The Supreme Court ruling on life insurance proceeds has estate tax implications

In a landmark decision earlier this year, the Supreme Court addressed a crucial issue regarding the valuation of shares in closely held corporations for federal estate tax purposes.

the case, Connelly v. United States (2024)clarified whether life insurance proceeds that are used to redeem shares of a deceased shareholder should be included in the valuation of the shares for estate tax purposes. The decision has many implications for CPAs, tax professionals, estate planners and investment advisors.

Case overview

Michael and Thomas Connelly were the sole shareholders of Crown C Supply, a closely held building supply corporation. To ensure continuity and keep ownership within the family, they had a share buyback agreement funded by corporate-owned life insurance policies worth $3.5 million each. ‘

Upon Michael’s death, the corporation used $3 million in life insurance proceeds to buy back his stock. But the IRS and the Connelly estate could not agree on the proper valuation of Michael’s shares. The estate valued the shares based on the $3 million buyout payment, but the agency insisted that the life insurance proceeds be included in the company’s valuation. From the perspective of the IRS, the proceeds would raise the total value of the estate to $6.86 million, thereby valuing Michael’s shares at $5.3 million.

This assessment resulted in a significant additional inheritance tax liability for the Connelly estate.

The decision of the Supreme Court

The Supreme Court sided with the IRS, stating that life insurance proceeds should be included in the corporation’s value when determining the value of the decedent’s stock. The court clarified that the obligation to repurchase shares at fair market value is not a debt that reduces the value of the company for income tax purposes.

The court’s decision means that the life insurance proceeds used for the buyout would increase the total value of the corporation, thereby increasing the value of the shares owned by the decedent at the time of death.

Contradiction in Blount v. Commissioner

The Connelly decision brings to mind the precedent set Blount v. Commissioner (2005) two decades earlier. In Blount, the Eleventh Circuit concluded that life insurance proceeds should be excluded (not included) from a corporation’s valuation when used to fund a stock repurchase obligation.

As you can see, the Supreme Court’s recent Connelly decision rejected the 11th Circuit’s approach as “demonstrably erroneous.” Again, the Supreme Court emphasized that an obligation to redeem not offset the value of the income from the life insurance and it should be included in the value of the company for property tax purposes.

This divergence highlights the Supreme Court’s intention to provide a clear and unified approach to handling such cases.

Implications for estate planning

This Connelly ruling emphasizes the importance of strategic planning for closely held businesses to avoid unexpected tax liabilities. Here are three strategies to consider:

1. Cross Purchase Agreements. Of using a cross purchase agreement instead of a corporate buyout agreement, the surviving shareholders individually purchase life insurance policies on each other. Upon the death of a shareholder, the surviving shareholders use the proceeds to buy the deceased’s shares outright. This method ensures that life insurance proceeds do not increase the value of the company for estate tax purposes because the proceeds are not part of the company’s assets.

Advantages of cross-buy agreements:

• Fiscal efficiency: Insurance proceeds do not increase the value of the corporation, avoiding higher property taxes.
• Direct transfer of ownership: The shares are transferred directly to the surviving shareholders, maintaining the continuity of the business.
• Flexible ownership structure: This allows for adjustments to ownership percentages without involving the corporation itself.

Challenges and considerations:

• Funding Requirements: Securing adequate financing for insurance premiums and potential purchases can be a challenge, especially for smaller businesses.
• Compliance with regulations: The Agreement must comply with relevant laws and regulations, which may require professional legal and financial advice.

2. Defensible valuation methods. To prevent litigation and ensure compliance with tax laws, it is essential to establish defensible valuation methods in buy-sell agreements. These methods may include mandatory assessments by qualified professionals, assessments with formulas or regularly updated agreed values.

Best practices for establishing evaluation methods:

• Regular review: Regularly reviewing and updating buy-sell agreements ensures they reflect current business values ​​and comply with evolving laws.
• Professional evaluations: Using qualified professionals for assessments can provide a more accurate and supported assessment.

3. Legal and Regulatory Compliance. Make sure the buy-sell agreements meet the requirements Section 2703 of the Internal Revenue Code governing the purchase or transfer of property at a price less than FMV. This section disregards assessments in buy-sell agreements unless they are bona fide arrangements, not devices to transfer property to family members for less than full and adequate consideration. They must be comparable to similar arrangements in normal transactions.

The Supreme Court’s decision in Connelly v. United States highlights the need for closely held businesses to reevaluate their estate planning and buy-sell agreements. By considering alternative strategies such as cross-purchase agreements and ensuring defensible valuation methods, businesses can better manage their property tax obligations and ensure smoother ownership transitions.