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How Does Connelly Affect Your Business Succession Plan?
The U.S. Supreme Court’s end of term best hits included Connelly v. U.S., 133 AFTR 2d 2024, 1680WL 3859749 (June 6, 2024). While not as sexy as many of the other groundbreaking releases, Connelly will shakeup the business succession plans of many businesses.
Succession plans are typically structured as either (a) cross-purchase agreements where surviving owners agree to personally purchase equity owned by a deceased owner or (b) redemption agreements where the business agrees to redeem shares owned by a deceased owner.
The Supreme Court affirmed an Eighth Circuit decision which held that (a) although the $3,500,000 in insurance proceeds received increases the value of the business (2) the $3,000,000 obligation to redeem shares owned by Connelly pursuant to a redemption agreement should not be considered as a reduction in value to the shares[1].
The Court posited that although corporate owned life insurance is an asset increasing value just like any other asset, the obligation to purchase the decedent’s shares should not be an offsetting liability. The Court’s rationale is that “a share redemption at fair market value does not affect any shareholder’s economic interest.”[2] IRS therefore correctly assessed an additional $889,914 in taxes due by the estate, with penalties and interest.
Two brothers owned the company involved in Connelly. Although family-owned businesses must meet additional legal tests for the buy-sell price to set the value of the shares for estate tax purposes, the decision is relevant to all businesses. Another key fact is that the redemption agreement didn’t contain a “fixed or determinable price” for valuing the share. A fixed or determinable purchase price is required to ensure that the buy-sell agreement price establishes the estate tax value of the affected shares.
As a result of Connelly, we urge all business owners (not just owners of family businesses) to revisit their arrangements for purchasing a deceased owner’s shares. A cross-purchase agreement would have avoided the result in Connelly since the insurance would have been received by another shareholder, not the company. In situations where a cross-purchase agreement is neither feasible nor practical because the business has more than two owners or other for reasons, other arrangements are possible but would have to be carefully considered[3]. Any buy-sell agreement should also meet all tests for ensuring that the buy-sell agreement price establishes the value of the shares for estate tax purposes.
Connelly shifts the landscape for ensuring that the price paid to a deceased shareholder’s heirs also establishes the value of same equity for estate tax purposes[4]. In other words, the amount paid by a company to a deceased owner’s estate should establish the value of the shares for estate tax purposes. Without making any necessary changes, a business owner may owe additional estate taxes, penalties and interest in an audit of an estate tax return that valued the shares at the amount paid as opposed to the value based upon the Connelly case.
[1] The Supreme Court overturned the Eleventh Circuit in the Estate of Blount v. Commissioner, 428 F.3d 1338 (11th Cir. 2005) on this issue. The 11th Circuit had concluded that insurance proceeds should be “deduct[ed]…from the value” of a corporation when they are “offset by an obligation to pay those proceeds to the estate in a stock buyout.”
[2] An example from Tax Notes, March 18, 2024, illustrates the Connelly Court’s point: “Suppose A and B are equal 50 percent shareholders of X Corporation, which has assets worth $100. Each shareholder’s stock is presumably worth $50, the price a hypothetical purchaser would pay in an arm’s-length transaction. The result is the same if the corporation is obligated to redeem A’s stock at death for its fair market value. The redemption price should be $50, regardless of whether the corporation uses life insurance or other corporate assets to fund the redemption. Treating X’s redemption obligation as a $50 corporate liability — as urged by the estate in Connelly — implies that X has a net value of $50 and A and B each own stock worth only $25. But that would be inconsistent with the assumed redemption price of $50 for A’s stock (leaving B as the sole shareholder of a corporation worth $50). Nor can it be true that A’s stock should be redeemed for $25 (leaving B as the sole shareholder of a corporation worth $75)”.
[3]Other options include using a separate LLC, taxed as a partnership, with a different business purpose such as leasing equipment or a trust, to hold and administer the policies.
[4] The estate-tax exemption, which is currently $13.6 million per individual, is scheduled to be cut in half at the end of 2025. Although some small business owners will remain below the threshold, others will not especially if the amount of insurance proceeds are added to a company’s value without any reduction for the redemption liability.
DISCLAIMER. We are providing this article for general informational purposes only. This does not provide legal advice.