Supreme Court’s Connelly decision could impact buy-sell agreements

A recent Supreme Court decision could have a major impact on the structuring of buy-sell agreements for closely held companies and the way life insurance is used to fund such arrangements.

This week, the high court handed down its decision in Connelly v. U.S., a case which questioned whether the proceeds of a life insurance policy taken out by a closely held company on a shareholder constitutes an asset of the company when calculating the value of the shareholder’s shares for purposes of the federal estate tax.

The court ruled unanimously that "a corporation’s contractual obligation to redeem shares is not necessarily a liability that reduces a corporation’s value for purposes of the federal estate tax." This means that the proceeds the company received from the policy increased the fair market value of the company because the cash received is considered an asset of the company. The parties were not able to offset that asset with the liability related to the repurchase obligation.

Connelly decision background

Michael and Thomas Connelly were brothers and the sole shareholders in a family business that sold roofing and siding materials called Crown C Supply in St. Louis, Mo. In 2001, the brothers and Crown made an agreement that gave the surviving brother the right to buy the deceased brother’s shares. If the surviving brother declined, Crown would be required to regain those shares.

Crown bought $3.5 million in life insurance policies for each brother. The Connelly brothers always intended for Crown to regain the shares of the brother who died first. In 2013, Michael Connelly died, and Crown received $3.5 million in life insurance funds.

At the time of his death, Michael owned about 77% of Crown’s stock, and Thomas owned about 23%. After negotiating with Thomas and Michael’s son, Crown purchased Michael’s estate for $3 million. Crown then used the remaining $500,000 to fund its general operating expenses.

Thomas Connelly filed an estate tax return on behalf of Michael’s estate, valuing the estate’s Crown shares at $3 million. After auditing the estate, the IRS issued a notice of deficiency. Although they determined that Michael’s shares were worth $2,982,000, they concluded that the $3 million in life insurance proceeds should have been included as an additional non-operating asset, increasing the value of Crown shares by almost 80%. Therefore, the IRS valued the estate’s shares at about $5.3 million instead of $3 million.

Thomas Connelly filed a suit against the IRS on behalf of Michael’s estate in the United States District Court for the Eastern District of Missouri, seeking a refund of more than $1 million in estate tax. The district court ruled in the IRS’s favor, and the United States Court of Appeals for the Eighth Circuit affirmed the decision. The Supreme Court upheld the appeals court’s decision as well.

How it could have been avoided

Jay Judas of Life Insurance Strategies Group said the court noted that the parties could have avoided this increase to the fair market value of the company via a so-called cross-purchase buy-sell. In this structure, it is the shareholders who have the obligation to purchase the shares of the deceased and each shareholder must obtain a policy on the other shareholder(s) to fund that purchase.

The court, in its opinion, said this structure has other drawbacks compared to an entity-redemption arrangement.

• Each shareholder, rather than the company, pays the premiums.
• There may be tax consequences for the shareholders.

The parties must ensure that the other shareholders will continue to pay the premiums and not let policies lapse so that their heirs will be able to receive payment for the shares.

What business owners should do

Judas advised that the owner of a closely held business with a buy-sell agreement in place should reach out to their team of advisors to review the arrangement and its funding mechanism. This way, the owner will know if any changes are required and be able to implement them before issues arise. This is especially true in light of the likely sunsetting of the current federal estate and gift tax exemption amounts.

“If you are an advisor who works with clients who have these sorts of arrangements, you should reach out proactively to alert them to the news, answer questions and guide them through any necessary changes,” he said.

Susan Rupe is managing editor for InsuranceNewsNet. She formerly served as communications director for an insurance agents' association and was an award-winning newspaper reporter and editor. Contact her at [email protected]. Follow her on Twitter @INNsusan.

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Susan Rupe is managing editor for InsuranceNewsNet. She formerly served as communications director for an insurance agents' association and was an award-winning newspaper reporter and editor. Contact her at [email protected].