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Client Alert: Time to Revisit Buy-Sell Agreements in the Wake of the Connelly Decision

Date: July 17, 2024
In its recent decision in Connelly v. U.S., the U.S. Supreme Court held that life insurance proceeds received by a corporation to fund an obligation to purchase a deceased stockholder’s shares in the corporation must be included in the corporation's value for federal estate tax purposes and is not reduced by the contractual purchase obligation.
 
Key Takeaways
 
  • The decision may result in higher estate tax liability for decedent-stockholders.
 
  • The decision highlights the importance of careful estate planning and the potential need to restructure the ownership and use of life insurance policies.
 
Buy-Sell Agreements Generally
 
A well-advised, closely-held corporation has likely adopted a buy-sell agreement where, upon certain events, the stockholders of the corporation are required to sell their stock either to the corporation or to other stockholders. These agreements allow the corporation and its stockholders to maintain orderly governance and ownership.
 
The death of a stockholder is a common event under a buy-sell agreement that will trigger an obligation to sell stock. In the case of death, the estate of the deceased stockholder must sell the stock held in the corporation for some stated purchase price, and the payment of that purchase price may be funded through a life insurance policy on the deceased stockholder. 
 
However, the Connelly decision provides a cautionary tale as to how a corporation and its stockholders structure a buy-sell agreement that is triggered by death and funded through a life insurance policy.
 
The Connelly Case and Decision
 
In Connelly, two brothers owned a corporation and adopted a buy-sell agreement that included the following terms:
 
  • If a stockholder dies, the surviving stockholder will have the option to purchase the deceased stockholder’s shares in the corporation; and
 
  • If the surviving stockholder does not exercise his option, then the corporation will have the obligation to purchase the deceased stockholder’s shares in the corporation.
 
In order to provide comfort that the corporation would have enough money to meet its obligation to purchase the shares of a deceased stockholder, the corporation obtained life insurance policies on each of the stockholders and was the owner and beneficiary of the policies.
 
One of the brothers died, and the surviving brother did not exercise his option to purchase the shares, therefore triggering the corporation’s purchase obligation. The corporation purchased the shares but was also able to collect the life insurance proceeds payable on the death of the stockholder.
 
In calculating the federal estate tax, the deceased stockholder’s estate took the position that the life insurance proceeds paid to the corporation did not increase the value of the deceased stockholder’s stock because the corresponding requirement that the corporation purchase the stock was a liability that offset the life insurance proceeds. The estate effectively took the position that the two related transactions resulted in a “wash.”
 
The IRS challenged this position and argued that, for purposes of the federal estate tax, the life insurance proceeds received by the corporation increased the value of all of the stock of the corporation (including the deceased stockholder’s stock) and there was no offsetting liability created by the corporation’s obligation to purchase the stock. Therefore, the IRS argued that the estate undervalued the stock for purposes of the federal estate tax and owed additional taxes.
 
The U.S. Supreme Court, affirming the lower court decisions, agreed with the IRS. The U.S. Supreme Court held that a corporation’s obligation to purchase shares is not necessarily a traditional balance sheet liability that reduces the value of its stock for federal estate tax purposes because the purchase obligation does not impact a stockholder’s economic interest in the corporation or how a buyer would view the value of the corporation in an arm’s-length purchase.   
 
Moving Forward under Connelly
 
In light of Connelly, there are important considerations for closely-held businesses and their stockholders.
 
First, be mindful that Connelly is a decision that deals with the federal estate tax. It is not an income tax case. It remains that, in most cases, life insurance proceeds paid to a corporation will not be treated as taxable income to the corporation (along with the concept that premiums paid by the corporation are also not deductible).
 
Second, there are planning techniques that can be adopted to potentially workaround the Connelly holding. For example, instead of the corporation being obligated to purchase shares at the death of a stockholder and holding the life insurance policy to fund that purchase, the other stockholder in Connelly could have been obligated to purchase the shares and held the life insurance policy personally to fund his purchase obligation. This is commonly referred to as a “cross-purchase” buy-sell agreement and will keep the life insurance proceeds entirely outside of the corporation. Be wary, however, that this technique becomes more complicated with multiple stockholders, as the stockholder group will now have to manage many different policies personally or create an entity to help centralize the administration of multiple policies using a third party.
 
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Structuring a buy-sell agreement for any business is complex. Connelly has introduced a new layer of complexity, and businesses are urged to consult with their advisors when adopting or amending buy-sell agreements.
The information contained here is not intended to provide legal advice or opinion and should not be acted upon without consulting an attorney. Counsel should not be selected based on advertising materials, and we recommend that you conduct further investigation when seeking legal representation.