Supreme Court’s Connelly Decision Shakes Up Buy/Sell Agreements for Closely Held Companies

July 25, 2024

The U.S. Supreme Court issued a decision this week that has major ramifications for both the estate planning strategies of shareholders of closely held companies and the formation of closely held companies themselves. In its Connelly decision (Connelly v. United States, 602 U.S. ____ (2024)), the Supreme Court held that a corporation’s contractual obligation to redeem the shares of a deceased shareholder is not necessarily a liability that reduces a corporation’s value for purposes of calculating the federal estate tax of the deceased shareholder’s estate. This holding can directly affect both the estate tax liability of the deceased shareholder as well as the valuation of the business at the time of the shareholder’s death depending on how the shareholders’ agreements are drafted.

Past Practice of Utilizing Life Insurance to Support Buy/Sell Provisions

When individuals come together to form a business, it is often a common goal of the group to ensure that they maintain control of the business and continue to have a say in the ownership structure of the business in the event of an untimely death of a partner. To effectuate this, the parties often include Buy/Sell provisions in their agreements that dictate the conditions under which a shareholder’s shares may be transferred. These provisions give the remaining shareholder(s) the first option to purchase the deceased shareholder’s shares. If the remaining shareholder(s) refuse to purchase the deceased’s shares, then the agreement usually requires the business to purchase the shares. To ensure that the business will always have available funds to redeem the deceased shareholder’s shares, it is a common practice for businesses to take out life-insurance policies on their principals. This way, if a shareholder dies, the business will cash in the life-insurance policy and use the proceeds to purchase the deceased’s shares. For years, this practice was viewed as the most effective method as it would ensure that the business retains the shares and has no effect on the value of the deceased shareholder’s estate tax liability.

Legal Backdrop

Under 26 U.S.C. § 2001(a), Congress imposes a tax on the transfer of the “taxable estate” of every decedent who is a citizen or resident of the United States. This “taxable estate” is the value of “all property, real or personal, tangible or intangible,” owned by the decedent “at the time of his death,” minus applicable deductions. A decedent’s taxable estate includes his shares in a closely held corporation and the fair market value of the corporation determines the value of the shares. Not all estates are subject to federal estate tax, however. The federal government only taxes estates of a certain value. Today, the threshold value for calculating a federal estate tax is about $13.6 million.

Background Facts of the Connelly Decision

In the Supreme Court’s Connelly Decision, two brothers were the sole shareholders of a building supply corporation. To ensure that the company stay in the family, the brothers entered into an agreement with the company: if either shareholder died, the surviving brother would have the option to purchase the deceased brother’s shares; if he declined, then the company would be contractually required to redeem the shares. To ensure that the company would have enough money to redeem the shares, it obtained a $3.5 million life insurance policy on each brother.

When one brother died, the surviving shareholder declined to purchase his shares. As a result, the company was required to redeem the shares and used the proceeds from the life insurance policy it retained on the shareholder to do so. The surviving brother excluded the life insurance proceeds and valued the company at $3.86 million, of which the deceased shareholder had 77.18% of the outstanding shares at the time of his death. As executor of the estate, the surviving shareholder filed a federal tax return for his brother’s estate and reported the value of the shares as $3 million ($3.86 million x 0.7718).

The IRS conducted an audit and disagreed with the valuation.  It insisted that the company’s obligation to redeem the deceased’s shares did not offset the value of the company’s life-insurance proceeds. As a result, the IRS counted the $3 million of life-insurance proceeds used to purchase the outstanding shares as assets of the company. Therefore, the IRS valued the company at $6.86 million and determined that the value of deceased’s shares was $5.3 million ($6.86 million x 0.7718). At this time, the federal estate tax threshold was $5.2 million, therefore the IRS determined that the deceased’s estate owed $889,914 in taxes.

Supreme Court’s Decision

The Supreme Court agreed with the IRS and found that, at the time of the shareholder’s death, the company was worth $6.86 million – $3 million in the life-insurance proceeds earmarked for redemption plus $3.86 million in other assets and income generating potential. The surviving shareholder argued that the life insurance proceeds could not be considered an asset of the company because a prospective buyer could never realize those proceeds since the company was contractually obligated to spend that money on the redemption of the shares the moment it cashed in the policy.

The Supreme Court refuted this, stating that for estate tax calculation, the purpose is to assess the value of the shares at the time of the shareholder’s death. Therefore, at the time of his death, the company was worth $6.86 million and his 77.18% was worth $5.3 million. It did not matter that the insurance proceeds ultimately needed to be used to redeem the shares. Because of the way the shareholders structured their agreement, the insurance proceeds became assets of the company the moment the shareholder died, and the Supreme Court held that those assets needed to be factored into the valuation of the deceased’s shares. As a result, the deceased’s estate was above the federal estate tax threshold and owed money to the government.

What it means moving forward

The historical use of corporate-owned life insurance plans to fund Buy/Sell obligations likely comes to an end with this decision as it now can subject shareholders’ estates to new tax liability. The Supreme Court suggested other ways to work around this outcome, such as use of a cross-purchase agreement, which would obligate the shareholders to purchase the life insurance policies on each other to keep the proceeds out of the business. This strategy has its drawbacks, however, as it requires the shareholders to individually pay the premiums on the policies. Due to the amount of money at issue to ensure that the shares could be bought back, this strategy raises the risk of the shareholder being unable to keep up with the high premiums. It also can create unwanted tax consequences on the individual shareholder who holds the policy.

As a result, closely held corporations and their shareholders are encouraged to seek counsel regarding their current agreements and estate plans. If you have any questions regarding this decision or its potential impact on your business or your shares, please contact Gaetano Urgo at gurgo@dcamplaw.com or by telephone at (312) 995-7128.