All U.S. closely held businesses just received a warning from the highest court in the land that they should review their succession plans (or else risk a higher tax bill for the estates of their owners). On June 6, 2024, the Supreme Court of the United States (“SCOTUS”) issued its unanimous decision on Connelly v. United States. Connelly requires fair market value calculations for a business interest to include the insurance proceeds, even where those insurance proceeds must be used to repurchase the ownership interests of a deceased owner. SCOTUS acknowledged that the same valuation issue would not be inherent in a cross-purchase, but quickly pointed out that a cross-purchase agreement is often more burdensome for the owners.
In Connelly, two brothers had entered into a buy-sell agreement to keep their family business in their family. The business obtained life insurance to fund the purchase. Upon the death of one brother, if the other brother elected not to purchase the shares, then the business was obligated to redeem (i.e. purchase) the shares. When the business redeemed the shares for $3 million, the IRS conducted an audit and disagreed. The surviving brother (who was the executor for his deceased brother’s estate) and the deceased brother’s son determined that the fair market value of the business at the date of death was $3.86 million (not taking into account the insurance proceeds). The deceased brother owned 77.18% of the business, which created an approximate value of $3 million for the deceased brother’s shares ($3.86 million x 0.7718). The IRS believed the business’s value should have been $6.86 million in total, which included the $3 million in life insurance proceeds; this would place the deceased brother’s share value at $5.3 million ($6.86 million x 0.7718). SCOTUS agreed with the IRS and affirmed the lower court decision.
This decision effectively requires small business owners to contemplate an additional gross-up for taxes, even if the buy-sell agreement calls for the entity to use life insurance proceeds to redeem shares upon death. Justice Thomas’s acknowledged alternative, a cross-purchase, is more complicated. In a cross-purchase arrangement, the other shareholders must pay the premiums, which means the owners must have cash on hand (and potentially will have different premium obligations depending on the health and age of the other business partners). Additionally, if a business has more than 5 members, maintaining the insurance policies could become administratively burdensome; each member will maintain a separate policy on the life of each other business partner, so any change to policy value or ownership will require paperwork for each of the numerous policies.
An additional alternative would be to form a trust that would maintain life insurance policies on each of the owners of the business. In this arrangement, the trust would pool funds from all of the owners in order to pay the policies collectively, and then would purchase the shares of deceased owners when they died, later distributing the shares to the surviving owners as beneficiaries of the trust. There are a variety of other alternative structures for business succession plans, some not funded by insurance, but each business should review its current plans with professional advisors to determine which business succession plan would work best.
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