Planning with Buy-Sell Agreements After Connelly

By:  William E. Sigler, Esq.

On June 6, 2024, the U.S. Supreme Court unanimously held in Estate of Connelly v. United States that life insurance proceeds received by a closely held corporation used to redeem a deceased shareholder’s stock were includable in the company’s value for federal estate tax purposes, but that the corresponding obligation of the company to redeem the deceased shareholder’s stock pursuant to a buy-sell agreement was not a liability that reduced the corporation’s fair market value.  The holding affirms the decision of the Eighth Circuit Court of Appeals, but overturns the decision of the Eleventh Circuit in Estate of Blount v Commissioner which had been the law since 2005.  The Eleventh Circuit had held that life insurance proceeds should not be included in a company’s value when they are offset by a redemption obligation. 

The Facts in Connelly

Michael and Thomas Connelly were the sole shareholders of a building supply company in St. Louis, Missouri.  There were 500 shares of the company’s stock outstanding of which 385.9 shares or 77.18% were owned by Michael, and 114.1 shares or 22.82% were owned by Thomas. 

A buy-sell agreement gave the surviving brother the option to purchase the deceased brother’s shares.  If the option was not exercised, then the company was required to redeem the deceased brother’s shares.  The buy-sell agreement specified that the price would be determined by an outside appraisal.  The company funded its obligation with $3.5 million in life insurance on each brother. 

Michael died in 2013.  Thomas opted not to purchase Michael’s shares.  As a result, the company was obligated to redeem those shares under the buy-sell agreement.  However, instead of obtaining an outside appraisal, the company agreed with Michael’s son that the value of Michael’s shares was $3 million.  The company used $3 million from the life insurance proceeds to redeem Michael’s shares, leaving Thomas as the sole shareholder. 

As the executor of Michael’s estate, Thomas filed a federal estate tax return reporting the value of Michael’s shares as $3 million.  The return was chosen for audit by the IRS.  In connection with the audit, Thomas obtained a valuation from an accounting firm.  Consistent with the holding in Blount, the accounting firm offset the insurance proceeds with the redemption obligation.  It concluded that the value of the company was $3.86 million, and that the value of Michael’s shares was approximately $3 million ($3.86 million x 0.7718). 

The IRS disagreed and added the $3 million in life insurance proceeds to the $3.86 million value determined by the accounting firm to obtain a total value for the company of $6.86 million.  The IRS then determined the value of Michael’s shares to be $5.3 million ($6.86 million x 0.7718), which resulted in an additional $889,914 in taxes. 

The estate paid the deficiency and sued for a refund.  The U.S. District Court granted summary judgment to the IRS, concluding that Michael’s estate was not entitled to a refund.  The estate appealed and the Court of Appeals affirmed the District Court’s decision, thereby setting the stage for the U.S. Supreme Court to resolve the conflict between the Eighth Circuit Court of Appeals decision in Connelly and the earlier Eleventh Circuit decision in Blount. 

Analysis by the U.S. Supreme Court

The U.S. Supreme Court defined the issue very narrowly as whether the company’s contractual obligation to redeem Michael’s shares offset the value of the life insurance proceeds committed to funding the redemption.  It took as a given that the company must be valued at fair market value for federal estate tax purposes, and that the life insurance proceeds were an asset that increased the company’s fair market value.

In concluding that the company’s obligation to pay for Michael’s shares did not reduce the value of his stock, the Court offered an example for support.  The example involved a corporation with no assets other than $10 million in cash.  It has two shareholders, A and B, who own 80 and 20 shares, respectively.  Each share is worth $100,000 ($10 million ÷ 100 shares).  Thus, A’s shares are worth $8 million (80 shares x $100,000), and B’s shares are worth $2 million (20 shares x $100,000).  To redeem B’s shares at fair market value, the corporation would have to pay B $2 million.  After the redemption, A would be the sole shareholder in a corporation worth $8 million.  A’s shares would still be worth $100,000 each ($8 million ÷ 80 shares). 

Based on the example, the redemption has no economic impact on either shareholder.  Accordingly, the Court concluded that a corporation’s contractual obligation to redeem shares at fair market value does not reduce the value of those shares. 

Analysis of the Court’s Decision

The sticking point for the Court appears to have been the result implicit in the estate’s position that the company’s redemption of Michael’s shares left Thomas with a larger ownership stake in a company with the same value as before the redemption.  According to the Court, “That cannot be right:  A corporation that pays out $3 million to redeem shares should be worth less than before the redemption.” 

The Court’s conundrum can be illustrated as follows: 

ESTATE’S POSITION

The problem becomes clear.  Prior to the redemption, Thomas’ stock was worth $7,720 per share.  After the redemption, it was worth $33,829.97 per share.  The difference is difficult to justify.  The approach argued by the IRS eliminates this problem: 

IRS POSITION

Under this approach, Thomas’ stock has a per share value both before and after the redemption of $13,720 per share.  One of the problems with the Court’s analysis is that it may not work if a different methodology is used to value the company, e.g., discounted cash flows.  This technique, sometimes referred to as the gold standard of valuation, estimates the value of a company based on the money or cash flows it is expected to generate in the future.  Since any insurance proceeds received would be offset by the redemption obligation, only the net amount of cash would be available for reinvestment back into the company to influence future cash flows.  Would the IRS essentially be able to disqualify a valuation method chosen by a qualified appraiser, or specified in a buy-sell agreement, solely based on the Court’s decision in Connelly?  It remains to be seen. 

