For closely-held businesses, buy-sell agreements have been used as a tool for business owners, providing a clear plan for the transfer of business interests upon certain triggering events, such as death, disability, or retirement. These agreements have been an essential tool to business succession planning. They ensure business continuity and provide a fair and predetermined process for valuation and purchase of the departing owner’s interest. However, the recent June 6, 2024 ruling in the Estate of Michael P. Connelly, Sr. v. United States has highlighted the need for business owners to review and potentially revise their buy-sell agreements to avoid unintended tax consequences.
The Supreme Court’s Decision
In layman’s terms, the Supreme Court ultimately decided that the value of life insurance proceeds received by a company upon the death of an owner increases the fair market value of the company. Previously, the industry understanding was that a company’s obligation to purchase or redeem the deceased owner’s interests would offset the value of the life insurance proceeds, but the Supreme Court has explicitly stated that is not the case. Further, the Supreme Court stated that this would make business succession planning slightly more complicated.
Key Lessons Learned for Buy-Sell Agreements and Business Succession Planning
- Importance of Accurate Valuation
The Connelly case underscores the necessity for buy-sell agreements to include clear and accurate methods for valuing business interests. The IRS scrutinizes valuations, and if a buy-sell agreement undervalues a business interest, the IRS may reject the valuation and impose a higher estate tax based on its determination of the Fair Market Value. - Potential for Estate Taxes Due to Improper Valuation
The Connelly decision effects all closely held businesses, including LLCs (limited liability companies), corporations, and partnerships. The addition of life insurance proceeds payable on death to the company could push the estate past the taxable exemption. If upon your death you have a taxable estate, you will likely face higher estate taxes due to the increase value of the company. Currently (as of 2024) the estate tax exemption is approximately $13 million for a single person and $26 million for a married couple, however, in 2026 the current law sunsets and we could see the taxable estate limit reduce to approximately $7 million. - Regular Updates and Review
Given the potential for changes in the business’s value and market conditions, your agreements should be reviewed and updated regularly. This ensures that the valuation methods remain appropriate and reflective of the true fair market value. Regular updates also help to prevent outdated valuations that could lead to challenges from the IRS, as seen in Connelly. - Coordination with Estate Planning
Along side your home or any real property, your interest in your business is one of your largest assets that you’ll leave to your beneficiaries, therefore, creating a businesses succession plan in isolation is not a great idea. Both your estate plan and your business succession plan should be integrated. This includes considering how life insurance policies are valued and reported for estate tax purposes. Connelly illustrated the complications that can arise when these elements are not carefully coordinated, leading to discrepancies in reporting values and increased tax liabilities.
Alternative Solutions
All hope is not lost as there are ways to keep life insurance proceeds out of the company’s valuation
- Cross-Purchase Agreements
The Court explicitly stated the use of cross-purchase agreements would cure the problems found in Connelly. Cross-purchase agreements are an arrangement where business partners/shareholders agree to purchase the other partner’s shares at death and purchase life-insurance policies on each other to fund the purchase agreement. The agreement allows for the surviving partner to purchase the deceased’s shares without being added to the company’s valuation because the life insurance proceeds go to the surviving partner instead of directly to the company. Of course there are downsides to this method as it requires the premiums to be paid by the individual which creates a risk that one of the partners would be unable to continue making payments. Also, it could have its own tax consequences on the individual. - Loans and Capital Contribution
Instead of using life insurance owned by the company and paid directly to the company to pay for the deceased shareholder’s shares, another method would be to provide capital contributions or loans to the company to assist in the purchase of the shares. - Irrevocable Life Insurance Trust (ILIT)
An irrevocable life insurance trust owns a life insurance policy and keeps the paid proceeds out of the deceased’s estate, therefore, it can reduce the taxable value and provide liquidity. Further, the ILIT is not added to the company’s valuation when set up properly.
Conclusion and Next Steps
Connelly serves as a vital reminder for business owners to carefully review their existing buy-sell agreements. Accurate valuation methods, regular updates, and alignment with broader estate planning strategies are essential to avoid potential disputes with the IRS and ensure the smooth transfer of business interests. By taking these steps, business owners can protect their legacy and ensure that their business continues to thrive beyond their tenure. It’s important to work with an experienced small business and estate planning attorney to ensure your plan works.