Business owners typically establish buy-sell agreements early in the life of the company to prepare for the eventual death of a partner. These common agreements include clauses that delineate how the surviving partner can buy out the shares of the deceased partner, providing business continuity. Since business owners typically have the majority of their wealth tied up in their businesses, they often use life insurance to create adequate liquidity to fund the purchase of shares from the deceased partner. Frequently, that life insurance is owned by the company. However, the recent Supreme Court decision in Connelly v. United States unveiled new implications for using company-owned life insurance to fund buy-sell agreements.
Smart Business spoke with Bethany Bryant, CPA, Regional Managing Director of Glenmede, about the importance of reviewing buy-sell agreements, life insurance ownership and personal estate plans in light of this decision.
What is the Supreme Court decision and how is company-owned life insurance affected?
Many business owners elect to use a redemption form of a buy-sell, which requires a company to purchase a deceased owner’s shares. To assist, they have the company purchase life insurance policies on its owners. When a partner dies, the death benefit is paid to the company and used to buy the deceased partner’s shares. This provides cash to the deceased’s estate and heirs, and increases the ownership percentage(s) of the surviving partner(s). This arrangement minimizes any interruptions to the business and essentially can eliminate a prolonged fight over control of the business.
The June 2024 Connelly case involved two brothers who owned a family business. They had a redemption form of buy-sell agreement, which was funded by life insurance owned by the business. When Michael Connelly died, the business used $3 million of the $3.5 million life insurance proceeds to redeem his shares. The value of his shares was based on the value of the business after netting out the $3 million obligation to buy the shares. The IRS disagreed, arguing that the entire $3.5 million of life insurance death benefit should be included in the company’s valuation with no offset. The Supreme Court agreed with the IRS, causing a shortfall to the estate and an increase in the estate tax owed by almost $1 million.
How does this affect the surviving partner’s ability to buy the shares of a deceased partner?
A very large death benefit may increase the IRS value of the company’s shares by millions of dollars. It could make an estate large enough to trigger an estate tax or increase the value of the deceased owner’s estate, raising the estate tax. Increased estate tax liability could also make it more difficult for families to keep businesses intact across generations, possibly forcing unanticipated sales to outside parties. And lastly, life insurance intended to provide liquidity for buying a deceased partner’s shares could become insufficient. Imagine two equal business partners in a company worth $1 million have a company-owned $500,000 life insurance policy. When one dies, the company value increases to $1.5 million, and the deceased’s share is now worth $750,000, which is $250,000 above and beyond the insurance.
Life insurance can still be a convenient way to solve the liquidity problem partners encounter when buying out a deceased partner. But since the Connelly decision, it can add unintended consequences to business valuations and tax liabilities. To minimize this risk, partners need to review their buy-sell agreements as well as their life insurance to determine the best way to structure both.
Business partners should work with their trusted legal, wealth and insurance advisers to review their buy-sell agreements and personal estate plans regularly — especially those funded with life insurance — to understand how the Connelly decision might affect their business valuation and tax situation, and to establish the best course for the business continuity in the event of an unforeseen death among shareholders. ●
INSIGHTS Wealth Management is brought to you by Glenmede.
This article presents general information and is not intended to be financial, investment, tax, legal or other advice. It contains information and opinions which may change after publication. Views expressed herein do not necessarily reflect the views of the author’s employer. No outcome, including performance or tax consequences, is guaranteed, due to various risks and uncertainties. Readers should consult with their own financial, tax, legal or other advisors to seek advice on their individual circumstances.
