On June 6, 2024, The Supreme Court’s decision in Connelly v. United States significantly impacted the tax treatment of life insurance proceeds in business transition strategies. This ruling emphasizes the importance of well-structured buy-sell agreements for protecting your business and heirs.
The Ruling
The Connelly ruling clarified that life insurance proceeds used in buy-sell agreements can increase a business’s value, potentially increasing the estate’s value for tax purposes. Before this decision, such proceeds were not typically included in a business’s value for estate tax purposes. This change has major implications for estate tax liabilities as increased estate tax values will result in a reduction of the heirs’ proceeds.
To summarize the Connelly case in the simplest terms, decedent Michael Connelly was a shareholder of a corporation that held a life insurance policy on him and had a buy-sell agreement in place to purchase his shares upon his death. The corporation used policy proceeds to do so, but did not count those proceeds in its valuation.
Connelly Business Valuation Discrepancy
| Estate’s Valuation | IRS’ Valuation | |
|---|---|---|
| Base Value of Company | $3.36M | $3.36M |
| Life Insurance Proceeds | $3.50M | $3.50M |
| Offsetting Redemption Obligation | ($3.00M) | $0 |
| Total Valuation | $3.86M | $6.86M |
| M. Connelly’s Share (77.18%) | $2.98M | $5.29M |
| Tax Liability on Shares (40%) | $1.19M | $2.12M |
For illustrative purposes only, derived from Connelly v. United States syllabus, Supreme Court of the United States.
As illustrated, the IRS audited the return and assessed that the corporation’s total valuation should include the $3M in life insurance proceeds that were used to purchase Michael’s shares, greatly increasing the valuation and estate taxes owed. The Supreme Court affirmed lower courts’ decisions, aligning with the IRS’ audited valuation of the corporation.
There are of course many more details to this case than are discussed here. Find The Supreme Court’s opinion at supremecourt.gov.
How to Protect your Business
While many business owners plan to sell their businesses during their lifetime, an unforeseen event can disrupt these plans. To minimize potential financial liabilities, consider the following strategies:
- Review and Update Buy-Sell Agreements: Work with tax, legal and valuation experts to ensure any existing buy-sell agreements account for all tax implications. A well-structured agreement ensures that your beneficiaries receive the business’s proper value. A guaranteed purchaser at a set value also helps avoid the pitfalls of selling in a buyer’s market.
- Evaluate Life Insurance Policies: Regularly assess and structure life insurance policies to alleviate unforeseen tax liabilities.
- Consider Cross-Purchase Agreements & Insurance LLCs: For businesses with two shareholders, opt for cross-purchase agreements, or consider an insurance LLC for businesses with more shareholders to avoid inflating estate values.
- Consult with Tax & Legal Professionals: Regularly consult estate planning attorneys and tax advisors to review and update corporate agreements and structures in-line with current laws and court rulings.
The Supreme Court’s decision in Connelly v. United States underscores the importance of meticulous estate planning and the need for precise buy-sell agreements. By proactively reviewing and structuring buy-sell agreements, evaluating life insurance policies, and consulting with professionals, business owners can better manage their estates, ensure smooth ownership transitions, and minimize tax liabilities. Ensure your agreements and policies are up-to-date and aligned with current laws and court rulings to avoid unexpected tax burdens. Speak with an Ancora Wealth Advisor to learn more and connect with our Wealth & Estate Planning team.