When it comes to business continuity planning, buy-sell agreements play a crucial role in ensuring stability during ownership transitions. The Connelly v. US case has brought new focus to how these agreements, particularly entity-redemption plans financed with life insurance, impact business valuation and taxation. At Valhalla Business Advisors, we help businesses navigate these complex issues to make informed decisions.

Valhalla Business Advisors is pleased to leverage our business experience, education and network to help our community of clients develop resources and solutions to business issues, including the effective design, implementation, and support of life insurance benefits; This includes for purposes of financing buy-sell agreements.

Review: What Are Buy-Sell, Entity-Redemption, and Cross-Purchase Agreements?

Buy-sell agreements are legal contracts that dictate how ownership transitions occur when a business owner departs due to retirement, death, or other circumstances. These agreements typically fall into two categories:

• Entity-Redemption Agreements: The business itself agrees to purchase the departing owner’s interest.
• Cross-Purchase Agreements: The remaining owners individually purchase the departing owner’s interest.

Life insurance is often used to finance these agreements because it provides a guaranteed source of funds upon the death of an owner, minimizing financial strain on the business or other owners.

Advantages of Entity-Redemption vs. Cross-Purchase Strategies

Each approach has distinct advantages:

• Entity Redemption:
  • Simpler to administer, as the business handles the buyout directly.
  • Avoids the complexity of multiple owners holding life insurance policies on each other.
  • Ideal for businesses with multiple owners or when ownership proportions vary significantly.

• Cross-Purchase:
  • Offers potential tax benefits, as the purchase may result in a step-up in the basis of the purchased interest.
  • Avoids the risk of the business being deemed the owner of life insurance proceeds, which could lead to adverse tax consequences in certain situations.

What Did Connelly Hold?

In Connelly v. US, the court examined the valuation of a business interest in the context of a buy-sell agreement funded with life insurance. The case highlighted several key issues:

1. How life insurance proceeds affect the valuation of the business.
2. The interplay between buy-sell agreements and the Internal Revenue Code in determining fair market value.
3. Whether life insurance should be included as an asset when calculating the value of the business for tax purposes.

The court ruled that the life insurance proceeds used to fund the buy-sell agreement could not be excluded from the business’s valuation, underscoring the importance of structuring agreements thoughtfully to avoid unintended tax liabilities.

One law firm, Dewitt, share the following insight on this post:

III. Connelly’s Impact on Your Business’s Succession Plan

As a result of Connelly, the full value of life insurance proceeds under a redemption agreement may be included in the valuation of a deceased shareholder’s stock for estate tax purposes.  To this end, the Supreme Court admitted that, to some degree, the Connelly decision “will make succession planning more difficult for closely held corporations.”

The Connelly holding does not necessarily mean that redemption agreements can “never decrease a corporation’s value.” (emphasis in original).  As the court noted, where a redemption agreement requires that “a corporation . . . liquidate operating assets to pay for the shares, thereby decreasing its future earning capacity,” it would decrease the value of the corporation.

There may be “other options,” as the Supreme Court noted, that business owners may use as part of their succession plans—such as cross-purchase agreements—but not without their own limitations.

In sum, the lesson Connelly imparts on us is that the design of one’s succession plan is crucial—and the type of buy-sell agreement one’s business has may impact the estate tax liability that a deceased individual’s loved ones may bear the liability of paying.

Another law firm offered a similar set of takeaways here including a clarifying example using the graphic below. Please review the blogpost for the full explanation or reach out to discuss with a member of the Valhalla team:

Key Questions Businesses Should Consider

• How will the inclusion of life insurance proceeds impact the valuation of the business?
• Are the terms of the buy-sell agreement consistent with IRS requirements and case law?
• Would a cross-purchase agreement better align with the business’s goals and minimize potential tax exposure?
• What provisions should be added to ensure fairness and clarity in valuation methods?

A very interesting comment from an aforementioned blogpost is worth restating:

With the estate tax exemption currently at $13.61 million per individual in 2024, many business owners' estates fall under the threshold where estate tax would become an issue whether or not business-owned life insurance proceeds are included in their businesses' value for estate tax purposes, and for them, the distinction doesn't really matter one way or the other. But for those whose estates do surpass the estate tax threshold (or for those who would be bumped over the threshold by including insurance proceeds), it's a big deal: As mentioned above, the difference in estate tax owed in the Connelly case was nearly $890,000. And with the estate tax threshold set to be reduced by 50% after 2025 with the expiration of the Tax Cuts and Jobs Act (to $6.8 million in 2024 dollars), many more business owners with lower business and estate values stand to be affected by this case in the years to come.

The Valhalla advantage

The Connelly v. US case serves as a critical reminder of the complexities involved in structuring buy-sell agreements, especially when life insurance is a funding mechanism. At Valhalla Business Advisors, we help businesses understand the implications of these legal decisions and craft strategies to mitigate risks. Reach out to us for tailored guidance on your business succession plans.

Valhalla Business Advisors is proud to bring boutique services to clients; Our team and resources can help you. Feel free to reach out to anyone on Team Valhalla to discuss further!

Please note that the information and insights provided by Valhalla are for informational purposes only and should not be construed as legal, tax, or accounting advice. We recommend consulting with qualified legal, tax, or accounting professionals to address specific circumstances or questions.