Supreme Court Rules on Estate Tax Consequences of Buy-Sell Arrangement

Over the summer, the U.S. Supreme Court decided that life insurance proceeds received by a closely held company and earmarked to redeem a deceased shareholder’s ownership interests increased the estate tax value of the company and, consequently, the deceased shareholder’s interests. Owners of closely held businesses should review any existing buy-sell arrangements, as this decision directly affects how they will want to structure their business succession and estate tax plans, particularly for family-owned businesses.

Buy-Sell Planning Overview

Many owners of successful closely held businesses have significant wealth concentrated in their companies. The ability to monetize that value becomes crucial at an owner’s death to create needed liquidity for the owner’s estate and beneficiaries. Buy-sell agreements (BSAs) meet this need by requiring the purchase of a deceased owner’s interests at a price set by the BSA, with the company as the buyer (a redemption arrangement), the other business owners as the purchasers (a cross-purchase arrangement) or some variation or combination of both approaches.

BSAs also can fix the fair market value of a deceased owner’s business interests for estate tax purposes if they meet certain safe harbor tax rules. Specifically, the BSA must be a bona fide arrangement comparable to similar arm’s-length business contracts. It cannot be a method to transfer property to the owner’s family members for less than full value. In addition, BSAs must (1) apply both during and after the owner’s life, (2) contain a fixed or determinable price for the company’s interests and (3) provide that the deceased owner’s estate receives at least the same price for the interests as the owner would have received during life.

Funding with Life Insurance

BSAs often use life insurance to fund the purchase of a deceased owner’s interests since the policy death benefits provide readily available, income tax-free liquidity at the owner’s death. This funding allows the owner’s heirs to receive immediate payment from the buyout (rather than relying on deferred payments or promissory notes). In the typical redemption arrangement, the company owns the life insurance and uses the proceeds to redeem the deceased owner’s interests at the value set by the BSA.

Estate Tax Implications of Redemptions

Since redemption BSAs require the company to use the life insurance proceeds to redeem the deceased owner’s interests, estates have taken the position that any potential increase in the estate tax value of the company (and correspondingly, the deceased owner’s interests) from the receipt of insurance proceeds is offset by the redemption obligation. The IRS, however, has repeatedly challenged this position, resulting in a split among the three federal circuit courts that have ruled on the issue—the Eighth Circuit in Connelly v. United States (2023) holding yes to an increase in the company’s value and the Ninth and Eleventh Circuits holding no to an increase in Estate of Cartwright v. Commissioner (1999) and Estate of Blount v. Commissioner (2005), respectively.

The U.S. Supreme Court accepted review of the Connelly case, in part to resolve this split among the circuits.

The Connelly Case

Connelly involved a redemption BSA for Crown C Supply, a corporation owned by two brothers, Michael and Thomas. At the first brother’s death, the BSA gave the surviving brother the option to buy the deceased brother’s shares and, if he declined, required Crown to redeem the shares. Crown purchased a $3.5 million life insurance policy on each brother for redemption purposes.

To determine Crown’s value and purchase price for the shares, the BSA required the brothers to agree annually, in writing, on Crown’s value. If they failed to agree, they were required to use the average value from two fair market value (FMV) appraisals or obtain a third if the two appraisals varied by more than 10%. The brothers never complied with these express provisions.

Michael passed first, and Crown purchased his 77.18% share ownership for $3 million using the life insurance proceeds it received on his death. The value was agreed to in a settlement between Michael’s son and Thomas as part of the estate administration and was reported on Michael’s estate tax return as the FMV for his Crown shares. During an IRS estate tax audit, Thomas also obtained a valuation from an outside accounting firm, which determined the FMV of Michael’s shares as $3 million, using a total FMV for Crown of $3.86 million. The valuation excluded the $3 million in life insurance proceeds used to redeem Michael’s shares, based on the premise that they were offset by Crown’s redemption obligation.

The IRS disagreed, arguing that Crown’s redemption obligation was not a liability in the ordinary business sense, meaning Crown’s total FMV as of Michael’s death was $6.86 million ($3.86 million + $3 million of insurance death benefits) and the FMV of Michael’s shares was $5.3 million (77.18% of $6.86 million). The IRS issued a notice of deficiency for the additional estate tax due. In subsequent litigation, both a federal district court and the Eighth Circuit held in favor of the IRS, and Michael’s estate appealed these decisions to the U.S. Supreme Court. 

Supreme Court Decision—Life Insurance Increases Company Value Despite Redemption Obligation

In a unanimous opinion (Opinion No. 23–146, June 2024), the U.S. Supreme Court found in favor of the IRS, ruling that Crown’s contractual obligation to redeem Michael’s shares did not offset the value of the life insurance proceeds received by Crown to fund that redemption obligation.

