The U.S. Supreme Court recently handed down a decision that will have a significant impact on buy-sell agreements and estate valuations. Connelly v. United States is the Court’s latest in its string of major decisions in 2024 impacting California businesses.
Connelly will fundamentally alter the way life insurance proceeds are treated in stock redemption agreements for estate tax purposes — supporting the Internal Revenue Service’s stance on these matters. Closely held businesses that rely on life insurance-funded, buy-sell agreements will need to reconsider this strategy.
Connelly v. United States
The case involves two brothers, Michael and Thomas Connelly, who co-owned Crown C. Supply, a closely held business in Missouri. They established a stock purchase agreement to keep the company in the family in the event of either brother’s death. The agreement stated that the surviving brother would have the option to buy the deceased brother’s shares. However, if the surviving brother declined, the company would be required to use the proceeds from the deceased’s life insurance policy to redeem the shares.
When Michael passed away in 2013, Crown C. Supply used $3 million from a life insurance policy to redeem his shares, making Thomas the sole shareholder. Michael’s estate excluded these proceeds from its valuation for federal estate taxes, relying on prior case law, but the IRS challenged the exclusion, instead asserting that the proceeds needed to be included in the taxable value of the estate.
The Supreme Court sided with the IRS, concluding that life insurance proceeds used for share redemption must be factored into the estate’s valuation. The Court stated that shares should be valued before redemption, requiring the inclusion of life insurance proceeds as non-operating assets. By rejecting the argument that the company’s obligation to redeem the shares offsets the proceeds, the Court effectively overturned years of precedent.
What This Means for California Business Owners
California business owners who use life insurance-funded, buy-sell agreements to plan for ownership transitions need to reconsider their structure in the wake of this decision. This ruling increases estate tax liabilities when using this structure, reducing the remaining estate to be passed on to heirs. This is a particular issue for closely held businesses where liquidity is an issue.
There are a couple steps business owners impacted by this ruling should take into consideration. The most obvious next step is to sit down with a California business attorney to review existing buy-sell, especially when using life insurance-funded stock redemptions. There are other ways to proactively structure these agreements, such as cross-purchase agreements or finding other funding methods instead of using life insurance proceeds, to avoid the impact.
The surest way to ensure your business isn’t impacted negatively by the Connelly decision is to work with an attorney who not only understands contracts and business law but also estate planning and tax strategy.
At Dahl Law Group, our knowledgeable team has experience in all relevant areas of the law to help your business handle the changes brought on by this Supreme Court decision. Contact our team at our offices in Sacramento or San Diego to make sure your business isn’t facing unnecessary tax liabilities due to the structure of business agreements.
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