Supreme Court Ruling Brings New Caution to Using Life Insurance to Fund a Buy-Sell Agreement

The United States Supreme Court shook up the estate tax landscape last month for closely held businesses using life insurance to fund buy-sell agreements. In Connelly v. United States, No. 23-146, 2024 WL 2853105, at *2 (U.S. 2024), the Supreme Court unanimously held that life insurance proceeds used to redeem a decedent shareholder’s stock in a closely held business are taxable corporate assets. The court’s June 6 decision impacts practitioners' reliance on the Eleventh Circuit’s ruling in Estate of Blount v. Commissioner, 428 F.3d 1338, 1345 (11th Cir. 2005), which held that life insurance proceeds used to fund buy-sell agreements are not corporate assets for estate tax purposes.

A buy-sell agreement is an agreement that outlines what happens to an owner’s share in an entity when that owner desires to transfer shares upon their death or departure. Buy-sell agreements are frequently used by closely held corporations, LLCs, and partnerships to facilitate transitions in ownership. Connelly has far-reaching consequences for any company with a buy-sell agreement funded by life insurance.

A Tale of Two Brothers

Two brothers—Michael and Thomas Connelly—were the only shareholders in a small building supply corporation. Because they wanted the company to stay in the family upon either of their deaths, they entered into a buy-sell agreement requiring the company to buy the shares of the first brother to die if the surviving brother declined to purchase them. The company obtained a life insurance policy on each brother to make sure it would have enough money to satisfy this requirement. 

When Michael died, Thomas elected not to purchase Michael’s shares, triggering the company’s purchase obligation. The company used the $3 million in life insurance proceeds it received as a result of Michael’s death to buy the shares. As executor of Michael’s estate, Thomas was required to file a federal estate tax return detailing the value of Michael’s assets, including his shares in the company. Thomas engaged a third party who determined that Michael’s shares in the company were worth $3 million; however, the third party excluded the life insurance proceeds when determining the fair market value of the company. Thomas reported the $3 million value on the estate tax return, relying on the Eleventh Circuit’s decision in Estate of Blount, which held that insurance proceeds should not be included in the value of a corporation when they are “offset by an obligation to pay those proceeds to the estate in a stock buyout,” 428 F.3d 1338, 1345.  

The IRS disagreed with Thomas’s reasoning. During its audit of Michael’s estate, the IRS contended that the total valuation of the company should include the life insurance proceeds—thereby making the total value of the company $6.86 million, rather than $3.86 million, when Michael died. Accordingly, the IRS said that Michael’s estate should have paid higher taxes based on the higher valuation of Michael’s stock. The estate paid the taxes and then sued the IRS for a refund. 

Supreme Court: Life Insurance Counts in Estate Tax Valuation

The case made it all the way to the Supreme Court. The dispute focused on the inclusion of the life insurance proceeds as part of the company’s total fair market value for purposes of the estate tax. The Supreme Court sided with the IRS in a unanimous decision, holding that life insurance proceeds that will be used to redeem a decedent’s shares must be counted when calculating the value of those shares for estate tax purposes. The court emphasized that the point of the estate tax is to assess the value of Michael’s shares at the time he died—even if the value would be drastically different a day later, once the life insurance proceeds were paid out.

What It Means for Your Business

A better understanding of the consequences of their buy-sell agreement may have prevented years of litigation for the Connelly family. There were alternate options available. The brothers could have purchased life insurance policies on each other, rather than having the company take out the life insurance. This structure, known as a cross-purchase agreement, would have placed the life insurance proceeds outside the company’s assets, potentially reducing the estate tax burden. (It is important to note that a cross-purchase agreement may have had different tax consequences for the brothers personally, but would have avoided a situation where the company experienced a stark increase in valuation.)

Connelly affects any company—including corporations, LLCs, and partnerships—with a buy-sell agreement funded by life insurance. Companies utilizing buy-sell agreements funded by life insurance should promptly review these agreements to ensure the best possible arrangement is in place to accomplish their owners’ goals and minimize tax liability.

We Can Help

Each estate plan is unique to the individual’s circumstances and wishes. If you own shares in a closely held company, it is imperative that you fully understand the tax implications of both your business succession plan and estate plan. Maslon’s experienced Estate Planning and Corporate groups can work together to help you navigate the complexities of estate planning for closely held businesses to ensure your wishes are met and tax liabilities are minimized.