The Supreme Court found that taking Crown’s redemption obligation into account in determining the company’s total value for estate tax purposes effectively valued the company on a post-redemption basis—in other words, after Michael’s shares had been redeemed. In the Supreme Court’s view, this position ran counter to the purpose of calculating the estate tax, which was to assess how much Michael’s shares were worth at the time he died, before any redemption by Crown or its redemption payment of the $3 million in insurance death benefits.

Michael’s estate argued that because the redemption price effectively excluded the value of the insurance death benefits, Crown’s value both before and after the redemption was the same: $3.86 million. The Supreme Court disagreed, concluding that Crown’s total value could not be the same before and after the redemption because a company that pays out $3 million to redeem shares should be worth less after that redemption.

Finally, the Supreme Court dismissed the estate’s assertion that this decision would make business succession planning more difficult for closely held corporations, noting that the result in this case was “simply a consequence of how the Connelly brothers chose to structure their agreement.”

What To Do Now?

While the logic of the Supreme Court’s analysis in Connelly may be debated, its decision is binding. Accordingly, closely held business owners should consider the following steps in consultation with their legal counsel and tax/insurance advisors:

• Review Existing BSAs and Compliance With Valuation Procedures. Review any existing BSAs to (1) assess whether the chosen structure (redemption, cross-purchase, etc.) and the corresponding funding method (life insurance proceeds, deferred payments, promissory notes) still accomplish the parties’ objectives and (2) confirm the potential estate and income tax implications of the BSA for the owners and the business. This review also should ensure that the BSA complies with the requirements to fix the estate tax value of a deceased owner’s interests, including the formula or method provided to determine the purchase price for an owner’s interests at death. The owners must follow any valuation procedures specified in the BSA and may want to consider using independent, professional appraisers to help determine the company’s FMV in accordance with the agreed-upon valuation procedures.

• Identify and Evaluate Life Insurance Funding. Confirm whether the BSA relies on life insurance to fund the purchase of a deceased owner’s shares and, if so, who owns the life insurance and receives the policy proceeds. If, as in Connelly, the BSA is an insurance-funded redemption arrangement in which the company owns the life insurance and receives the death benefits, consider restructuring the BSA and/or the policy ownership as discussed below to mitigate the owners’ potential estate tax exposure from the inclusion of the insurance proceeds in the company’s FMV at an owner’s death. This issue will be key for owners with estates in excess of the federal estate tax exemption (which is scheduled to drop significantly in 2026). Also take this opportunity to review the appropriateness and sufficiency of the life insurance coverage (i.e., whether the coverage is still required, whether the death benefit is enough to buy out a deceased owner’s interest, whether the policy is performing as initially projected, whether any revisions should be made to the policy funding, premium payments, face amount, product design, etc.).

• Consider a Different Structure for Insurance-Funded BSAs. Consider alternatives to redemptions for BSAs funded with life insurance. As the Connelly opinion indicates, inclusion of the insurance proceeds in Crown’s value was “simply a consequence” of the redemption structure, so a different arrangement presumably could avoid this inclusion risk. Options include cross-purchase arrangements, in which each owner holds life insurance on each other owner and uses the insurance proceeds to buy the deceased owner’s interest, and/or the use of trusts or special purpose entities, which are designed to hold the policies on the owners and then purchase the deceased owner’s interest in accordance with the trust or entity agreement. Each alternative has unique variations, benefits and challenges that owners and their advisors will need to evaluate and match to the circumstances of the particular closely held business. In addition, there are several issues that the owners/business may need to navigate when restructuring an existing insurance-funded BSA, including compliance with the transfer-for-value and reportable policy sale rules if the restructuring involves the transfer of life insurance. Underwriting issues also may arise if new or additional life insurance is recommended to address an increase in the company’s value or to offset tax risks.

• Document and Periodically Review Agreements, Procedures and Compliance. Clearly document the terms of the BSA, and keep records of compliance with the BSA’s procedures, especially with respect to any required valuations of the business. Conduct periodic reviews to ensure compliance and that the BSA’s terms and any life insurance funding continue to meet the owners’ business succession needs. These steps are particularly critical when dealing with closely held family businesses.

• Coordinate Estate Tax Plans With the Business Succession Plan. Owners should review individual estate plans to understand the potential estate tax implications of the BSA and the impact on their beneficiaries, including which beneficiaries will receive what and when (i.e., lump sum or deferred payments, promissory notes, a portion of the business interest, etc.). Owners should coordinate their estate plans with the BSA as needed and plan for any liquidity needs due to their anticipated estate tax exposure, especially if the BSA defers payment of part or all of the purchase price for their interests over time.

Proceed Carefully and Work With Experienced Advisors.

Consult with legal counsel and tax and insurance advisors before undertaking the restructuring or creation of any BSA. There are numerous legal and tax implications associated with life insurance planning, business succession planning and BSAs, and noncompliance with applicable laws and legal decisions could result in inadvertent tax consequences or failure of a deceased owner’s heirs to receive intended amounts.