The recent Supreme Court case Connelly v. United States has garnered significant attention within both the business and legal communities.[1] In Connelly, the court addressed the effect of insurance funds linked to a redemption agreement on a company’s valuation.[2] The holding, discussed in further detail below, could be cause for concern among entrepreneurs or start-ups focused on structuring their businesses for long-term growth or succession.[3] Ultimately, the court’s holding highlights critical issues in tax, corporate governance, and the shifting of assets and control following a partner’s departure or death.[4]
Background
A redemption agreement is a contractual arrangement in which a company agrees to repurchase shares from a shareholder at a set price, often in scenarios like succession planning or resolving disputes.[5] The redemption agreement may be funded with life or disability insurance with the premiums paid by the corporation.[6] Under this model, the corporation owns the policy and is also the beneficiary.[7] The primary goal of this planning tool is to ensure that a company stays afloat in the case of a partner’s death or departure by having funds available to buy out their shares.[8] The life insurance funds would first be paid to the corporation, and then the corporation would pay the appropriate parties the value of the former partner’s stock without needing to deplete its existing assets.[9]
Discussion
In Connelly, Michael Connelly owned a building materials business, Crown C Supply, with his brother, Thomas.[10] When Michael died, Crown C was required to purchase his shares pursuant to a stock redemption agreement.[11] Crown used $3 million in proceeds from Michael Connelly's life insurance policy to fund the stock redemption.[12] However, a dispute arose when the IRS challenged the tax characterization of the redemption agreement on Michael Connelly’s estate tax return.[13]
Michael owned about 75% of the company’s shares while Thomas owned about 25%.[14] At the time of Michael’s death, the company was worth a bit less than $4 million.[15] Michael’s estate took the position that his shares were worth about $3 million (75% of $4 million).[16] The IRS, however, argued that the corporation was worth about $7 million, pointing to the additional $3 million in insurance proceeds.[17] This additional value made Michael’s shares worth slightly more than $5 million (75% of $7 million) and thus added $1 million in taxes owed by his estate.[18]
The sole issue on appeal before the Supreme Court was whether the obligations under the stock purchase agreement to redeem Michael Connelly’s shares would offset the value of the life insurance proceeds.[19] This question is important for founders of closely-held companies because, if the life insurance proceeds are included in a company’s valuation, then their estate taxes will likely be higher, leaving less money post-tax for their families.[20] Ultimately, the government successfully argued that the insurance proceeds Crown used to redeem Michael Connelly's shares increased the company’s value.[21] Accordingly, the Supreme Court affirmed the Eighth Circuit’s decision and held that the value of the life insurance policy is includable in fair market value of the corporation for estate tax purposes, without any offset for the related stock redemption agreement.[22] Therefore, the $3 million insurance proceeds should have been added to the company’s balance sheet even though they were earmarked to redeem the shares from Michael Connelly’s estate.[23]
Legal and Business Implications
The Connelly v. U.S. decision is a cautionary tale for business owners navigating buy-sell agreements.[24] While redemption agreements have been the preferred transaction structure for dealing with shares of a deceased partner, there are some other business planning options available, although they are generally more complicated.[25] For example, an alternative method could be a cross-purchase agreement.[26] Under a cross-purchase agreement, each shareholder would purchase an insurance policy on every other shareholder.[27] This can quickly become complicated in a closely-held business with just three shareholders.[28] As an illustration, in a redemption agreement scenario, there would be only three policies between the company and the individual shareholders.[29] However, if a company uses cross-purchase agreements, there would be six total insurance policies “crossing” between the three shareholders.[30] This quickly becomes unrealistic as the number of shareholders increases.[31] Following this decision, the preference for redemption agreements is on shaky ground and business attorneys are scrambling to establish a reasonable alternative to facilitate a company’s purchase of a deceased stakeholder’s shares.[32]
[1] See generally Ryan Flatley, Conor McKenzie & Downs Rachlin Martin PLLC, What Connelly v. United States Means for Closely-Held Businesses, JD Supra (Oct. 22, 2024), https://www.jdsupra.com/legalnews/what-connelly-v-united-states-means-for-9679234/#:~:text=United%20States%2C%20144%20S.,for%20federal%20estate%20tax%20purposes.
[2] Connelly v. United States, 602 U.S. 257, 258 (2024).
[3] See Bryan E. Pearce & Kelly A. Berardi, The Potential Ripple Effects of Connelly v. United States on Business Succession Planning, Gray, Gray & Gray, LLP (July 17, 2024) https://www.gggllp.com/the-potential-ripple-effects-of-connelly-v-united-states-on-business-succession-planning/.
[4] See Anna Scott Farrell, Top Federal Tax Decisions of 2024, Law 360 (Dec. 20, 2024, 3:03 PM), https://www.law360.com/tax-authority/articles/2271842 (“[m]oving forward under the decision, practitioners will see an added layer of complexity to their structuring of buy-sell agreements...”).
[5] See Practice Note, Closely-Held Corporations Interests and Tax Considerations, LexisNexis (Dec. 20, 2024), https://plus.lexis.com/api/permalink/32e9cd94-a65e-44b3-a05c-e39cc555adfb/?context=1530671.
[6] See id.
[7] See id.
[8] See id.
[9] See id.
[10] See Connelly, 602 U.S. at 259.
[11] See id. at 261.
[12] See id. at 262.
[13] See id.
[14] See id. at 261.
[15] See id. at 262.
[16] See id.
[17] See id.
[18] See id.
[19] See id. at 263.
[20] See Farrell, supra note 4 (summarizing potential estate tax return complications following Connelly decision).
[21] See Connelly, 602 U.S. at 264.
[22] See id.
[23] See id. at 264–65.
[24] See Pearce & Berardi, supra note 3 (encouraging business lawyers and closely-held companies to explore alternative buy-sell agreement options).
[25] See Closely-Held Corporations Interests and Tax Considerations, supra note 5 (outlining options for buy-sell agreements of shareholders' interests).
[26] See id.
[27] See id.
[28] See Cross Purchase Agreement, