In a landmark decision on June 6, 2024, the Supreme Court affirmed the lower court’s decision upholding the IRS position on how life insurance proceeds and redemption obligations should be treated for federal estate tax purposes. The case, Connelly, As Executor of the Estate of Connelly v. United States, involved the valuation of a small, family-owned business and has significant implications for business owners nationwide.
Brothers Michael and Thomas Connelly were the shareholders in Crown C Supply Inc. (Crown), a closely held family business that sold roofing and siding materials. Michael owned approximately 77% of the company’s shares while Thomas owned approximately 23%.
The two brothers and Crown entered into a stock-purchase agreement. The brothers always intended that Crown, not the surviving brother, would redeem the other’s shares. To fund the redemption obligation, Crown purchased $3.5 million of life insurance on Michael and Thomas. Michael died in October 2013, and the company repurchased his shares, which constituted an approximately 77% ownership interest in the company, for $3 million. The rest of the life insurance ($500,000) went to fund company operations. Michael’s estate paid estate taxes on his share in the company at the $3 million value.
The buy-sell agreement further provided that the price to be paid for the deceased brother’s stock would be determined by a “certificate of agreed value” to be executed each year by the brothers. If they failed to do so (and in fact they never signed any such document at any point), the value of the stock would be determined by reference to at least two appraisals. When Michael died, the company received a $3.5 million death benefit. Without obtaining any appraisals, the company paid $3 million to Michael’s estate in redemption of his 77.18% stake in the company. The balance of the proceeds was used in the company’s business. Michael’s executor, Thomas, determined the value of Michael’s interest through an “amicable and expeditious” negotiation with Michael’s son, Michael Connelly, Jr.
On appeal to the Eighth Circuit, the estate advanced two alternative arguments. First, the estate claimed that the actual redemption pursuant to the buy-sell agreement established the value of Michael’s stock for federal estate tax purposes at $3 million. The estate’s alternate argument was that the value of Michael’s stock should not reflect the death benefit paid under the life policy because, while such proceeds are an asset of the company, the asset is offset by the corporation’s liability to redeem Michael’s shares. The Eighth Circuit affirmed summary judgment for the IRS.
Before the Supreme Court, the estate maintained the argument that the corporation’s obligation to redeem Michael’s shares offset the value of the death benefit received from the policy on Michael’s life. But the Supreme Court unanimously rejected that argument, affirming the Eighth Circuit’s holding.
The estate also argued that the insurance proceeds should be ignored when valuing the company because they would leave the company as soon as they arrived to complete the redemption. But the Court observed that this argument assumes that valuation should be based on what a willing buyer would pay for the shares after the redemption, when the relevant inquiry is the value at Michael’s death, which necessarily is before the redemption.
The Court ultimately affirmed that the proper estate tax value of Crown was significantly higher, and Michael’s shares were worth $5.294 million. As a result, Michael’s estate owed tax based on a $5.294 million valuation, despite only receiving $3 million in the buyout.
Is a Cross-Purchase Agreement the Better Option?
The agreement could have been structured as a cross-purchase agreement. In a cross-purchase agreement, each brother would have bought a life insurance policy on the life of the other to fund the purchase of the shares. That doesn’t completely eliminate potential tax exposure, though. For example, if Michael had purchased a policy on Thomas’s life, Michael’s gross estate would likely still include the value of that policy, although this amount would typically be less than the full death benefit. A cross-purchase structure may offer a step-up in basis for the purchasing shareholder, depending on the circumstances.
Alternatively, rather than individuals purchasing life insurance on each other, they could form a partnership to own the life insurance policies on each owner’s life.
Structuring Life Insurance for Buy-Sell Agreements: Planning Options
Business owners have several options when it comes to structuring ownership of life insurance in connection with buy-sell agreements. Each comes with its own pros, cons, and tax implications:
1. Avoid Company-Owned Life Insurance for Redemption Agreements
How it works: The company can still buy out a deceased shareholder, but it should consider self-funding or borrowing to pay the purchase price rather than using company-owned life insurance, which may increase the value of the company for estate tax purposes.
In some cases, a surviving shareholder who owns a policy on the deceased shareholder may use the proceeds to lend funds to the company or buy the shares directly.
2. Use a Cross-Purchase Agreement
How it works: Each shareholder (or sometimes an irrevocable trust) owns, and is the beneficiary of, life insurance policies on the other shareholders. The surviving shareholders use the death benefit to directly purchase the deceased shareholder’s interest.
This structure avoids having the insurance proceeds flow through the company, potentially limiting estate tax exposure.
3. Use an LLC to Own the Life Insurance Policies
How it works: A separate LLC owned by the shareholders is established solely to own life insurance policies and fund the purchase of shares. This approach simplifies ownership and avoids each shareholder having to maintain multiple policies.
However, in light of the Connelly decision, there may be uncertainty as to how the IRS will treat these LLC arrangements in the future.
4. Use a Promissory Note
If life insurance is not a feasible option—due to age, health, or other reasons—the buy-sell agreement can be funded using a promissory note. This allows ownership to transfer immediately, with payments spread over time. While flexible, this method does carry risk for the selling party and creates a long-term liability for the buyer.
Conclusion
The Connelly decision underscores the importance of thoughtful estate and business succession planning, particularly when it comes to life insurance-funded buyouts. Including life insurance proceeds in the company’s value can lead to higher estate tax bills than families might expect.
Clients are encouraged to review their existing buy-sell agreements and insurance arrangements with a qualified advisor. Small oversights in structure—like the ones in Connelly—can have significant financial consequences for surviving family members and business partners.
The views stated in this article are not necessarily the opinion of CWM, LLC. and should not be construed directly or indirectly as an offer of services. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed.
This article is strictly for information purposes and is not intended as an offer of solicitation for any transaction.
The information herein is not intended as legal, tax, or investment advice. For such advice, consult an attorney or tax professional. Investment advisory services offered through CWM, LLC, an SEC Registered Investment Advisor. Carson Partners, a division of CWM, LLC, is a nationwide partnership of advisors.
