Redemption Agreements and Life Insurance Proceeds: What the SCOTUS Decision in Connelly Means for Closely Held Businesses

Many closely held businesses have shareholder buy/sell redemption agreements. These agreements are critical to maintaining business continuity when a key shareholder exits the company. When the redemption agreement is triggered by a shareholder’s death, companies often redeem the shares with life insurance proceeds. A recent Supreme Court decision has raised questions regarding the impact of redemption agreements and company-owned life insurance policies on share valuation for the estate tax of a deceased insured shareholder.

In Connelly v. United States, the Supreme Court held that the company redemption obligation did not offset the value of a company-owned life insurance policy used to satisfy the obligation for purposes of estate tax valuation for the deceased insured shareholder’s estate tax. In the case, the sole shareholders of Crown C Supply – brothers Michael Connelly and Thomas Connelly – had an agreement whereby the company would redeem a deceased shareholder’s shares with the proceeds of a company-owned life insurance policy. When Michael passed away, the company used the life insurance proceeds to buy out his shares. Michael’s estate did not include the value of the life insurance proceeds in the calculation of the company’s value under the theory that the redemption obligation offset the value of the life insurance policy. The estate valued the shares at $3 million.

The IRS disagreed, arguing that the redemption obligation does not reduce the company’s value for estate tax purposes. The IRS reasoned that the life insurance proceeds were a nonoperating asset to include when calculating the value of a shareholder’s shares. The IRS valued the shares at $5.3 million, resulting in a significantly larger tax bill for the deceased shareholder’s estate.

In a unanimous decision, the U.S. Supreme Court agreed with the IRS, holding that a redemption obligation does not offset the value of a company-owned insurance policy with respect to a shareholder’s economic interest. The Court stated:

“The question here is whether Crown’s contractual obligation to redeem Michael’s shares at fair market value offsets the value of life-insurance proceeds committed to funding that redemption. The answer is no. Because a fair-market-value redemption has no effect on any shareholder’s economic interest, no hypothetical buyer purchasing Michael’s shares would have treated Crown’s obligation to redeem Michael’s shares at fair market value as a factor that reduced the value of those shares…For calculating the estate tax, however, the whole point is to assess how much Michael’s shares were worth at the time that he died—before Crown spent $3 million on the redemption payment.”

In other words, the Court viewed the life insurance proceeds as an asset but did not view the redemption obligation as a liability at the time of the deceased shareholder’s death.

What does this mean for closely held corporations with redemption agreements?

While the Court admitted that the dispute in the Connelly case is narrow, with its result “a consequence of how the Connelly brothers chose to structure their agreement,” the decision may have far-reaching implications for closely held businesses. If your company has a redemption agreement funded by life insurance at the company level, it is essential to understand the implications of those agreements from an estate tax perspective. Together with legal counsel, you should carefully review your company’s shareholder-level agreements and insurance ownership with the following questions in mind:

• Are life insurance proceeds earmarked in the agreement to satisfy the redemption obligation?
• Does the agreement set the redemption price using a value other than the estate tax value?
• Are the company shareholders related parties?
• Have there been ownership or leadership changes in the company since the redemption agreement was drafted?
• Does the agreement otherwise meet the requirements of Internal Revenue Code Section 2703(b)?
• Does the agreement restrict a decedent’s shares from participating in the value of the life insurance proceeds?

Various succession and estate planning options exist and should be discussed with legal counsel and accountants. For instance, a closely held business and their shareholders may want to consider shareholder cross-purchase agreements with life insurance policies owned by the shareholders (or trusts or a shareholder limited liability company).

Attorneys in LP’s Trusts & Estates Group and Tax Planning Group will guide you through the process of assessing your redemption agreement and making any necessary changes to avoid unintended consequences of company ownership of life insurance.