Connelly Supreme Court ruling: What it means for your business

Executive summary:

• A recent Supreme Court case could reduce the value your heirs receive for a closely held business interest by up to 40% of any life insurance proceeds used in a redemption buy/sell arrangement
• The Supreme Court upheld the lower court decision that estate tax value was not reduced by the redemption obligation funded by life insurance to buy back a deceased owner's shares
• Take action now: If your company has a redemption agreement funded by life insurance, review your agreement and consider making changes to avoid an unintended result

The recent Connelly Supreme Court case examined how life insurance used in business succession plans affects estate taxes.

What are the details of the case?

The case addressed whether buy/sell redemption obligation funded by life insurance proceeds should reduce the company's estate tax value.

Michael Connelly and Thomas Connelly, the sole shareholders of Crown C Supply, had an agreement that the corporation would redeem a deceased shareholder’s shares using company-owned life insurance. When Michael passed away, the business used the life insurance proceeds to buy out Michael's share of the company. Michael’s estate did not include the value of the life insurance proceeds in the calculation of the company’s value included in his estate, arguing that the value was offset by the company’s obligation to redeem the estate’s shares.

The IRS argued that the redemption obligation should not reduce the calculation of the company value included in Michael’s estate for estate tax purposes, leading to a higher estate tax bill. The table below compares the estate's valuation of the company with the IRS's valuation for estate tax purposes.

Assuming there was no adjustment to the proceeds the result of this change could be catastrophic to the heirs of a closely held business. In Michael’s example it cut the value received by his heirs in half from the intended $1.81M to $0.88M.

What did the Supreme Court decide?

The Supreme Court, in a unanimous decision, ruled that the proceeds from the life insurance policy used to buy out the deceased owner's share of the business were not offset by the redemption obligation.  The Court reasoned that the appropriate estate tax value should not affect the economic value for the remaining owners. Essentially, if each share was worth $100,000 prior to the redemption it should be worth the same amount following the redemption.

There is uncertainty if this decision would have been different had the parties involved had not been family members. However, the logic utilized could create issues for certain redemption arrangements.

What does this mean for your business?

For businesses, especially closely held entities, this decision underscores the importance of understanding how life insurance proceeds used for share redemptions are treated for estate tax purposes. In certain situations, this answer could decrease the amount passed to your heirs by up to 40% of the total life insurance proceeds.

Should you revisit your redemption agreement after the Connelly case?

• Does your redemption agreement use company-owned life insurance?
• Can your agreement set the redemption price at something other than the estate tax value?
• Are the parties involved in your buy-sell family members?
• Are you uncertain of the tax treatment of your existing redemption agreement?
• Have there been significant changes in ownership structure or overall value of your business since the agreement was drafted?

If you answered yes to any of these questions, there are solutions. Your tax advisor can help you assess the potential impact on your estate and explore alternative structures to ensure the agreement aligns with your goals and minimizes estate tax liability.