Connelly Ruling: Risk to business clients' estate plans
A recent ruling creates a critical need to understand and review entity purchase agreements.
The U.S. Supreme Court issued a ruling in June 2024 that continues to ripple across the business planning community. Its ruling in Connelly v. U.S., which had been appealed from a decision in favor of the IRS by the U.S. 8th Circuit Court of Appeals, upended conventional wisdom regarding the use of buy-sell agreements in estate planning that had existed for decades.
The long-standing view in the Estate of Blount v Commissioner 11th Circuit case in 2005 held that life insurance paid to a business was offset by the business liability to redeem shares of a deceased owner. The Blount case only applied to the 11th circuit and is no longer applicable today.
Fallout from an IRS audit
The business continuation and estate tax case arose when the IRS audited the estate of Michael Connelly. The government challenged the business value on the federal estate tax return. It claimed that life insurance proceeds payable to the business, which Michael owned with his brother Thomas, were includible in determining the business’ fair market value.
The facts of the case helped the IRS. Thomas was the estate executor as well as the trustee of Michael’s trust. No independent or third party was involved. The brothers had failed to periodically update the value of the business as the agreement required. Lastly, the price paid for the decedent’s business interest was markedly below its fair market value. It appeared that if the brothers were not going to follow the terms of their agreement, then the IRS would not be bound to it either.
Who is impacted?
Direct impact falls on business owners who have an entity purchase buy-sell agreement funded with life insurance and who will be subject to estate tax. Entity purchase design plans are now at high risk for what many consider to be “double taxation” when insurance is used to fund the purchase.
Note, however, that business owners with cross purchase (CP) agreements are not impacted as the life insurance is owned by and payable to the surviving shareholders, not the business.
Example of the ruling’s effect
Consider a business valued at $3 million with three owners, A, B, and C. The business has an entity purchase agreement, which requires the business to purchase the decedent’s interest for $1 million. The business is the owner and beneficiary of a $1 million life policy on each owner. If A dies, what happens?
After Connelly, the value of the business at death is $3 million plus the value of the death proceeds ($1 million) or $4 million. Therefore, A’s estate must list on the estate tax return a one-third interest in $4 million or $1,333,333, even though A’s estate only received $1 million under the buy-sell agreement.
Potential solutions to double taxation
There are several ways to avoid having the life insurance death benefit included in the value of the decedent’s shares.
First: Consider changing the existing entity purchase plan to a cross purchase design. CP plans are attractive when there are two or perhaps three owners as the number of policies required is limited. The number of policies needed is governed by the formula of N*(N-1), where N is the number of owners.
Second: To minimize the complexity, consider utilizing a trustee CP design so that only one policy per owner is needed. Even with a trustee CP plan, the transfer for value rule may be triggered after the first death if the decedent’s interest in the policy is transferred to the surviving shareholders to fully fund the buy-sell agreement par, the following: A transfer of the policy which violates the transfer for value rule triggers income tax on the death benefit to the extent the death proceeds exceed any consideration paid for the policy and any subsequent premiums paid.
Third: Consider implementing an insurance LLC taxed as a partnership. To protect against having the life insurance included in the decedent member’s estate, an independent third party should serve as manager of the LLC. Owners make capital contributions to the partnership to pay for premiums. The LLC interests are allocated per the operating agreement. Upon death, the LLC receives the death proceeds. In a separate transaction, the LLC purchases the deceased member’s interest and allocates the interest among the surviving members in proportion to their underlying ownership.
Action to undertake today
Entity purchase plans should be reviewed in light of Connelly. This call to action is especially critical for business owners who have a substantial interest in a business and who are or will be subject to federal and/or state estate taxation. Failure to address this issue can cause an owner to pay unnecessary estate taxes on their business interest. In a worst-case scenario, the estate taxes paid on their business interest could be greater than the amount received for the business interest under the buy-sell agreement.
The tax information presented here is for general information only and should not be used nor relied upon as specific tax advice. Taxpayers should consult with their CPA or qualified tax professional for advice regarding their own tax situation and the tax status of LTC premiums and benefits.