Buy-Sell Agreements and Life Insurance: Your Business Succession Plan After Connely

06 Sep

Buy-Sell Agreements and Life Insurance: Your Business Succession Plan After Connely

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By: Attorney James A. Spella, Schloemer Law Firm, S.C.

On June 6, 2024, the U.S. Supreme Court issued a unanimous decision on a closely held business valuation case that has significant impact on co-ownership buy-sell agreements—redemption agreements in particular. (Connelly v. United States, U.S. No. 23-146).

Succinctly, this case states that life insurance proceeds used to purchase a decedent owner’s ownership interest shall be included in that decedent’s estate for estate tax purposes – EVEN IF, the decedent’s estate did not receive payment that factored in the decedent owner’s share of the life insurance proceeds.

BACKGROUND

Co-Owners of privately owned businesses should have in place an agreement to address ownership and governance matters. Of utmost importance is what happens if one of the owners dies: Is that owner’s ownership interest controlled by his/her estate planning documents (or lack thereof)?

Customarily, the owners will enter into a planning agreement to address these planning objectives.

Planning Agreements

The planning agreements customarily utilized are either a Redemption Agreement or a Cross-Purchase Agreement.

In a Redemption Agreement, the entity will be the purchaser of the decedent’s ownership interest. That is, the entity will redeem the ownership interest.

In a Cross-Purchase Agreement, the surviving owner(s) will be the purchaser(s) of the decedent’s ownership interest.

In both types of agreements, it is customary to have life insurance policies issued on the lives of the owners to provide the funds to satisfy the purchase obligation.

Statutory Background

In addition to the important, practical provisions of planning agreements as to ownership restrictions and governance, owners need to have a planning agreement comply with IRC 2703, which allows the agreement to be recognized as controlling for estate tax purposes – especially for the value of the decedent’s interest.

SEC. 2703. CERTAIN RIGHTS AND RESTRICTIONS DISREGARDED.

Section 2703(a) provides that, in general, any agreement or right to acquire property at a price less than its fair market value will be disregarded in valuing the property for federal estate tax purposes.

Section 2703(b) creates an exception to section 2703(a), as follows:

(b) Exceptions. —Subsection (a) shall not apply to any option, agreement, right, or restriction which meets each of the following requirements: (1) It is a bona fide business arrangement. (2) It is not a device to transfer such property to members of the decedent’s family for less than full and adequate consideration in money or money’s worth. (3) Its terms are comparable to similar arrangements entered into by persons in an arms’ length transaction.

Accordingly, if the Exception requirements are met, the planning agreement will determine the purchase price, instead of a metric used by the IRS such as the fair market value.

CONNELLY IMPACT

Redemption Agreements. Connelly stated the value of the business interest in the decedent’s estate will BE INCREASED by that owner’s share of the insurance proceeds that the entity received in the Redemption Agreement.

Example 1: ABC Inc. is equally owned by Rose and Beth and has a value of $1 Million. Beth dies. At death, ABC Inc. is required to purchase (redeem) Beth’s interest for $500,000 and does so; ABC Inc. did not own a life insurance policy on the life of Beth. Beth’s estate received $500,000 and her estate tax return reported a value of $500,000.

Example 2: Same facts as above, but ABC Inc. owned a $500,000 life insurance policy on Beth and used those proceeds to redeem her ownership interest.

Per Connelly, the value of ABC Inc. is $1,500,000 ($1 Million agreement value plus $500,000 life insurance proceeds). Beth’s estate still only receives $500,000, but the value of ABC Inc. in her estate is $750,000 because it now owns half of the value of ABC Inc which increased to $1,500,000 upon Beth’s death. So, Beth’s estate is subject to estate tax on an additional $250,000 at a 40% tax rate ($100,00) without ever receiving that extra $250,000.

Connelly had many other tax nuances including non-compliance with Section 2703 and the importance of valuation of the company’s worth set by appraisal at the buy-sell agreement signing with a determined formula, but its most significant impact on Redemption Agreements is the estate tax value write-up from life insurance proceeds.

In addition, the case did not address whether the estate would be able to deduct a “loss” since it had an asset valued in Example 2 for $500,0000 with a basis of $750,000. Nor did it address whether the estate could adjust the value of the interest to take into account discounts for lack of control—controlling owners have the ability to do things like set company policies and purchase/sell company assets which make those interests more valuable than interests with a lack of control. Accordingly, interests with a lack of control are sometimes worth less, i.e. given a discount for lack of control.

NEXT STEPS

Future of Redemption Agreements

Redemption Agreements that are in place or will be entered into in the future need to be reviewed in light of Connelly. Owners need to be aware of Connelly’s impact on value and estate tax exposure.

Planning Actions:

All Agreements should be reviewed.
Have valuation formulas developed by appraiser/accountant and added as an Exhibit to the Agreement
Ensure compliance with Section 2703
Owners need to be aware of possible Connelly estate value write-up.
- Note: This may or may not be of concern dependent on decedent’s available Unified Estate Tax Credit (subject to scheduled January 1, 2026, downward revisions https://schloemerlaw.com/tcja-federal-estate-tax-exemption/).
Consider termination of Redemption Agreement and converting to a Cross-Purchase Agreement.

Future of Cross-Purchase Agreements

The use of Cross-Purchase Agreements will be given renewed consideration in light of Connelly.

A significant advantage of a Cross-Purchase Agreement is the “basis” increase in the entity to the purchasing owner. This can have significant tax advantages such as a decrease in capital gains ta should an owner later decide to sell his or her interest.

As to life insurance, a Cross-Purchase Agreement with 2 owners requires each owner to purchase a policy on the life of the other owner. Owners will need to consider how to handle any difference in premium costs where one owner will pay more than the other based on underwriting and age. With 2 owners the issuance of life insurance policies is not problematic. When there are more than 2 owners, the process of life insurance policies becomes more complicated. For example, if there were 4 owners, each owner would need to buy a policy on the other 3 owners—12 policies in all. In a Redemption Agreement, only 4 policies would be required.

To address this multiplicity of policies, an Insurance Partnership could be created by the owners. The Partnership would own 4 policies, and the death proceeds would be specially allocated to the surviving owners on the death of a partner. This would avoid the value of the ownership interest in a deceased owner’s estate increasing by a fraction of the amount of the life insurance because the company to which the interest belongs does not own the life insurance policies, the Insurance Partnership does. Therefore, because the company doesn’t gain the proceeds from the life insurance, it doesn’t increase in value and neither does the decedent’s ownership interest.

Caveat: Since each partner will own an equal interest in the Insurance Partnership, the value of the Insurance Partnership would be part of the decedent’s estate and subject to tax. A special allocation of death proceeds to the surviving partners may however, avoid the problem presented by Connelly. The valuation of the partnership after Connelly remains undetermined.

Using a partnership also provides helpful future planning for any roll-out of life policies to insureds under the “transfer for value” provisions of the Internal Revenue Code (IRC), which must be considered when one wishes to move ownership of life insurance. Insurance proceeds shall continue to be income tax free when paid when the former owner dies.

CONCLUSION

All planning should be periodically reviewed by owners to address both changing personal and tax consequences. Connelly provides impetus to create such periodic planning reviews with legal, accounting, and tax advisors. The IRS wins when taxpayers are too busy or too lazy to manage these agreements and stay up to date with the ever-changing rules and regulations.

If you have questions about this article and/or want to review your business and estate planning, please contact this article’s author or one of our business law attorneys at 262-334-3471 or [email protected].

Originally published: September 6, 2024