Business owners: Check your buy-sell agreement
This article will ...
Detail the change in business tax treatment due to a recent Supreme Court decision.
Note the details of the case and how it changes business valuation in a buy-sell agreement.
Answer some basic questions about the decision’s immediate effect.
Have a buy-sell agreement for your business? Does it include life insurance? You should probably review it with your attorney and financial professional.
That’s because the Supreme Court recently ruled that life insurance proceeds received by a corporation to cover the repurchase of the deceased shareholder’s stock interest must be included in the value of the corporation for federal estate tax purposes. Those proceeds are not offset by the corporation’s obligation to repurchase the deceased shareholder’s stock.
Previously a corporation’s obligation to redeem a deceased shareholder’s interest effectively offset any increase in value to the corporation from the receipt of life insurance death benefits or the insurance proceeds weren’t included in the corporation’s value. That’s no longer the case.
Note that this ruling only applies to entity purchase, stock redemption agreements — not cross-purchase agreements.
The Connelly case
This new tax treatment for a business is the result of a case involving two brothers, Michael and Thomas Connelly, who were co-owners of a building supply firm. The brothers had a buy-sell agreement, which allowed the surviving brother to buy the deceased brother's shares. If the surviving brother declined, the business itself was required to redeem the shares using life insurance proceeds.
Michael died triggering the company’s obligation in the buy-sell agreement to redeem Michael’s shares using $3 million in life insurance proceeds. The estate reported the shares' value at $3 million. However, the IRS valued the shares at $5.3 million, which was the value of the company including the $3 million of life insurance used to redeem Michael’s shares, arguing the life insurance proceeds should be included in the corporation's valuation, resulting in an additional estate tax liability of $889,914.
The estate thought otherwise and sued. The case made its way to the Supreme Court, which unanimously sided with the IRS.
The ruling means business owners with taxable estates, or estates that could become taxable, must evaluate whether to utilize a stock redemption arrangement versus utilizing a cross-purchase arrangement.
The Connelly decision should have no effective impact on business owners whose business value, and overall estate value is significantly below the federal exemption, at $13,610,000 for 2024. However, that exemption is scheduled to drop by 50 percent in 2026. (Related: The estate planning 2026 question mark)
Also, there are currently 18 states, including the District of Columbia, that impose a state estate or inheritance tax. In 17 of those jurisdictions, the taxation threshold is lower than the federal amount, sometimes significantly lower.
When is this decision effective?
You can expect the IRS and courts to begin applying this decision immediately, if they weren’t already applying it.
Does this decision only apply to corporations?
No, the decision applies regardless of the type of business entity involved if the entity has the obligation to buy a deceased shareholder’s business interest.
Does this decision affect the validity of our buy-sell agreement?
No, your agreement is still valid. It affects how the business’s value is determined for federal estate tax purposes. It will likely also apply in the eighteen states with estate or inheritance taxes.
Your agreement’s valuation method still applies and your obligations under your buy-sell agreement will not change because of this decision.
I don’t expect to have a taxable estate. Do I need to do anything?
Yes, you should discuss the impact of the decision with your legal, tax, and other advisors. Changes in the estate tax law or growth in your estate could cause your estate to be subject to estate tax.
Does this decision apply to cross-purchase agreements?
No, it applies only to entity purchase agreements. In a cross-purchase agreement, the other owners must buy a deceased owner’s interest. The business is not obligated to buy the interest.
Would a cross-purchase arrangement be an alternative to a stock redemption arrangement?
Yes. A cross-purchase arrangement would not be impacted by the valuation issue involved in the Connelly decision. If A and B own a $4 million business, they can each own a $2 million life insurance policy on each other to facilitate the purchase of a deceased owner’s stock interest. Upon the death of A, B will receive $2 million, and will purchase A’s stock from A’s estate. A’s estate tax value is the $2 million redemption price. Since the corporation did not receive any of the death benefit, A’s stock value is not impacted by the life insurance death benefit.
Why doesn’t everyone just use cross-purchase?