Planning Alternatives

There have always been alternatives to stock redemption buy-sell agreements.  For example, even the U.S. Supreme Court noted that “the brothers could have used a cross-purchase agreement.”  Many advisors likewise recommend cross-purchase agreements, particularly for C corporations, since it avoids corporate AMT because the policies are not owned by the corporation.  Instead, each shareholder owns a policy on each of the other shareholders.  Since the shareholders own the policies and receive the tax-free death benefit, they can get a basis step-up by buying the stock from the deceased shareholder’s estate.  In the case of a “wait-and-see” buy-sell agreement, the shareholders have the option to contribute the tax-free death benefit as capital to the corporation if the stock redemption alternative is chosen. 

But, cross-purchase agreements are not without their drawbacks.  For example, a company with four owners requires 12 policies (4 x [4 – 1] = 12).  In addition, the premium burden is allocated based on the cost of insurance on the other owners, so the youngest and healthiest owners often end up paying more than their proportionate share of the premiums, since they own the policies on the older, arguably less healthy, owners. 

A trust is sometimes suggested as an alternative to a cross-purchase arrangement, because it eliminates the problem of multiple policies and unequal premium burdens.  With a trust, each shareholder is a beneficial owner of a proportionate share of his or her own policy and effectively, through the trust agreement, names the other shareholders as beneficiaries of the policy.  However, care is required because the beneficial interest in the policies on the surviving shareholders, owned by the deceased shareholder through the trust, transfers to the surviving shareholders, and that transfer may make the death benefits taxable under the transfer-for-value rule. 

Another alternative that used to be very popular involved split-dollar life insurance.  Under this arrangement, each shareholder would own the policy that insures his or her life.  Each shareholder would then enter into a collateral assignment agreement with the company and endorse the death benefit to the other shareholders in order to make the policy’s death benefit available to effectuate the buy-sell agreement.  One problem with this arrangement was that the endorsement was a transfer-for-value, and a co-shareholder was not an exception to the transfer-for-value rule.  Thus, the arrangement was typically only available when the company was either a partnership or LLC.  Interest in split-dollar life insurance further waned when the IRS issued final regulations in 2003, changing the taxation of split-dollar life insurance.  Under those regulations, all of the premiums paid by the employer are treated as a loan to the employee.  If the loan does not bear an adequate rate of interest, as determined under the regulations, then the regulations set forth a complex system of deemed interest flowing to the employee as income and back to the employer as interest. 

The problems with the foregoing arrangements have led many planners to incorporate a partnership or LLC into an otherwise standard corporate buy-sell arrangement.  This avoids the transfer-for-value rule by utilizing a partnership to hold the policies that insure the lives of the shareholders.  Each shareholder is a partner in the partnership and, on the death of a shareholder, the death benefit is received income tax-free by the partnership and is specially allocated to the surviving shareholders, which increases their basis in the partnership.  This permits the proceeds of the policy to be withdrawn tax-free by the surviving shareholders.  One area of concern with using a partnership is whether holding life insurance policies is sufficient to have a valid partnership interest.  Pursuant to Rev. Proc. 2022-3, the IRS has a “no rule” policy on whether an insurance-only partnership or LLC will be treated as a partnership for tax purposes, and whether the transfer of policies to the insurance-only partnership or LLC is exempt from the transfer-for-value rule.  Nonetheless, there are reasons for believing that an insurance-only partnership or LLC would be a valid partnership for tax purposes.  For example, that appears to have been the conclusion reached in PLRs 9042023 and 9309021. 

Somewhat more recently, PLR 200747002 discusses provisions in the operating agreement of an insurance-only LLC that helped to prevent the insureds from being viewed as possessing incidents of ownership in the policies that the other members contributed to the LLC.  In the ruling, each member purchased policies on the lives of the other members, and contributed the policies to the LLC.  Thus, the LLC was the owner and beneficiary of the policies.  The LLC was managed by a manager which had to be either a corporate trustee or an individual who was not related or subordinate to the members.  The members were precluded from exercising any incidents of ownership in the policies, but each member was required to contribute sufficient capital to pay the premiums for the policies on the lives of the other members.  The proceeds of the policies were allocated to the capital account of the member who contributed the policy.  They were then distributed to the members in proportion to their respective capital accounts.  

Conclusion

There will undoubtedly be further developments as clients and their advisors test the limits of the U.S. Supreme Court’s decision in Connelly.  It’s likely that there will also be renewed interest in the alternatives to a stock redemption buy-sell agreement.  However, care must be exercised to avoid the pitfalls inherent with these different approaches.  As can be seen from PLR 200747002, even drafting a partnership or operating agreement for an insurance-only partnership or LLC can be challenging. 

If you have any questions or need assistance, please visit our Tax Practice Group page or contact one of our tax attorneys.