By Bryan E. Pearce & Kelly A. Berardi, JD, LL.M.
Gray, Gray & Gray, LLP
Companies whose business succession planning includes the use of life insurance policies to fund a buy/sell agreement may have to go back to the drawing board.
The recent U.S. Supreme Court decision in Connelly v. United States has significant implications for succession strategies. This landmark ruling could have major ramifications for businesses that rely on life insurance policies to fund buy/sell agreements – a common practice in many succession plans.
Let’s examine the key aspects of the decision and potential impact, including ways in which the Court’s ruling might reshape our approach to business succession planning going forward.
Background on Connelly v. United States
The case centered around the estate of Michael Connelly, a successful business owner who had implemented a fairly typical succession strategy. Connelly and his business partner, his brother Thomas, had established a cross-purchase buy/sell agreement funded by life insurance policies on each other’s lives. Upon Michael Connelly’s death, the agreement automatically triggered the purchase of his shares by the company, using a $3.5 million payout from a life insurance policy.
The crux of the dispute arose when the IRS challenged the valuation method used for Connelly’s business interest. The estate had valued the business based on its fair market value, excluding the life insurance proceeds. The IRS argued that the insurance payout should be factored into the overall value of the business interest for estate tax purposes.
The Supreme Court’s Decision
In a 6-3 decision, the Supreme Court sided with the IRS, ruling that the life insurance proceeds should indeed be considered when valuing a deceased owner’s business interest for estate tax purposes. The majority opinion emphasized that the insurance payout was inextricably linked to the business arrangement and therefore couldn’t be separated from the overall value of the ownership stake.
This decision overturns decades of common practice and lower court rulings that had generally allowed estates to exclude insurance proceeds when valuing business interests in buy/sell situations. As such, it represents a significant shift in how these arrangements will be treated for tax purposes going forward.
Potential Impacts on Business Succession Planning
The most immediate and obvious consequence of the Connelly decision is the potential for substantially higher estate tax bills for business owners with insurance-funded buy/sell agreements. By including the life insurance proceeds in the valuation of the business interest, the overall taxable estate may increase significantly. This could lead to liquidity issues for estates that weren’t prepared for this additional tax burden.
There will be an increase in the complexity of business valuations. Business appraisers and valuation experts will need to grapple with new factors in determining fair market value for businesses with insurance-funded buy/sell agreements. This may lead to more disputes with the IRS and potentially increased litigation over valuation methodologies.
Because of this, many businesses will need to review and potentially revise their current buy/sell agreements. Agreements that were structured based on the assumption that insurance proceeds would be excluded from valuation may no longer be optimal or achieve their intended goals. This could necessitate complex and potentially costly restructuring of long-standing business arrangements.
Shift in Insurance Strategies
With the potential for higher valuations and increased tax liability, there may be a greater emphasis on ensuring buy/sell agreements are adequately funded. This could lead to businesses increasing insurance coverage or exploring supplemental funding sources to cover both the purchase price and potential tax obligations.
The decision may also prompt a reconsideration of how life insurance is used in business succession planning. Some businesses may explore alternatives to the traditional cross-purchase model, such as, 1.) entity purchase agreements, where the business itself owns the insurance policies; 2.) the use of irrevocable life insurance trusts (ILITs) to own policies outside of the estate; or 3.) exploring other funding mechanisms for buy/sell agreements that don’t rely as heavily on life insurance.
Greater Emphasis on Lifetime Planning
The Connelly decision underscores the importance of proactive lifetime planning to mitigate potential estate tax issues. Business owners may be more inclined to explore strategies like gifting ownership interests during their lifetime or implementing more sophisticated estate freezing techniques.
In addition, with the potential for significant tax consequences hinging on business valuations, it will be more critical than ever for companies to conduct regular, thorough appraisals. This may increase costs but will be essential for proper planning and to avoid surprises in the event of an owner’s death.
Family-owned businesses, in particular, may face challenges in the wake of this ruling. The increased estate tax liability could make it more difficult for families to keep businesses intact across generations, potentially forcing more sales to outside parties or creating conflicts among family members over how to fund the additional tax burden.
Some businesses may explore reorganizing their ownership structure or entity type to mitigate the impact of the Connelly decision. For example, there may be renewed interest in employee stock ownership plans (ESOPs) or other structures that can provide tax advantages in succession planning.
Given the far-reaching implications of the Connelly decision, there may be pressure on Congress to address the issue through legislation. Business advocacy groups and estate planning organizations are likely to lobby for laws that would codify the previous treatment of insurance proceeds in these situations. Planners will need to stay attuned to any potential legislative developments in this area.
A Seismic Shift
The Connelly v. United States decision represents a seismic shift in the landscape of business succession planning. While the full ramifications of the ruling will take time to unfold, it’s clear that many businesses will need to reevaluate their succession strategies in light of this new interpretation.
A succession planner’s role will be more crucial than ever in navigating these complex waters. Companies will need to work closely with tax professionals, appraisers, and legal experts to develop innovative solutions that balance the goals of smooth business transitions with the new tax realities created by this decision.
In the coming months and years, we can expect to see a period of adjustment and experimentation as businesses and advisors grapple with the implications of Connelly. Those who adapt quickly and creatively to this new paradigm will be best positioned to achieve their succession planning objectives while minimizing potential tax pitfalls.
Ultimately, while the Connelly decision presents significant challenges, it also offers an opportunity for businesses to take a fresh look at their succession strategies and potentially implement more robust, flexible plans. As always in the world of business planning, change brings both obstacles and opportunities for those prepared to meet them.
Bryan Pearce is Director of Strategic Business Planning, and Kelly Berardi, JD, LL.M. is a Partner at Gray, Gray & Gray, LLP.