Cross-purchase arrangements provide a number of benefits over stock redemption arrangements in addition to avoiding the valuation concerns present in the Connelly case. When shareholder B receives the death benefit on shareholder A’s life, and purchases A’s stock from A’s estate, shareholder B receives an increase in her basis in the corporation equal to the purchase price that she just paid for A’s stock.
There are, however, some drawbacks to cross-purchase arrangements. For one, the shareholders must pay the premiums on the policies on each other. If I am a healthy, younger shareholder, I might not be too excited about paying the premium on a policy on the life of an older, smoker, co-shareholder.
This type of situation can be addressed by having the business issue a bonus to each of the shareholders, with the bonus covering the amount of life insurance premiums required to be paid by each respective shareholder. An alternative would be for the corporation to pay all of the life insurance premiums under a Split Dollar arrangement. All of the policies will still be cross-owned, but they would each be collaterally assigned to the corporation. The corporation owns all of the policies’ cash value, which are listed as assets on the corporation’s balance sheet. Upon the death of a shareholder, the insurance carrier would write a check to the corporation equal to the policy cash value, and a second check to the policyowner for the remainder of the death benefit. This arrangement works especially well with a wait-and-see buy-sell arrangement.
Also, once there are greater than 3 to 4 shareholders, administering a cross-purchase arrangement becomes much more complex. In those situations, a trusteed cross-purchase or using a partnership or LLC taxed as a partnership to own the policies may be an attractive alternative.
If business owner agrees to a cross-purchase arrangement, but there is insufficient life insurance, won’t the shareholders be personally liable for the excess buy-out price?
Consider a “wait-and-see” arrangement, where the shareholders agree to personally purchase the decedent’s stock up to the amount of life insurance death proceeds that were received and leaving the corporation liable for purchasing any remaining unpurchased stock.
Does this decision apply to wait-and-see arrangements?
Possibly. It will depend on how the life insurance is owned and whether the business is the ultimate buyer of a deceased owner’s interest.
Life insurance ownership.
Policies owned by the owners on each other, by a partnership, or an LLC taxed as a partnership will not be included in the business’s value.
Policies owned by the business will be included in determining the value of the business.
If the business must buy any interest not purchased by the other owners, the business value will not be reduced by that potential liability.
Life insurance paid to a partnership or LLC created to facilitate buy-sell planning with a separate business entity will not impact the value of the primary business entity. The partnership or LLC entity itself will likely be brought within the scope of the Connelly decision.
For example, 4 business associates created an LLC/partnership arrangement to facilitate their buy-sell arrangement. The entity purchased $5 million of insurance on each member. Upon the death of member A, the IRS would include the $5 million death benefit in the value of the entity.
Does this decision apply to buy-sell agreements funded with term insurance or not funded with any insurance?
Yes, the business’s obligation to buy is not considered in determining its value, regardless of any funding mechanism in place.
Does this mean that the value of a business a day before an owner’s death is different than its value when the owner dies?
It can be for estate tax purposes. The value before the owner’s death will not include any life insurance proceeds on the owner. For estate tax purposes, the proceeds are included in determining the value of the business.
What requirements must the value specified in a buy-sell agreement meet for it to apply for estate and gift tax purposes?
The tax law disregards the business value set by a buy-sell agreement unless the agreement meets the following requirements:
The price is fixed and determinable.
Agreement must be legally binding during life and at death.
Agreement must be bona fide and not a testamentary substitute.
If the agreement is between family members, the agreement must meet the following additional requirements:
Agreement must be a bona fide business arrangement.
Agreement must not be a device to transfer interests to members of the decedent’s family for less than full consideration.
Agreement must be comparable to similar arrangements entered into by persons in an arms’ length transaction.
How do business owners ensure that at least initially they will have sufficient life insurance to meet their buy-sell obligation?
Consider consulting with a qualified appraiser prior to the creation of a buy-sell agreement to obtain the suggested valuation methodology language for the type of business involved.
Provided by Jeffrey Albin, a financial representative with Vault Financial, courtesy of Massachusetts Mutual Life Insurance Company (MassMutual).
©2023 Massachusetts Mutual Life Insurance Company, Springfield, MA 01111-0001 MM202706-309442
