By Nancy Burner, Esq.
The United States Supreme Court recently issued a landmark decision in the case of Connelly vs. IRS. This ruling has significant implications for buy-sell agreements and corporate redemptions. The Court’s decision addresses key issues related to the tax treatment and enforceability of these agreements, which are critical for estate planning, business succession, and corporate governance.
For estate tax planning, the importance of this case is that it affirms that the death benefit of life insurance is an asset that raises the value of the business. In particular, it indicates that the value of the business will include the insurance proceeds that the company holds on the life of the shareholder, even though those payments have to be made to the estate of the shareholder in order to re-purchase the deceased shareholders interest in the corporation. The liability to purchase shares from the estate cannot be applied to reduce the fair market value of the business for estate tax purposes.
Traditionally, in a redemption buy-sell agreement, the company will own a life insurance policy on the life of shareholders to be used to buy out the decedent’s shares held by the estate. This ensures that the remaining business owner(s) can stay in control and run the business without being partners with the estate of the deceased owner. In Connelly, two brothers were shareholders of a business. They had a buy-sell agreement backed by life insurance owned by the company. One brother died and the business was valued without the death benefit of the life insurance. The taxpayer’s estate argued that business valuation which included the value of the insurance proceeds should be reduced by the obligation to purchase the shares of the decedent.
The IRS disagreed and the Supreme Court affirmed that, regardless of the fact that they had the obligation to buy the shares back from the decedent’s estate, the value of the business, for tax purposes was the full valuation plus the insurance proceeds that were realized at the decedent’s death. That inclusion could significantly increase the value of the estate and, in many instances, will increase the amount of estate tax due.
Among other things, the Supreme Court also affirmed in this decision that the valuation method stipulated in buy-sell agreements will generally be respected for tax purposes, provided it meets certain criteria. This includes the necessity for the valuation to be conducted in good faith, and it must reflect fair market value.
The decision underscored the importance of having clear, well-drafted buy-sell agreements. The Court emphasized that these agreements must be binding and enforceable under state law to ensure their effectiveness for tax purposes. It highlighted the necessity for proper documentation and adherence to tax regulations to avoid adverse tax consequences.
The Supreme Court’s decision in Connelly vs. IRS provides clarity on the tax treatment and enforceability of buy-sell agreements and corporate redemptions. By proactively addressing these changes, we can ensure compliance and optimize the tax outcomes for business owners.
Business owners must maintain meticulous documentation supporting the valuation and terms of buy-sell agreements and corporate redemptions to substantiate tax positions. In light of this decision, it is crucial to engage with an attorney to review, and potentially revise, existing buy-sell agreements and corporate redemption plans to ensure compliance with the clarified standards.
Nancy Burner, Esq. is the Founding Partner of Burner Prudenti Law, P.C. focusing her practice areas on Estate Planning and Trusts and Estates. Burner Prudenti Law, P.C. serves clients from New York City to the east end of Long Island with offices located in East Setauket, Westhampton Beach, Manhattan and East Hampton.
