Life insurance rarely figures prominently in U.S. Supreme Court cases. But there are scattered exceptions, and on June 6 2024, the Court released its decision in Connelly v. United States, originally a Tax Court case involving life insurance in an entity stock redemption arrangement between two brothers who owned a closely held corporation. The Court ruled in favor of the IRS and held that in this case, for purposes of establishing the value of the corporation for estate taxes, the corporation's obligation to purchase the deceased brother's shares did not offset the value of corporate owned life insurance proceeds earmarked for use in the stock redemption.
The result? The value of the life insurance proceeds on the deceased brother were deemed to be includable in the value of the business for estate tax purposes, which in this case significantly inflated the estate value and the corresponding taxes due.
What does it mean for your clients?
The Connelly decision impacts C and S corporation shareholders who use corporate owned life insurance to fund entity purchases and wait-and-see buy-sell agreements. It definitively resolved a split in opinions among the Tax Courts and the Courts of Appeal, and is broadly applicable to the structure and estate tax consequences of life insurance funding in an entity redemption agreement.
Because the decision upends almost 20 years of traditional redemption arrangements for closely held entities, clients and closely held business owners in your orbit will be looking for agents and advisors to craft new business continuation and buy-sell agreements, funded by life insurance, and structured to exclude the value of life insurance proceeds from the deceased's estate.
Note that the Connelly decision does not prohibit the use of life insurance to fund an entity redemption arrangement, nor does it expose life insurance proceeds per se to estate taxes in such an arrangement. It simply adds the life insurance proceeds that are received by the business at the deceased's death to the value of the business for estate tax purposes. If shareholders do not have concerns regarding federal or state estate tax or inheritance tax, Connelly's impact on business continuation planning may be negligible.
Some alternative solutions for agents and advisors
The first and perhaps most important action item for agents and advisors is to assist clients in a review of their buy-sell agreements and life insurance policies. Once the review is complete, clients will have several options including:
- Terminate the redemption agreement and replace it with a cross-purchase agreement.
- Transfer any existing redemption life insurance to the shareholders or an insurance LLC owned by the shareholders.
- Connelly may also affect businesses that are structured as partnerships or LLCs taxed as partnerships, when those entities provide for the redemption of partnership interests using life insurance. The partnership tax rules may make it possible to move to a cross purchase structure without gain recognition at the partnership level. And a separate insurance LLC may be used as well.
Looking to the Future
Connelly may have struck the death knell for many redemptions funded with entity-owned life insurance. But when the dust settles, Connelly will have just closed one planning strategy. You have many other buy-sell planning strategies to choose from, and you can help your clients to find the one that's right for them.
The next step? Reach out to your business owner clients (whether or not they have a buy-sell agreement in place) and to your centers of influence to make them aware of the impact of the Connelly decision and to discuss their business planning needs. And, as always, Windsor is here to help when you need us.
For Financial Professional use only. Not intended for use with the general public. Windsor Insurance Associates, Inc. does not provide tax advice. Financial Professionals and their clients should consult with a licensed tax advisor on the issues presented in this material.
Reference Material for further reading
United States Supreme Court Holds Redemption Insurance Proceeds Increase Value of Corporation Despite Redemption Obligation – Partners Financial White Paper – June 2024
Buy-sells may now cause estates to be taxable - A review of Connelly v. Department of Treasury Supreme Court ruling - Lincoln Financial - June 2024
Supreme Court upholds inclusion of life insurance proceeds when valuing business in Connelly – John Hancock Central Intelligence – June 2024
Syllabus and Opinion of the Court – Supreme Court of the United States – Thomas A. Connelly, Petitioner v. United States – June 6, 2024
IRS Can Tax Death Benefits Used to Purchase Stocks, High Court Rules – Courthouse News Service – June 6, 2024
Supreme Court Connelly Ruling Shows Flaws of Taxpayer's Argument – Bloomberg – June 10, 2024
The Life Insurance Only LLC - A Consideration for Buy-Sell Agreements– Steven M. Saraisky, Author, Cole Schotz P.C. – September 16, 2022
Connelly's Conundrum:Life Insurance and Stock Redemptions – Grayson M.P. McCouch – Taxnotes – March 18, 2024