, it was commonly believed that the insurance proceeds used to redeem a deceased owner's shares under a buy-sell agreement would not be included in the business's value for estate tax purposes. The reasoning was that the company's obligation to redeem the deceased owner's share with the insurance proceeds constituted a liability that offset the insurance value. However, the Supreme Court rejected this reasoning, ruling that a corporation's contractual obligation to redeem shares does not reduce the company's value for federal estate tax purposes​.


Implications for Business Owners


The Connelly decision has far-reaching implications for business owners who rely on buy-sell agreements funded with life insurance. For instance, if a business worth $30 million has two owners, each owning a 50% interest, traditionally, each owner's shares would be valued at $15 million. The company would purchase life insurance for each owner for $15 million to fund the buyout. Under the Connelly decision, the decedent's stock would now be valued at $22.5 million, including the $15 million in life insurance proceeds. This could result in an additional estate tax liability of $3 million​.


Strategic Planning Post-Connelly


Given the potential tax implications of the Connelly decision, business owners must reassess their current buy-sell agreements and consider alternative strategies to mitigate estate tax liabilities. Here are some recommendations:


1. Review Existing Buy-Sell Agreements


Business owners should review their current buy-sell agreements to determine whether the Connelly decision applies. This review should include a detailed examination of the terms and the structure of the agreement.


2. Consider Cross-Purchase Agreements


Where feasible, structuring buy-sell agreements as cross-purchase agreements can avoid the inclusion of life insurance proceeds in the company's value under the Connelly ruling. In a cross-purchase agreement, the other individual owners have the right to purchase the deceased owner's stock. This provides an income tax advantage as the buyers' income tax basis in their interests increases by the amount they pay the seller.


3. Address Multiple Ownership Challenges


For businesses with multiple owners, a conventional cross-purchase agreement funded with life insurance can become unwieldy because each owner needs to own a policy on every other owner. To streamline this process, consider using a standalone partnership or limited liability company (LLC) taxed as a partnership to buy and hold the life insurance policies. This structure allows the partnership or LLC to distribute the proceeds to the owners to fund their buyout obligations.


4. Be Cautious with Policy Transfers


If shifting from a redemption buy-sell structure to a cross-purchase structure, business owners must be cautious about transferring ownership of the policies out of the company. Usually, life insurance death benefits are not subject to income tax, but this exemption does not apply to policies transferred for value to a new owner. Exceptions to this transfer-for-value rule include transferring a policy to a partnership in which the insured is a partner or to a partner of the insured. Utilizing a partnership for these transfers can help avoid unintended tax consequences.


5. Reevaluate Life Insurance Coverage


The Connelly decision presents an opportunity to reexamine other elements of the company's buy-sell agreement. Key considerations include whether the current life insurance coverage is sufficient given the company's growth, the expiration dates of term policies, and the age and retirement plans of the owners. Ensuring that the life insurance policies and buy-sell agreements are aligned with the company's current valuation and succession plans is crucial.


Conclusion


The Supreme Court's ruling in Connelly vs. United States necessitates a careful review and potential restructuring of buy-sell agreements funded with life insurance. By understanding the implications of this decision and taking proactive steps to adapt, business owners can protect their interests and ensure a smoother transition in the event of an owner's death. For personalized advice and to explore the best path forward, business owners should consult their financial and legal advisors to align their buy-sell agreements with their business and personal goals.


 

For further guidance and expert assistance, contact DPH Financial Services. Our team is committed to helping you navigate the complexities of business succession planning and ensure your business's continuity and stability.


Sources: Buy-Sell Agreements Funded with Life Insurance Whitepaper, Truist IHA, June 2024​

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