Review and Update Your Buy-Sell Agreements

Following a recent Supreme Court decision, parties to buy-sell agreements will want to review their documents and consult their advisors regarding their use of life insurance for the redemption of an owner’s interest in the business and potential negative business and tax consequences. The U.S. Supreme Court ruled in Connelly v. U.S. that life insurance proceeds used to redeem a deceased shareholder’s shares, must be included in the company’s fair market value when calculating the estate tax.

The Connelly case involved two (2) brothers who were the sole shareholders of a closely held corporation. To ensure the corporation remained in the family, the two (2) brothers agreed that the surviving brother could purchase the deceased brother’s shares, if one of them died. The corporation purchased life insurance on each brother in order to fund the possibility of a shareholder redemption. After one brother died, the surviving brother reported the value of the shares at the $3 million redemption price on his federal tax return, as the executor of his brother’s estate. The IRS challenged the estate’s valuation method, which excluded the life insurance proceeds. The unanimous decision determined that the value of the life insurance policy held by the company increased the fair market value of the company, which in turn increased the value of the decedent’s interest. The Court also stated that there is no corresponding liability to offset the increased value from the life insurance policy based on the contractual obligation of the company to repurchase the decedent’s interest. The end result was a significant increase in the estate tax owed by the decedent’s estate.

Best Practices to Avoid Adverse Tax Consequences:

• Review and Update Buy-Sell Agreements: Given the new ruling, it is essential that shareholders review their corporate buy-sell agreements, and how the buy-sell agreement is funded. Buy-Sell agreements should be structured in a way that minimizes estate tax liabilities. It is key to make sure your documents are drafted and updated to stay current as well as support your tax positions.
• Consider Possible Alternative Tax Saving Structures: Explore alternative structures for buy-sell agreements that might be more tax-efficient. Utilization of cross-purchase agreements for the direct purchase of shares by the other shareholders would avoid the Connelly result. Irrevocable life insurance trusts (ILITs), which own the policy instead of the corporation directly, are also a potential solution.
• Regular Insurance Policy Reviews Are a Must: A regular review of estate tax and life insurance policies, including buy-sell and key-man policies, should never be put off. Changes in a person’s health, the availability of new products, or shifts in the tax landscape can put your planning at risk and significantly increase your tax liability.

Consult your business and tax advisors about reviewing your buy-sell agreements, life insurance policies, and business, estate, and other tax planning documents to be sure you are in the best position possible going forward.

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