Lessons from the Connelly case on buy-sell agreements

On June 6, the U.S. Supreme Court directly addressed the topic of life insurance in the case of Connelly v. United States.  The court does not commonly issue decisions in the life insurance space and Connelly is notable in that it deals with the broadly popular business transition strategy of entity stock purchase agreements. The Connelly decision may generate questions from clients and their tax and legal teams.

Understanding entity purchase stock redemption buy-sell agreements

First, a quick overview of the arrangement addressed in Connelly. Entity purchase stock redemption buy-sell agreements often rely on life insurance policies to provide the instant liquidity necessary to purchase the shares of a recently deceased business owner. This type of arrangement has a specific structure. The business acts as the policyowner, premium payer and beneficiary of a policy on each of the business owners according to their respective ownership percentages.

As the beneficiary, upon the death of a business owner, the life insurance proceeds are paid to the business. The terms of the buy-sell agreement require the business to pay these proceeds to the decedent's estate in exchange for the decedent’s ownership interest (shares) in the business. This leaves the remaining owners with an increased share of the business and the decedent's family with the policy proceeds representing the value of the shares redeemed. While the Supreme Court’s ruling does not reject the validity of this arrangement, it does address and clarify its tax implications.

Prior to Connelly, this type of exchange was broadly viewed and treated as a “wash,” with life insurance proceeds never seen as additive to the value of the business for estate tax purposes. The value of an estate for tax purposes includes all a taxpayer’s assets at death, including their respective ownership interest in a business.

The Connelly case addresses the traditional treatment of these proceeds

In this case, one of the Connelly brothers (Michael) held around 75% of the business’ shares and the other brother (Thomas) owned 25%. All parties agreed the business was worth approximately $4 million prior to Michael’s subsequent death. The active buy-sell agreement at the time of Michael’s death required the business to purchase shares of a deceased owner if the surviving shareholder opted not to purchase the decedent’s shares.

The business held a $3.5 million policy on Michael so it could meet its obligation to purchase shares in the event of Michael’s death. Upon his death, per the agreement, $3 million of the proceeds were exchanged by the business in return for the shares held by Michael. The estate took the stance that the value of Michael’s ownership interest in the business for estate tax purposes was $3 million ($4 million x his 75% interest at death).

IRS interpretation significantly raised the estate tax value

The IRS took a different stance. In their view, Michael’s shares would instead be worth around $5.2 million. This was calculated as follows:

1. $4 million original value plus $3 million of proceeds = $7 million.
2. 75% of $7 million = $5.2 million estate tax value.

This increased the estate tax liability by $889,000!

The questions before the court were:

• Does receiving the life insurance proceeds make the business more valuable (because the money remains within the business)?
• Or do the proceeds leave the business’ value unchanged (because they are immediately used to redeem the shares of the deceased shareholder)?

The court held that the policy proceeds were additive rather than merely transitive. As such, the estate tax value of Michael’s interest resulted in the increased tax assessment.

The importance of clear buy-sell agreements: Lessons from the Connelly case

The facts in Connelly probably didn’t help the credibility of the parties involved. We’ve heard the maxim, “Bad facts make bad law.” The original buy-sell agreement failed to have a determinate buy-out price, thus the value of the business for estate tax purposes was never established. In addition, the price of the eventual buyout appeared inconsistent with the terms of the agreement.

Could the court have ruled differently had the brothers presented “better facts”? It’s reasonable to speculate it could have. With that said, it’s more important than ever to work with your clients' legal and tax advisors to ensure the structure of the buy-sell agreement is aligned with the intentions of the parties. In the case of Connelly, this misalignment and the court’s holding resulted in an $889,000 increase to the tax bill of Michael Connelly’s estate.

Strategies for structuring buy-sell agreements to minimize potential estate tax liabilities

1. Review entity buy-sell agreements

Work with tax, legal and valuation advisors to verify buy-sell agreements are structured with all tax implications in mind. The structure of these agreements can significantly affect estate tax liabilities. As mentioned earlier, negative estate tax impacts may have been avoided if the agreement had been drafted and implemented appropriately.

2. Consider cross-purchase agreements
   This type of agreement should be considered when two shareholders exist. The owners can purchase insurance on one another. Potential adverse estate tax complications may be avoided as the insurance proceeds will go directly to purchase the surviving owner’s shares without inflating estate tax values.

Andrew Rinn is associate vice president of advanced markets at Sammons Financial Group. Contact him at [email protected].

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Andrew Rinn, JD, CFP, CLU, ChFC, is assistant vice president of advanced sales strategy at Sammons Financial Group. He has been a NAIFA member since 2018, and he is president-elect of the Society of Financial Service Professionals. Contact him at [email protected].