Tax Law Blog

Business Owners: How to Avoid Additional Estate Taxes after Connelly v. Commissioner

In early June, the Supreme Court issued an opinion that clarifies how company-owned life insurance impacts the value of the company for estate tax purposes. As a business owner, you may need to re-evaluate the use of those policies and whether they will subject you to increased estate tax exposure. Here’s what happened in Connelly and how it may affect you.

What Caused an Additional $800,000 in Estate Taxes?

The company in Connelly was owned by two brothers, Michael and Thomas. The brothers wanted to ensure the company would stay in the family name, so they entered into a buy-sell agreement. This agreement required the company to redeem the deceased brother’s stock if the surviving brother refused to personally purchase the stock. To fund a potential stock redemption, the company took out life insurance policies on both brothers.

When Michael passed, Thomas chose not to purchase his stock. So, the company purchased Michael’s stock based on a $3.86 million dollar company valuation and used the proceeds of Michael’s life insurance policy to purchase his shares from his estate. The IRS audited Michael’s estate, claiming the company was actually valued at $6.86 million (the corporation’s valuation plus the value of the life insurance policy). The Supreme Court ruled that the life insurance policies owned by a company must be added to the valuation of the company for estate tax purposes. This resulted in Michael’s estate owing more than $800,000 in additional estate taxes without receiving additional compensation for the increased value of his shares.

The result of Connelly is that a company can never fully-fund a redemption obligation with life insurance because the insurance proceeds continue to increase the value of the company.

What Can Business Owners Do to Avoid These Additional Taxes?

Business owners have several options available to them to help avoid this insurance-valuation price loophole:

1. Affiliated Insurance LLC. Consider creating a new LLC that is owned by the same persons as your current company. The new LLC would purchase life insurance policies on all its members, and it would be structured so that when a member dies, the life insurance policy is paid to the surviving members of the new LLC. This way, the value of the life insurance policies cannot be added to the value of your current company, because the policies are owned by the new LLC, its brother-sister company.
2. Cross Purchase Agreement. Rather than a company redemption, the individual owners could have an obligation to purchase a deceased owner’s shares. Each owner could purchase life insurance on the other. The value of the life insurance still increases the net worth of the holder, but disconnecting the policy from the company locks in the value of both without causing a price escalation to the company.
3. Fund a Redemption. Consider funding your redemption with core assets rather than life insurance policies.

As a practical matter, Connelly only impacts business owners subject to estate tax, which requires a gross estate (i.e. net worth) in excess of $13.61 million per taxpayer (married couples have $27.22 million). However, these allowances will be drastically reduced on December 31, 2025. If you have company-owned life insurance and have (or will have) a taxable estate, now is a good time to re-evaluate your buy-sell agreements to confirm succession planning can happen in a tax-efficient manner.

Please contact Mike Zahrt or another member of Foster Swift’s Business and Tax Team with questions on whether your company should change its buy-sell agreement or life insurance policy structure.

Categories: Alerts and Updates, Did you Know?, Insurance, News, Tax, U.S. Supreme Court