Background

In the case of Connelly v. United States, No. 23-146, the United States Supreme Court addressed the valuation of a decedent’s shares in a closely held corporation for federal estate tax purposes. Michael and Thomas Connelly, the sole shareholders of Crown C Supply, had an agreement to purchase the deceased brother’s shares, funded by life insurance policies worth $3.5 million each. Upon Michael’s death, Crown redeemed his shares using $3 million from the life insurance proceeds. The IRS included these proceeds in the corporation’s value, leading to a higher estate tax assessment.

Legal Issues

The core issue was whether the corporation’s obligation to redeem shares at fair market value should offset the value of life insurance proceeds when calculating estate tax.

Supreme Court Decision

The Supreme Court unanimously held that the fair market value of a decedent’s shares must reflect the full market value of the corporation, including life insurance proceeds. The Court ruled that a corporation’s contractual obligation to redeem shares does not necessarily reduce the corporation’s value for estate tax purposes. The fair market value principle dictates that life insurance proceeds are an asset that increases the corporation’s overall value, impacting the valuation for estate tax purposes.

Types of Buy-Sell Agreements

Cross-Purchase Agreements

• Each owner holds life insurance policies on the other owners. Upon an owner’s death, the surviving owners use the insurance proceeds to buy the deceased owner’s shares.
• Proceeds are paid directly to the surviving owners, avoiding inclusion in the corporation’s value and thus not increasing the estate’s taxable value.

Entity Purchase Agreements

• The business entity holds life insurance policies for each owner. Upon an owner’s death, the entity uses the insurance proceeds to buy back the deceased owner’s shares.
• Before Connelly, there was consensus that life insurance proceeds should be included in the corporation’s value but that a properly structured redemption obligation created an offsetting liability.
• The Connelly decision clarifies that these proceeds must be included, increasing the estate’s taxable value, and that an offsetting liability is “not necessarily” created by a redemption obligation.

Hybrid Agreements

• Combine elements of both cross-purchase and entity-purchase agreements.
• Allow flexibility depending on the circumstances, such as who has the funds available or which method is most tax-efficient.

A BSIE is an innovative structure that can mitigate some of the tax impacts highlighted by the Connelly decision.

Formation

Create a separate LLC for holding life insurance policies and executing buy-sell agreements.

Ownership

The LLC, generally owned by the business owners, holds the life insurance policies.

Execution

Upon an owner’s death, the LLC uses the insurance proceeds to purchase the deceased owner’s shares from their estate.

Tax Impact

This structure can potentially exclude life insurance proceeds from the valuation of the operating company, as the proceeds are utilized by the LLC rather than the operating entity itself.

Formation

Establish a special purpose LLC with the primary function of holding life insurance policies.

Policy Transfer

Analyze the transfer for value impact of transferring existing life insurance policies and transfer existing life insurance policies to the LLC.

Operating Agreement

Draft an operating agreement that outlines the buy-sell procedures and the use of life insurance proceeds.