How a Recent Supreme Court Decision Could Impact Business Planning
Key takeaways
The Connelly decision impacts business owners who have buy-sell agreements funded with business-owned life insurance
The ruling may increase the value of your estate, which could lead to your estate paying more money in estate tax.
Now is a good time to review any existing buy-sell-agreement with your advisor.
When a business owner passes away, a buy-sell agreement helps ensure that their business can continue smoothly. When the business itself will buy the deceased owner’s interest, the arrangement is called an “entity purchase” or “redemption” agreement. These agreements often use company-owned life insurance to handle the purchase of the deceased owner's shares.
A recent U.S. Supreme Court decision in the case Connelly v. United States (known as the Connelly decision) has changed how these agreements affect estate taxes, which could impact business owners who have substantial wealth.
Connelly v. United States
Understanding the Connelly Decision
The case involved two brothers, Michael and Thomas Connelly, who co-owned a family business. Their buy-sell agreement called for the corporation to buy out a deceased brother’s shares, funded by corporation-owned life insurance policies on each brother. When Michael passed away, the corporation received a $3.5 million death benefit from the life insurance policy. It then agreed to purchase his shares for $3 million as outlined in the buy-sell agreement. The estate received $3 million in cash, and the executor filed an estate tax return that valued Michael’s stock at $3 million.
The IRS argued that Michael’s estate undervalued his shares because the purchase price did not account for the $3.5 million death benefit just received by the business, and as a result, the estate should have paid more estate tax based on that higher valuation.
Courts Rule That Business Value Is Increased by Insurance Proceeds
Both the district court and the appeals court sided with the IRS, saying that 1) the estate could not value the stock by referring to the buy-sell agreement and 2) the fair market value (FMV) of the business must include the life insurance proceeds without a corresponding offset for the business’s obligation to purchase the deceased owner’s stock.
While the Supreme Court did not address whether a buy-sell agreement could control the estate tax valuation, it did rule that the Connelly estate must include the life insurance proceeds received by the corporation when determining the FMV of the business without an offset for its redemption obligation.
Let's review your buy-sell agreement, together.
With access to a team of estate, tax and business planning experts, your Northwestern Mutual financial advisor is well positioned to help you get started.
Find your advisorKey Takeaways for Business Owners
Let’s explore the implications of this decision and how, as a business owner, you can adapt your planning strategies.
Your estate value may increase: The Connelly decision could increase the value of your estate, potentially leading to higher estate taxes. This is especially true if you have substantial wealth, as the federal estate tax exemption is expected to halve at the end of 2025.
Family businesses need to exercise special caution: The Connelly decision almost guarantees that family businesses with entity-owned life insurance have to include death benefit proceeds when valuing the business interest of the deceased insured. If estate taxes are a concern for you, it may be time to reconsider entity purchase agreements funded with business-owned life insurance.
Unrelated business owners need to be attentive, too: While some unrelated business owners may still be able to use an entity purchase buy-sell agreement funded with business-owned life insurance, a cross-purchase agreement may still be a preferable alternative. A cross-purchase agreement is where each owner buys life insurance on the others, and each is obligated to buy out the deceased’s shares. This arrangement could help mitigate some of the risks highlighted by the Connelly decision.
To help you navigate these changes effectively, start a conversation with your financial advisor. Together with your estate attorney and/or tax professional, they can help you better understand how the changing exemptions might affect your buy-sell and estate plans.
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Now Is the Time to Review Existing Buy-Sell Agreements
Given the Supreme Court’s stance, it is crucial for business owners to review their current buy-sell agreements. The focus should be on how the purchase price will be determined and how the agreement is funded. This review will help ensure that the agreement aligns with the new legal landscape and the individual owner’s estate plans.
Enhancing Your Business Succession Plan
While the Connelly decision poses new challenges, it also provides a valuable opportunity to revisit and strengthen your business succession strategy. By understanding the implications of the ruling and adapting accordingly, you can help ensure that both the future of your business and your legacy are secure.
The path forward involves careful consideration of legal structures, tax implications and the overarching goals for your estate plan. With access to a team of estate, tax and business planning experts, your Northwestern Mutual financial advisor is well positioned to help you get started.
