SCOTUS ruling impacts buy-sell agreements

Scott Bushkie

Guest Columnist

July 29, 2024

The recent United States Supreme Court decision in Connelly vs. United States has implications for closely held businesses with life insurance-funded buy-sell agreements.

Though the case is primarily an estate tax issue, it’s also a reminder of the importance of succession planning and how an up-to-date business valuation informs those plans.

Background

The Connelly case revolves around two brothers who owned a building supply company – Crown C Supply.

They had a traditional buy-sell agreement to keep the business in the family upon either brother’s death.

The agreement stipulated that the surviving brother could purchase the deceased’s shares, or if he declined, the company would be obligated to redeem them.

To fund this arrangement, the company purchased $3.5 million of life insurance for each brother.

When one brother passed away, the company used $3 million from the life insurance payout to redeem his shares as per the agreement.

However, when it came time to value the deceased brother’s estate for tax purposes, a significant dispute arose.

The estate argued the $3 million used for share redemption should be excluded from the company’s value.

The IRS disagreed, contending the redemption obligation didn’t offset the insurance proceeds, effectively increasing the company’s value by $3 million and resulting in an additional $900,000 in federal estate tax.

This dispute made its way through the legal system, with both the district court and the 8th Circuit Court of Appeals siding with the IRS.

Ultimately, the Supreme Court unanimously affirmed these decisions.

The decision

The court emphasized that estate tax valuation happens at the time of death.

At that moment, Crown was worth $3 million more than before, due to the insurance payout.

Connelly’s lawyers argued that such a ruling would make succession planning more difficult for closely held businesses.

The court suggested there are other ways to structure succession planning that could lead to more favorable tax outcomes, such as a cross-purchase agreement – (in a cross-purchase, the surviving shareholders personally buy the deceased shareholder’s shares, often using proceeds from life insurance policies they own on each other).

Regular business valuations matter

Based on news reports of the Connelly case, we can infer there was no conflict about the actual value of the business, in terms of buying out the deceased brother’s shares.

So, the family was ahead of the game in that regard.

What happens all too often is that partners buy life insurance when the business is young, without updating their coverage over time.

That can put the business at risk in several ways, including:

• Underfunded buy-out – If the life insurance policy was based on the old valuation, it might not provide enough funds to buy out the deceased brother’s share at the current market value.
• Business continuity risk – If the buy-out can’t be completed due to insufficient funds or disputes over valuation, it could threaten the continuity and stability of the business.
• Tax implications – As seen in the Connelly case, the IRS values the business at the time of death. If the actual value is much higher than the old valuation, it could result in unexpected estate tax liabilities.
• Fairness issues – The surviving brother might end up with a windfall if they can buy out the deceased’s shares at a price well below the current market value.
• Potential for litigation – Discrepancies between the agreed-upon price in the buy-sell agreement and the current market value could lead to lawsuits between the surviving owner and the deceased owner’s estate.

Business valuations are a crucial part of succession, estate and business planning.

A fair, up-to-date assessment of your company’s value will help you make informed decisions about ownership transfers, structuring buy-sell agreements and planning for potential tax liabilities (with appropriate legal advice).

Implications
The Connelly ruling particularly affects businesses with life insurance-funded buy-sell agreements.

These arrangements, once considered a straightforward solution for succession planning, now require careful consideration and potential restructuring.

If your business has a buy-sell agreement funded by life insurance, key man insurance arrangements or other insurance-funded plans, talk to your legal counsel about whether the Connelly ruling affects your strategy.

As part of those discussions, you may need to update your business valuation to ensure proper coverage and protect your legacy for future generations.