By Ed Sparkowski, CFP®, CIC, Partner, CPS Private Client Solutions
The Supreme Court’s decision in Connelly v. United States on June 6, 2024, has significant implications for closely held corporations and their shareholders, particularly regarding the valuation of corporate-owned life insurance proceeds for estate tax purposes. This ruling resolved a contentious issue that had divided lower courts and clarified how life insurance proceeds should be treated when calculating the value of a corporation for estate tax purposes.
Background of the Case
The Connelly brothers – Michael and Thomas – owned a closely held corporation. To ensure the business remained in the family, they established a buy-sell agreement funded by corporate-owned life insurance. When Michael died, the corporation used the insurance proceeds to buy back his shares. A dispute arose over whether these proceeds should be included in the corporation's value for estate tax purposes.
The Supreme Court’s Ruling
In a unanimous decision authored by Justice Clarence Thomas, the Supreme Court sided with the IRS. The Court held that the obligation to redeem shares at fair market value does not offset the value of life insurance proceeds when calculating the value of a corporation for estate tax purposes1. The Court reasoned that the life insurance proceeds increase the value of the corporation because they are assets that the corporation holds, even if they are immediately used to redeem shares. Justice Thomas provided a clear example to illustrate the Court’s reasoning. He poised a corporation holding $10 million in cash and nothing else, with each of its 100 shares worth $100,000. If the corporation redeems 20 shares for $2 million, the remaining 80 shares would still be worth $100,000 each because the corporation’s total value would be $8 million. Similarly, in the Connelly case, the $3 million in life insurance proceeds increased the corporation’s value to $7 million, making Michael’s 75% stake worth $5.25 million instead of $3 million1.
Implications of the Decision
The Connelly decision has far-reaching implications for estate planning and the use of corporate-owned life insurance in buy-sell agreements. By ruling that life insurance proceeds must be included in the valuation of a corporation without any offset for redemption obligations, the Supreme Court has effectively increased the estate tax exposure for shareholders of closely held corporations.
This ruling impacts both C and S corporation shareholders who use corporate-owned life insurance to fund entity purchase and wait-and-see buy-sell agreements. It resolves a split in opinions among the Tax Court and some of the Courts of Appeal, establishing a clear precedent that must be followed nationwide.
Alternative Strategies
Given the potential increase in estate tax liability, shareholders and their advisors may need to reconsider their estate planning strategies. Alternatives to corporate-owned life insurance-funded buy-sell agreements include cross-purchase agreements, where the surviving shareholders personally purchase the shares of the deceased shareholder, or the use of an insurance LLC to hold the life insurance policies.
These alternative structures can help avoid inflating the value of the corporation for estate tax purposes, thereby reducing the overall tax burden on the estate. It is essential for business owners to consult with their legal and financial advisors to determine the most appropriate strategy for their specific circumstances.
Conclusion
The Connelly decision represents a pivotal moment in the realm of estate planning and corporate-owned life insurance. By clarifying that life insurance proceeds must be included in the valuation of a corporation for estate tax purposes without any offset for redemption obligations, the Supreme Court has provided much-needed guidance on this complex issue. Shareholders and their advisors must now navigate this new landscape and consider alternative strategies to mitigate the potential tax impact of this ruling.
To discuss in more detail, please contact Ed Sparkowski, CFP®, CIC; Partner – CPS Private Client Solutions; Phone: 949-225-7180 / esparkowski@cpsprivateclientsolutions.com
