In the recent landmark case of Connelly v. IRS, buy-sell agreements were examined, specifically how the proceeds of a life insurance policy in a buy-sell agreement were treated. Here's what you need know and how to minimize the court’s ruling on your assets.
The Situation
- Two brothers owned a corporation together and had a buy-sell agreement. The agreement stated the company would redeem (buy back) a deceased brother's shares using life insurance proceeds. To fund the buyout a $3.5 million life insurance policy was issued for each brother.
The Dispute
- The deceased brother held a majority share (77%) of the company. The remaining shares (23%) belonged to the surviving brother.
The Transaction
- Following the primary shareholders death, the company used the $3.5 million life insurance proceeds to buy back the deceased owner's shares from their estate, negotiating a final price of $3 million with the heirs and using $500,000 for operating expenses for the company
- The surviving owner filed an estate tax return valuing the deceased owner's shares at $3 million (buyback price). However, the IRS disagreed during the audit. The IRS argued that the life insurance proceeds should be included as an additional company asset, significantly increasing the value of the deceased owner's shares (nearly an 80% increase). This resulted in a higher estate tax valuation of $5.3 million for the deceased owner's shares compared to the $3 million reported by the estate.
The Court's Decision
- The Supreme Court sided with the IRS. They ruled that a buy-sell agreement's obligation to redeem shares isn't necessarily a liability that reduces the company's value for estate taxes. So, the full value of the company, including the life insurance proceeds, is considered when calculating the estate tax on the deceased brother's share. So, the full value of company, including the $3.5 million life insurance proceeds, are used to calculate the estate tax on the deceased brothers shares resulting in shares.
Why This Matters
- This case means life insurance proceeds used in a buy-sell agreement could increase the estate tax burden for the deceased owner's estate. Business owners with buy-sell agreements funded by life insurance should be aware of this potential tax consequence.
In light of the Supreme Court’s decision in Connelly v. IRS, it’s clear that many insurance-funded buy-sell agreements need to be reviewed.
How Wealth Advisory Lab Can Help
At Wealth Advisory Lab, we provide proactive, personalized support to help you navigate complex financial landscapes and achieve continued success. Here are strategies to consider in light of the Connelly v. IRS ruling:
Review and Update Existing Agreements
- Ensure your buy-sell agreements reflect current needs and minimize potential tax implications from the Supreme Court ruling.
Alternative Funding Options
- Cross-Purchase Agreements: Instead of the company buying back shares (stock redemption agreement), explore a cross-purchase agreement. Each owner takes out life insurance on the other owners. Upon an owner's death, the surviving owners use their life insurance proceeds to purchase the deceased owner's shares directly.
- Entity-Level Planning: This more complex strategy involves structures like holding companies or LLCs to potentially isolate life insurance proceeds from the value of the main operating company, impacting the estate tax calculation.
Valuation Discounts
- Incorporate provisions for valuation discounts in your buy-sell agreement to reflect the fact that the deceased owner's shares are not readily marketable (lack of marketability) and represent a minority ownership stake (minority discount). These discounts can potentially reduce the overall value of the shares for estate tax purposes.
Our estate planning, advanced life insurance and business valuation experts are here to help you navigate the complexities of the Connelly v. IRS ruling and secure your business’s future.
Schedule a consultation with Wealth Advisory Lab today.