In a pivotal ruling with significant implications for business valuations and buy-sell arrangements, the U.S. Supreme Court in Connelly v. United States addressed the inclusion of life insurance proceeds in the valuation of a business when the business is the beneficiary of a deceased shareholder’s life insurance policy. This decision brings to light critical considerations for business owners and legal practitioners regarding the proper structuring of buy-sell arrangements and the potential tax consequences.
Background on Buy-Sell Agreements and Life Insurance Policies
Buy-sell arrangements are commonly part of the governing documents of a closely-held business. Typically, these arrangements are codified in an operating agreement, company agreement, or shareholders agreement and are often called “buy-sell agreements”. The purpose of the agreement is to document the facilitation of the transfer of ownership upon the death, disability, or departure of an owner. These agreements often rely on life insurance policies to provide the necessary funds to buy out a deceased owner’s interest. In many cases, the business itself is designated as the beneficiary of the life insurance policy, ensuring liquidity to purchase the ownership at a pre-determined price.
The intersection of business law principles and estate tax principles creates a nuance that adds a dimension to buy-sell planning. From a business law perspective, the foundation legally is built on contract law. The owners of a business may design an agreement to best deal with “what if” scenarios where an owner is leaving the business. From an estate tax perspective, the foundational issues are built on the value of the estate when someone dies. Friction is created between these two when the buy-sell agreement does not conclusively establish the value of the shares through either (1) a professional valuation at the time the buy-sell was signed or (2) the buy-sell setting a fixed and determinable price for the shares.
The Connelly Decision
In Connelly v. United States, the Supreme Court was tasked, in a situation where there was not a conclusive value of the shares, with determining whether life insurance proceeds should be included in the valuation of a business when the business is the named beneficiary of the deceased shareholder’s life insurance policy. The case involved a family-owned business with a buy-sell agreement funded by a life insurance policy. Upon the death of one of the shareholders, the Internal Revenue Service argued that the life insurance proceeds should be included in the valuation of the business for federal estate tax purposes, thereby increasing the overall value of the estate and the corresponding tax liability.
The Supreme Court sided with the United States, holding that when the business is the beneficiary of the life insurance policy, the insurance proceeds must be included in the valuation of the business. The Court emphasized that life insurance proceeds paid to a business enhance its financial position and therefore should be reflected in the business’s overall value. This ruling underscores the principle that the true economic value of the business must account for all assets, including cash inflows from life insurance policies that directly benefit the business.
Implications for Business Owners and Legal Practitioners
The Connelly ruling serves as a critical reminder for business owners and their advisors to reassess the terms of their buy-sell agreements, especially those funded by life insurance policies. With the inclusion of life insurance proceeds now affirmed as part of business valuation for estate tax purposes, careful planning and precise language in buy-sell agreements are essential to manage potential tax implications effectively.
Restructuring Buy-Sell Agreements
Businesses should carefully review their buy-sell agreements to ensure that they accurately reflect the intended valuation methodology. Otherwise, businesses may need to restructure their agreements. Below are a couple of potential solutions for restructuring buy-sell agreements:
- Define a Conclusive Value in the Buy-Sell: One solution, in interpreting the Connelly decision, would be to tighten the valuation formula or price in the buy-sell agreement. If life insurance proceeds are to be excluded from the business’s valuation, explicit language to that effect must be included in the agreement. The best practice would be to complement this new language with a business appraisal at the time the buy-sell agreement is signed and each time the business is revalued (if called for in the buy-sell agreement).
- Create Cross-Beneficiary Ownership Structure: Another solution, as suggested in the Connelly decision, is for business owners to name each other as cross-beneficiaries on life insurance policies, rather than having the business as both the owner and beneficiary. Under this arrangement, each shareholder owns a policy on the life of the other shareholders and is the beneficiary of that policy. This structure helps prevent the insurance proceeds from being included in the business’s valuation because the proceeds are paid directly to the surviving shareholder(s) instead of to the business itself. This approach minimizes the risk of an increased estate tax liability by keeping the life insurance proceeds outside of the business’s value.
- Creation of a Separate Entity: A third potential option is to create a separate entity, such as a trust or a limited liability company (LLC), with mirror ownership to hold the life insurance policies. This entity would own the policies and be the beneficiary, and consequently isolate the insurance proceeds from the business’s valuation. Since the policies are held by a separate entity and not directly by the business, the life insurance proceeds are less likely to be included in the business’s valuation for estate tax purposes. This strategy can provide an additional layer of protection and clarity, ensuring that the proceeds are used as intended for buyouts without impacting the business’s taxable value. It is important to acknowledge potential risks with this strategy. Because this decision is new, solutions to the problem caused by this ruling are untested. This separate entity strategy can also cause additional corporate and taxable issues necessitating work with your advisory team to make sure it does not create a new taxable impact.
Ensure Your Buy-Sell Agreements Are Up-to-Date – Contact ByrdAdatto
The Supreme Court’s decision in Connelly v. United States highlights the importance of accurately accounting for all assets, including life insurance proceeds, when valuing a business for buy-sell agreements. By considering alternative structuring options, such as cross-beneficiary ownership or creating a separate entity to hold life insurance policies, business owners can better manage potential tax implications and ensure a fair and accurate valuation of their business interests. Business owners should proactively review their agreements to ensure compliance with this ruling, safeguarding against unexpected tax liabilities.
At ByrdAdatto, we recognize the complexities involved in structuring buy-sell agreements and the importance of balancing legal, financial, and tax considerations. Our team collaborates closely with insurance advisors and tax advisors to design efficient buy-sell structures that align with your business goals while minimizing potential tax liabilities. Contact ByrdAdatto for assistance in reviewing or structuring your buy-sell agreements.
