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Supreme Court Issues Ruling Affecting Valuation of Closely Held Corporations Employing Life-Insurance-Funded Redemption-Type Buy-Sell Agreements

Trusts & Estates

Improperly structured buy-sell agreements for closely held businesses will lead to an unexpected increase in the estate tax imposed on the estate of the deceased owner. The Supreme Court decision emphasizes the need for a review of the structure being used for buy-sell agreements involving closely held businesses, especially those utilizing life insurance. It is imperative, wherever possible to replace redemption-type buy-sell agreements with cross-purchase type buy-sell agreements.

The Supreme Court recently issued a decision in the case of Connelly v. United States[i], which addressed the issue of valuing shares of a corporation for the purpose of calculating the federal estate tax due upon the death of a shareholder. The shareholders in Connelly used a life-insurance-funded redemption type of buy-sell agreement. In this type of agreement, the corporation purchases life insurance on the lives of the shareholders. When a shareholder dies, the life insurance is used by the corporation to purchase (“redeem”) the shares of a deceased shareholder for the purchase price specified in the agreement. The amount of the purchase price, if any, in excess of the life insurance proceeds is paid in accordance with the payment terms set forth in the agreement usually over a period of time.

In contrast, in a cross-purchase type buy-sell agreement, the shareholders each own life insurance on the other shareholders. When one shareholder dies the surviving shareholders are obligated under the buy-sell agreement to buy the shares of the deceased shareholder.

In the Connelly case, a deceased shareholder’s shares in a closely held corporation were redeemed upon death for an amount equal to the life insurance proceeds received. The estate of the deceased shareholder reported the amount received as the value of the shares for estate tax purposes based on the value of the corporation without including the value death benefit needed to effectuate the redemption.

The Court ruled that in this type of redemption, the life insurance proceeds payable to the corporation for the purpose of purchasing the shares of the deceased shareholder increased the value of the corporation, and therefore increased the value of the deceased shareholder’s shares for estate tax purposes. The Court rejected the estate’s argument that the life insurance proceeds received by the Corporation were offset by the corresponding liability of the Corporation to redeem the deceased shareholder’s shares.

The Supreme Court’s decision also highlighted how the Internal Revenue Service may not need to respect the purchase price agreed upon under a buy-sell agreement, resulting in a different value for estate tax purposes and for redemption purposes. As a result of the Supreme Court’s reasoning, the deceased shareholder’s estate owed estate tax using a value of the corporation that included the value of the life insurance death benefit, but only received a redemption amount based on the agreed value in the buy-sell. The estate was unexpectedly forced to pay a 40 percent Federal estate tax on the proportionate share of the life insurance death benefit owned by the Corporation corresponding to the decedent’s ownership percentage, even though the estate was not able to use this inflated value to increase the redemption amount.

While it is always important to review existing buy-sell provisions among business owners on a regular basis, it is imperative that business owners with redemption-type buy-sell agreements take action as a result of the Connelly decision. Specifically, clients with redemption-type buy-sell agreements should, to the extent practicable, consider the following:

I. Establish a cross-purchase-type agreement.

As discussed above, in a cross-purchase arrangement, each shareholder owns life insurance on the lives of the other shareholders. When a shareholder dies, the remaining shareholders collect the life insurance proceeds and then use those proceeds to purchase the equity of the deceased shareholder. A cross-purchase arrangement avoids the issue in Connelly because the life insurance is not owned by the entity and therefore is not included in the valuation. In addition, the purchasers of the deceased owner’s equity enjoy a step-up in income tax basis to the purchase price, which is not obtained when stock value is increased as a result of the redemption of outstanding shares. Careful consideration must be taken in transferring existing entity-owned life insurance in place for redemption-type buy-sell purposes to the owners and whether this may trigger “transfer for value” issues under the Internal Revenue Code (“IRC”) that would eliminate the tax-free nature of the death benefit receipt (discussed further below).
 

II. Update life insurance structuring to address policy ownership.

If an entity has more than three owners, it can get cumbersome for each owner to own a life insurance policy on all of the other owners. This has been historically addressed by using a redemption-type buy-sell arrangement where the business can then obtain one policy on each owner to provide the necessary liquidity to redeem the shares of a deceased owner. However, in light of the Connelly decision, the business is no longer the appropriate entity to hold life insurance for buy-sell purposes.

Similarly, if a business already has a redemption-type buy-sell agreement in place, it may not be possible to convert the same policies to a cross-purchase agreement because (1) the entity likely only has one policy per each owner, when a cross-purchase would require each owner to have a separate policy on every other owner, (2) transfers of life insurance from corporations to shareholders would run afoul of the “transfer for value” rules of IRC 101(a)(2) causing the death benefit to be subject to income tax, and (3) starting over with new policies creates additional complication and expense.

Business owners can, however, hold life insurance in a specific purpose entity or trust designed to effectuate the collection of life insurance proceeds and then the distribution of those proceeds to the surviving members. The surviving members then use those proceeds to purchase the deceased owner’s shares, affording them all of the benefits of a cross-purchase type agreement.

Conclusion

It is important for closely held businesses and their owners to carefully consider the structure of the buy-sell agreements they employ and the potential tax consequences of such agreements. All redemption-type agreements should be reviewed in the wake of Connelly, or if you are not sure what type of buy-sell agreement you have in place, you should have it reviewed as soon as possible to determine whether it needs to be updated as well as to make sure it still meets the goals and objectives of the owners.

For additional information or to evaluate your business or individual succession plan, please contact a member of Blank Rome’s Private Client Trusts & Estates team.
 


[i] 602 U.S. ___ (June 6, 2024).

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© 2024 Blank Rome LLP. All rights reserved. Please contact Blank Rome for permission to reprint. Notice: The purpose of this update is to identify select developments that may be of interest to readers. The information contained herein is abridged and summarized from various sources, the accuracy and completeness of which cannot be assured. This update should not be construed as legal advice or opinion, and is not a substitute for the advice of counsel.