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Company-Owned Life Insurance Proceeds On Deceased Shareholder Are Included In Their Estate Tax Calculation: The United States Supreme Court Weighs In

June 10, 2024 Business Entities and Transactions

The recent decision of the U.S. Supreme Court in Connelly v. United States, U.S., No. 23-146, 6/6/24, has thrown an enormous monkey wrench into traditional buy-sell planning for closely held businesses.  The Court held that the proceeds of life insurance on a deceased shareholder must be included in determining the estate tax value of the deceased shareholder’s stock in the corporation.  The result is that the estate tax value of the shares owned is increased beyond their economic value.  That artificial increase in value is then subject to the estate tax.  This decision reverses decades of conventional wisdom, crystallized by the decision of the 11th Circuit Court of Appeals in Estate of Blount v. Commissioner[1] and relied upon by estate planners in designing and implementing buy-sell agreements.

The owners of a family business are particularly concerned about keeping those shares in the hands of family.  One inevitable threat is the death of a shareholder, which can result in the shares being inherited by beneficiaries who are not involved in the business, or the inheritors need to sell the shares to raise funds to pay estate taxes.  A common, if not ubiquitous, solution to these concerns is life insurance, the proceeds of which the business uses to purchase the shares of the deceased owner.  Often that insurance is purchased by the business, regardless of its form (corporation, partnership or limited liability company).  After all, it is the preservation of the business that motivates the purchase in the first place, and that is the most natural and convenient source of funds to pay the premiums.  What’s more, the business only has to purchase a single policy on the life of each owner.  If the policies were instead owned by the shareholders or partners, then a business with more than 2 owners would require a multitude of policies—one on the life of each owner to be owned by each other owner.  Finally, company ownership facilitates the timely payment of premiums and administration of the policies as part of the business.  All of these factors and practical conveniences have led many closely held businesses to adopt this practice.

Prior to the Court’s decision in Connelly, estate planners were confident that with a properly drawn buy-sell agreement, the business’s ownership of life insurance to fund its obligations to repurchase the shares of deceased owner would be estate tax neutral.  In other words, the insurance proceeds would not be taken into account in valuing the shares for estate tax purposes upon the death of an insured owner.  Since the buy-sell agreement, to which the business is a party, obligates the business to purchase the shares, that obligation to purchase the shares of the deceased shareholder would naturally offset the value that might be added by the insurance proceeds.

The Court’s decision in Connelly has now extinguished that confidence—a unanimous Court held that the insurance proceeds must be included in determining the value of the deceased owner’s share on the business.  That decision was influenced, at least in part, by the terms of the buy-sell agreement that did not, in the Court’s view, adequately fix the price the corporation was obligated to pay for the shares.  The lack of a binding purchase price, combined with the family ownership of the business, resulted not only in the inclusion of the life insurance in the valuation of the business, but also in the deceased shareholder’s family receiving less value than was included in the estate for estate tax purposes!

This Court decision requires that all buy-sell arrangements funded with life insurance be re-examined to ensure that outcome is avoided.

[1] 428 F.3d 1338 (CA11 2005).

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