Connelly’s impact on tax and insurance planning

Planning techniques for business succession and estate and gift taxes are continually evolving in response to legislative efforts, court cases, and market dynamics. In June 2024, the Supreme Court added further clarification through its unanimous decision in Connelly v. United States. That case, involving a closely held business, has key implications regarding how buy-sell agreements funded by life insurance proceeds are executed. Our tax specialists review Connelly and consider its future impact.

Connelly: Facts and decision

In Connelly, a closely held corporation was owned by two brothers, Michael and Thomas Connelly. They had a buy-sell agreement in place, underpinned by corporate-owned life insurance. The agreements stipulated that when one brother died, the surviving brother would have the first option to buy the deceased brother’s shares. If the surviving brother declined the option, then the corporation would be obligated to redeem the shares. The redemption price was to be determined by either an outside fair market value appraisal or by mutual agreement. To ensure sufficient funds for the redemption, the corporation secured $3.5 million life insurance policies for each brother, leaving the corporation to buy the shares.

When one of the brothers died, the surviving brother declined to exercise his option to buy, and the corporation became obligated to redeem the deceased brother’s shares. However, despite the agreement, there was no outside appraisal. Instead, the surviving brother and the deceased brother’s son agreed on a redemption amount of $3 million. The corporation then used $3 million of the $3.5 million in life insurance proceeds to redeem the deceased brother’s shares. The deceased brother’s estate then filed a return showing the shares’ value as $3 million.

Upon audit, the IRS and the estate viewed the situation differently. The IRS viewed the insurance proceeds received by the corporation as an increase in its assets. That would have increased the value of the stock to be redeemed to something more than $3 million. The estate’s view was that the insurance proceeds were offset by the redemption liability. In that light, there would have been no increase in the net value of the stock. The estate paid the deficiency resulting from the exam and sued for a refund. The estate argued that the stock purchase agreement determined the value of the shares and cited Estate of Blount v. Commissioner (11th Cir. 2005) in support of its position. The district court granted summary judgment for the IRS. On appeal, the Eighth Circuit affirmed, concluding the stock purchase agreement should be disregarded and that the proceeds had to be considered in determining the value of the corporation’s stock.

The Supreme Court considered the issue regarding the inclusion of the life insurance proceeds and affirmed the decision of the Court of Appeals. The Court ruled that a fair market value redemption has no effect on a shareholder’s economic interest because no buyer would have treated the contractual obligation to redeem the shares at fair market value as a factor that reduced the value of the shares.

The landscape prior to Connelly

Prior to the ruling in Connelly, the legal landscape surrounding the valuation of corporate stock included in a shareholder’s estate was subject to at least some degree of uncertainty. Sections 2031 and 2042 of the Tax Code were best read to say that the value of a deceased shareholder’s stock increases in proportion to the value of insurance proceeds received by the corporation. However, a few decisions, including Blount, were also used to argue that a corporation’s obligation to redeem its shares or interest could offset insurance proceeds. The effect of such an interpretation was a reduction in value that would be subject to the estate tax.

In Connelly, the Court held that life insurance proceeds received by a corporation aren’t offset by such corporation’s obligation to redeem shares. For federal estate tax purposes, this means that the life insurance proceeds must be accounted for in the value of corporate stock. As a result, this ruling effectively resolved any lingering ambiguity surrounding the offset of obligations against insurance proceeds, providing clarity for legal practitioners and taxpayers.

Valuation considerations after Connelly

The first issue, which wasn’t addressed by the Court but did figure into the Court of Appeals’ decision, concerns the valuation of the shares. In order to disallow discounts created by family members, Section 2703(a) states the general rule that the value of any property is determined without regard to either (1) an agreement to acquire the property at a price that’s less than fair market value; or (2) any restriction on the right to sell or use the property. However, Section 2703(b) contains a statutory exception to this general rule, which applies if three requirements are met. First, the agreement must be a bona fide business arrangement. Second, it must not be a device to transfer the property to a member of the decedent’s family for less than full and adequate consideration. Lastly, the terms must be similar to those used in arrangements entered by persons in arm’s-length transactions. 

The estate in Connelly argued in the Court of Appeals that the stock purchase agreement satisfied the three requirements of the exception. The agreement didn’t include an objective formula or calculation to serve as a reference for fair market value and instead laid out two mechanisms by which the shareholders could agree on a price. One of the methods, an independent appraisal, didn’t contain a formula or measure for the appraisers to reach. The second method and the one ultimately implemented by the surviving brother and the decedent’s son, a certificate of agreement, was simply a mutual agreement and was thus not objective. Therefore, the Court of Appeals decided to disregard the stock purchase agreement when determining the value of the company.

Based on the Court of Appeals’ decision, businesses would be well-advised to consider case law in conjunction with Section 2703, as it offers valuable explanations on its requirements. Further, valuation methods selected in an agreement should contain adequate appraisals with a specific calculation or formula. This will enable businesses to determine stock value through an unbiased approach.

Structuring life insurance policies and proceeds

The second issue, which was actually decided by the Supreme Court, deals with the inclusion of life insurance proceeds in the value of a corporation. Insurance proceeds are frequently used to fund buy-sell agreements, which are divided into two categories: redemptions and cross-purchase agreements. In a redemption, the type of agreement at issue in Connelly, the entity itself purchases the equity interest from a shareholder or member upon a triggering event such as death or retirement. In the wake of the Connelly decision, this type of buy-sell agreement may not be the most tax-efficient option available since the insurance proceeds meant for the redemption will be included in the company’s valuation.

Closely held businesses may need to consider alternative structures to avoid inflating the value of the entity. One such method involves a cross-purchase buy-sell agreement, where each owner buys a policy on the others. In this strategy, upon an owner’s death, the surviving shareholders or members use the life insurance proceeds to buy the decedent’s shares directly, rather than having the entity redeem its own equity. This arrangement circumvents the issue encountered in Connelly, as the life insurance proceeds aren’t part of the business’s assets and therefore don’t inflate value for estate tax purposes. The primary challenge with this structure relates to administrative complexity given the need for each owner to purchase policies relating to other owners. Such complexity is amplified as the volume of owners increases.

Hybrid alternatives are also available, should owners still desire to have the company redeem some of the equity. Under this approach, owners can make a portion of the purchase using down payments and promissory notes. In doing so, the entity would use a smaller life insurance policy to buy the remainder. At present, based on current federal law containing an estate tax exemption amount of $10 million adjusted for inflation, estates valued below $13.61 million per individual will not be subject to federal estate taxes. Therefore, the smaller the policy, the less likely it is to push over the valuation of the estate over the minimum estate filing threshold. This approach is also a good alternative for entity’s that have more than two or three shareholders or members since it would reduce the overall administrative burden.

Moving forward after Connelly

Connelly v. United States is an important ruling that has necessitated a reevaluation of planning strategies for closely held companies. Central to this ruling is a clarification of the requirements for stock purchase agreements funded by corporate-owned life insurance. Importantly, however, Connelly has not eliminated all opportunities for innovation in the structuring of individual or trust-owned life insurance policies and cross-purchase agreements.

All information article is believed to be from reliable sources; however, no representation is made to its completeness or accuracy. The material is for informational purposes only and is not intended provide specific advice or recommendations for any individual nor does it take into account the particular investment objectives, financial situation, or needs of individual investors. This information is not intended for use as tax or legal advice. Persons should consult with their own tax or legal advisors for advice.

Steve Gibson is a registered representative and offers securities through Valmark Securities, Inc. Member FINRA, SIPC. Plante Moran Insurance Agency and Plante Moran Financial Advisors are separate entities from Valmark Securities.