Businesses Just Became More Valuable at Death – SCOTUS Rules
June 24, 2024The Supreme Court recently unanimously decided in Connelly v. United States that, for estate tax purposes, the value of a deceased shareholder’s equity interest in a closely held company must be increased by the life insurance proceeds received by the company upon the death of the shareholder, even if the proceeds are specifically allocated to fund a mandatory redemption of the deceased shareholder. The Court’s decision stresses the importance of estate tax planning and how business owners should structure their buyout obligations upon the death of an owner. Business owners, particularly those who may become subject to the estate tax, may want to consider a cross-purchase arrangement or other alternative to company-owned life insurance to fund buyouts.
Most owners of closely-held businesses put plans in place to restrict transfers of business interests and to provide liquidity for those who are entitled to receive the interests of an owner at death. To accomplish these objectives, most owners include in their business succession plan a buy-sell agreement where, upon the death of one of the owners, the other owners or the business has either an option or an obligation to purchase the decedent’s outstanding shares. In situations where a company is obligated to redeem an owner’s interest following death, the company may choose to buy life insurance on each of its owners to fund the redemption.
In Connelly, the Court rejected the taxpayer’s argument that, for estate tax business valuation purposes, a company’s obligation to redeem an owner’s interest offsets the value of life insurance proceeds received by the company to fund that redemption. Accordingly, the life insurance proceeds that are received by the company increase the value of the business. This increased valuation may result in an estate tax value of the redeemed equity that significantly exceeds the purchase price actually paid. If the value of the decedent’s estate exceeds the exemption amount, this increased valuation can be costly. Currently, the federal estate tax exemption amount is $13,610,000 (reduced by any lifetime taxable gifts), and the federal estate tax rate on assets exceeding this amount is 40%. It should be noted, however, that unless Congress takes further action, the federal exemption amount will be cut in half on January 1, 2026.
Taxpayers who are owners in closely held businesses can avoid the increased estate tax valuation of a company resulting from the company owning the life insurance policy by using a cross-purchase agreement. In a cross-purchase arrangement, the owners purchase life insurance on each other rather than the company purchasing life insurance covering the lives of the owners. Having the owners hold the life insurance policies directly avoids an increase in the company’s valuation (as the company does not receive the proceeds), but it may require each owner to pay different premiums.
Another potential issue with a cross-purchase arrangement is ensuring that the owners have sufficient cash available to pay the premiums. Additionally, structuring a cross-purchase can be complex when there are more than two owners of the business. Finally, a cross-purchase agreement has its own income and estate tax consequences that must be considered. If an individual, at the time of his or her death, owns a life insurance policy on another person’s life, the value of the policy (typically the Interpolated Terminal Reserve (ITR) value) is generally includible in such individual's estate for estate tax purposes. To minimize estate taxes, business owners should consider establishing irrevocable life insurance trusts to own and be the beneficiary of the life insurance policies. Business owners that have estate tax concerns should also consider transferring certain business interests to an irrevocable trust or implementing other wealth transfer techniques to maximize their exemption amount and reduce future estate taxes.
If you would like to discuss a succession plan or other estate planning strategies for your closely held business, please contact one of the authors listed above or a member of the Firm’s Estate Planning Department.
Special thanks to Joseph R. Link for his contributions to this article.