Buy/Sell Agreements Supported by Insurance Policies – ALERT

July 22, 2024 by Adam Fox

On June 6, 2024, in a unanimous decision, the United States Supreme Court issued a ruling in Connelly v. United States, 602 U.S. (2024) which is potentially impactful to business owners who have entered into equity redemption buy/sell agreements supported by life insurance policies.

Under the facts of the Connelly case, two brothers, Michael Connelly (77.18% owner) and Thomas Connelly (22.82% owner), owned a closely held building supply company in St. Louis, MO (the “Company”). The brothers and the Company entered into a buy/sell agreement whereby:

• In the event of the death of one of the brothers, the surviving brother had the option to purchase the deceased brother’s shares of stock in the Company for fair market value;
• If the above option was not exercised by the surviving brother, then the Company was required to redeem the deceased brother’s shares at fair market value; and
• The Company took out and funded its redemption obligation with a $3.5 million life insurance policy on each brother.

After Michael died, Thomas elected not to exercise his purchase option, so the Company was required to redeem Michael’s shares. The Company paid $3 million to Michael’s estate for his shares (the agreed upon fair market value), leaving Thomas as the Company’s sole shareholder. Michael’s executor subsequently filed a federal estate tax return, reporting the value of Michael’s shares as $3M. The IRS elected to audit the estate tax return.

At issue in the audit was the value of Michael’s shares in the Company at the time of his death. Michael’s executor took the position that the value was the redemption price paid by the Company under the buy/sell agreement ($3M). To support this position, Michael’s executor had an appraiser value the Company at $3.86M at the time of Michael’s death (which valuation included the $500K from the insurance policy that was not used in the redemption price). The executor argued that this valuation was consistent with the agreed upon value in the redemption above ($3.86M * .7718 ~ $3M).

The IRS, on the other hand, argued that Michael’s stock had a much higher value. The IRS took the position that the $3M in life insurance proceeds used in the redemption should be added to the valuation of the Company, thereby increasing the value to $6.86M, making the amount subject to Michael’s estate tax ($6.86M * .7718 ~ $5.3M). The IRS disputed the original appraiser’s offset of the insurance proceeds by the Company’s redemption obligation. Based on this position, the IRS determined that Michael’s estate owed additional estate taxes of nearly $900K.

In its decision in Connelly, the Supreme Court unanimously held that the Company’s redemption obligation was not a liability which would reduce the stock value for federal estate tax purposes because a redemption at fair market value does not affect any shareholder’s economic interest. Accordingly, for the purpose of calculating estate tax, Michael’s stock would be valued at $5.3M and not $3M.

Whether or not we agree with the IRS’ position and the Supreme Court’s ultimate decision (or can predict how they will be applied), whether or not the ruling will spur federal legislation to address their inequitable effect on business owners, and whether or not your current buy/sell agreement would be factually distinct from the Connelly brothers’ buy/sell agreement, the potential consequences from the decision are severe enough that business owners should immediately reevaluate any buy/sell agreements in their business supported by company-owned life insurance policies. For those potentially affected, below is the situation you want to avoid:

1. The owners of a business enter into a buy/sell agreement funded by an insurance policy on each owner whereby the company owns each policy and pays the premiums.
2. In the event of the death of one of the owners, the company ultimately has an obligation to redeem the decedent’s equity from the decedent’s estate in exchange for fair market value, or some agreed-upon formula (the “Redemption Price”) which would be funded by all, or a portion of, the insurance proceeds from the applicable policy.
3. One of the owners dies and the applicable insurance policy pays the death benefit to the company. The company then delivers the Redemption Price to decedent’s estate or heirs in exchange for decedent’s equity per the buy/sell agreement. The result is that the surviving owners own the business and the decedent’s heirs are paid a fair value for decedent’s equity.
4. The IRS comes in after all this, audits decedent’s estate tax return, and determines that the value of the equity redeemed in #3 above should be increased from the redemption price under the buy/sell agreement to a greater amount to reflect the Company’s receipt of the insurance proceeds.
5. The decedent’s estate is then stuck with a potentially huge tax bill that could have been avoided if an alternative buy/sell structure was pursued.

The takeaway here is that any business owner who has a buy/sell agreement structured consistent with the above should reach out to their attorney and financial advisor to explore alternatives to their current buy/sell structure.

Adam Fox

adam@brownfoxlaw.com

Adam Fox co-founded Brown Fox and has emerged as a go-to confidant and wise counsel for business leadership, ranging from billion dollar companies to innovative start-ups.

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