The Supreme Court likely shook up your buy-sell agreement

The Supreme Court likely shook up your buy-sell agreement.

Does your company have a buy-sell agreement that uses life insurance to redeem your shares after your demise? Here is the latest US Supreme Court decision that could impact you and your heirs in case of your demise.

These advantages can get knocked off by the hobby-loss rules that restrict your benefits and call for unfair taxes.

The impacts are as follows:

The Supreme Court decision means that the life insurance proceeds could cause an increase in your estate tax.
Based on how your buy-sell agreement is valued, the Supreme Court’s treatment of life insurance proceeds could cause a valuation result that could differ from what you expect.
The Supreme Court decision may require you and your fellow shareholders to rethink your buy-sell agreement.

Let us see how the recent Supreme court ruling in the Connelly case impacts your corporate redemption buy-sell agreement.

What happened?

Thomas Connelly and Michael Connelly owned all the stock in Crown C Supply, their building supply business. To protect their business from risk in the event of either Connelly’s death, the brothers decided created and funded a stock redemption agreement. Crown purchased life insurance on each shareholder’s life, and the proceeds were to be used to redeem the deceased shareholder’s shares.

Michael died in 2013. Per the redemption agreement, the company bought Michael’s shares using $3 million of the life insurance proceeds. Michael’s estate filed a federal tax return listing the value of his shares at $3 million, the value proclaimed by the redemption agreement.

Hello, IRS

The bad news for the estate was that the IRS disagreed. It said the company’s value was $6. 86 million at the time of Michael’s death. When Michael died, the estate tax redemption was $5.25 million per individual. The IRS change in the valuation of the business, just one of the estate’s assets, caused Michael’s estate to pay more in estate taxes.

The estate paid the tax. Then Thomas, the surviving brother and estate executor, sued for a refund in the US district court. But nothing good happened, as the court agreed with the IRS and held that the company’s value had increased due to the life insurance proceeds. According to the court and the IRS, the required redemption did not reduce the value of the shares for estate tax purposes. Though, Thomas did not give up. He moved the US Courts of Appeals for the Eighth Circuit but lost again. Then the case was moved to the US Supreme Court.

The Supreme Court upheld the decision of the IRS, district court and the appellate court on June 6, 2024. Taking the Connelly case as precedent, the buy-sell redemption agreement liability can no longer offset the life insurance proceeds on your company’s balance sheet for estate tax purposes.

After Connelly, life insurance money is treated as the company’s asset. This increases the value of the deceased person’s shares before they are bought back, resulting in higher redemption costs and more estate tax could be due.

What to do about it

Review the structure and terms of your buyout agreement first. If your buy-sell agreement uses company-owned life insurance, the Supreme Court decision can affect you. If your estate value is safely under the federal estate tax threshold (presently, the exemption is $13.61 million), you may want to leave the insurance-funded redemption agreement in place.

Despite life insurance adding to your company’s value, no federal estate tax would be due if you are under the exemption limit. But some states have lower limits, and you can still owe state taxes.

Note: The Tax Cuts and Jobs Act increases in the federal estate tax redemption expire on December 31, 2025. Thus, beginning in 2026, the tax code, as currently written, will cut the estate tax exemption in half.

So, what is the alternative?

Alternatively, you may want to change your arrangement to a cross-purchase agreement. With this type of structure, each owner buys insurance on the other owners and uses the proceeds to purchase the shares of the deceased. The value of the insurance does not affect the company’s value, as it did in the case of Connelly.

This is what comes with a cross-purchase agreement funded with life insurance:

You receive the life insurance monies free of federal income tax
You use the life insurance money to buy the shares of the deceased and
Your stock basis in the company increases by the price you pay for newly acquired shares.

The glitch here is that altering the existing redemption agreement is tricky, and you need the assistance of good life insurance and estate planning advice. If you are worried that not all owners will pay the premiums to keep it active or if the number of owners is too many to monitor, consider a cross-purchase trust or an insurance LLC. The benefit is that instead of having each shareholder’s policies on all the other owners, there is only one insurance policy per owner.

Takeaways

The Supreme Court decision in the Connelly case clearly states that the life insurance money paid to the company to redeem the deceased shareholder’s shares increases the company’s value for estate tax purposes. If you are an owner involved in a business agreement that uses life insurance to fund a redemption of ownership when one owner dies, it’s time to spend some time with your estate tax advisors to make sure what happens at death is what you expect to happen.

Post Connelly’s case, the redemption buy-sell is not advised, while the cross-purchase agreement is a better alternative.