Impact of the Connelly Ruling on Buy-Sell Agreements and Life Insurance Strategies

According to a study conducted by MassMutual of 800 U.S. business owners (2022 MassMutual Business Owner Perspectives Study), 32% of respondents have a buy-sell agreement in place but only 46% say it’s funded with life insurance. And only 25% of participants have reviewed their agreements in the last year.

A common practice is for businesses to hold life insurance intended to be used to fund a stockholder redemption in the event of death. This practice should be reconsidered due to a recent Supreme Court ruling.

In June 2024, the Supreme Court ruled on the Connelly case, a decision that has profound implications for business owners, particularly regarding buy-sell agreements funded by life insurance. This ruling underscores the importance of carefully structuring these agreements to avoid unintended tax consequences and highlights the need for a proactive review of existing arrangements.

The Connelly Case: Key Takeaways

The Connelly case involved a company with a buy-sell agreement funded by life insurance. Upon the death of one of the shareholders, the company received $3 million in life insurance proceeds, which were intended to buy out the deceased shareholder’s estate. The remaining owner expected that the asset created from life insurance proceeds would be offset by the obligation to repurchase the deceased owner’s shares. However, the IRS argued that the obligation was not a liability of the company, which increased the value of the deceased shareholder’s estate. The court sided with the IRS, ruling that the life insurance proceeds should be included as an asset with no offsetting liability for the obligation to redeem the shares.

This ruling challenges a previously held assumption that the proceeds from a life insurance policy used to redeem shares would not affect the company’s valuation for estate tax purposes. Consequently, business owners must reconsider how their buy-sell agreements are structured to mitigate the potential tax implications revealed by this case.

Implications on Buy-Sell Agreements

The ruling primarily affects buy-sell agreements, where the company is both the owner and beneficiary of life insurance policies on its shareholders (otherwise known as entity purchase agreements). In these cases, life insurance proceeds can increase the company’s value, thereby increasing the value of the deceased owner’s estate and potentially leading to higher estate taxes.

There are alternatives to this structure. One alternative is a cross-purchase agreement, where each owner buys and owns a life insurance policy on the other owners. Upon the death of a shareholder, the surviving owners use the proceeds to buy out the deceased owner’s shares directly, without affecting the company’s value. However, cross-purchase agreements can be cumbersome, especially in companies with multiple shareholders, as each owner needs to purchase and maintain separate policies on every other owner.

Another option is utilizing an Irrevocable Life Insurance Trust (ILIT), which keeps the life insurance proceeds out of the estate and thus avoids increasing its value. The trust receives the insurance payout and uses it to purchase the deceased owner’s shares, transferring them according to the terms of the trust. This strategy can reduce estate taxes, making it an attractive option for business owners with significant assets.

Lastly, business owners can set up a separate LLC to hold the life insurance intended to fund the buy-sell agreement.

How this Affects Business Owners

In light of the Connelly ruling, we recommend business owners review their buy-sell agreements. This review should involve not just the business and estate planning attorneys but also an insurance advisor who can evaluate the current policies and suggest changes if necessary. The goal is to ensure that the agreements are specific about how life insurance proceeds will be treated and to explore potential restructuring options that minimize tax liabilities.

For companies that already have entity purchase agreements in place, converting these to cross-purchase agreements or utilizing an ILIT may be advisable. However, each option comes with its own set of complexities and costs, which should be weighed carefully with professional guidance.

If your business does not have an immediate estate tax problem, the Connelly ruling might not seem directly relevant. However, the potential for future tax implications remains. Even if a company currently has a valuation below the estate tax threshold, an unexpected death coupled with an increase in company value due to life insurance proceeds could push the estate above the threshold, leading to unanticipated tax burdens.

Working with a Partner in Insurance and Tax

The Connelly Supreme Court ruling is a reminder of the importance of carefully structuring buy-sell agreements to avoid unforeseen tax consequences. By taking proactive steps to review and, if necessary, revise these agreements, business owners can protect their companies and estates from significant tax liabilities.

Our team can work with your legal advisors to review your current buy-sell agreement and funding needs, and then assess how best to use insurance, helping you identify any potential risks and recommending strategies tailored to your specific needs. Whether it’s restructuring your agreements, exploring cross-purchase options, or setting up an ILIT, we provide the expertise and support you need to make informed decisions.

If you have concerns about how this ruling might affect your business or would like to discuss your life insurance options, please contact us.

Sikich Financial does not provide tax or legal advice. The information presented here is not specific to any individual’s personal circumstances. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances.

These materials are based upon publicly available information and are provided for general information and educational purposes only. The information contained herein has been compiled from data considered to be reliable.

About Our Authors

Maggie Woroniecki is a financial advisor, who provides a holistic approach to coaching clients and delivers financial strategies to help them achieve their goals. Maggie is a results-driven leader and former business owner of an insurance practice. With nearly 20 years of experience helping clients accumulate wealth, mitigate risk and build retirement strategies, she is passionate about understanding what makes each client enjoy a full life and is focused on helping people feel confident in their financial decisions.

Tom Bayer, CPA, CExP, has specialized expertise in the areas of business succession planning, tax planning and compliance, and business advisory. He has deep experience providing a range of accounting, tax, and business advisory services to commercial clients across industries.