A recent U.S. Supreme Court decision in Connelly v. United States disputes a common succession strategy for many closely owned businesses with more than one owner. For decades, business owners agreed to buy life insurance so that when one owner dies, there’s cash to buy out his or her stock.
The goal is for the insurance death benefit payment from the policy to be tax-free and for the company to avoid the challenge of funding a share repurchase from its operating profits. In the Connelly decision, however, the court ruled that the strategy will negate much of the income tax benefits.
As a result, a deceased owner’s estate may wind up paying substantially more in death taxes.
Background of Case
Two brothers were co-owners of a building-supply corporation. The majority owner died.
Years earlier, the corporation had bought $3.5 million of life insurance on each brother and agreed to repurchase the shares of either brother who died. After the death of his brother, the surviving brother agreed with the estate that the company would buy the decedent 77% stake for $3 million, although they never had the business formally appraised. A valuation done later, during the Internal Revenue Service audit valued the company at $3.86 million without the life insurance.
Both brothers thought the life insurance payout would be estate-tax-free. The U.S. Supreme Court disagreed. In a unanimous opinion, the Court sided with the IRS. As a result, $3 million of insurance proceeds were added the corporation’s value, giving it a total value of $6.86 million at death. That raised his total value in the company to $5.3 million and increased his estate taxes by nearly $900,000.
The Court reasoned that the requirement to repurchase Michael’s shares wasn’t an offset because it wasn’t a liability like a debt. Instead, the exchange of shares for dollars provided something of value to the firm.
A number of tax specialists have agreed with the Court’s conclusion.
For owners who might be affected by this case, here are some options to consider.
Begin by checking the company’s buy-sell agreement, especially if no one has reviewed it in years. Buy-sell agreements are crucial contracts explaining what happens if an owner dies, retires, or otherwise leaves the business.
In many cases, these agreements require an independent appraisal of the company with annual or periodic updates. If there is a valuation, have the valuation updated. In Connelly, the brothers failed to have the valuations updated as they were supposed to.
Next, are the reinsurance policies in place to fund a buyout at an owner’s death, owned by and payable to the company? If so, beware: This structure is attractive because it ensures premiums are paid and can work well when there are multiple owners. But it was also what caused the deceased brother’s estate to owe higher taxes, so it’s important to check the effect on the owners’ estate taxes.
Remember, the estate tax exemption is currently $13.6 million per individual, but is scheduled to expire and default to $7 million at the end of 2025, unless extended. While many small business owners won’t realistically have to deal with this high exemption amount, maybe others will – especially if insurance proceeds are added to the value of the company.
Cross-Purchase Agreements
A “cross-purchase” where each owner buys life insurance on the life of other owner(s) to acquire the shares if one dies is an option. This can keep insurance proceeds from inflating the value of the company and the estate of the deceased owner. It can also provide the buyer with a higher cost basis in the stock, which could lower future capital-gains taxes if he or she sells.
But cross purchases have issues too; especially with multiple owners.
For many closely held business owners, the Connnelly case will mean advice from tax advisors regarding both income and estate tax consequences.
To discuss your NJ business, please contact Fredrick P. Niemann, Esq. toll-free at (855) 376-5291 or email him at fniemann@hnlawfirm.com. Please ask us about our video conferencing or telephone consultations if you are unable to come to our office.
By Fredrick P. Niemann, Esq. of Hanlon Niemann & Wright, a Freehold Township, Monmouth County, NJ Business Attorney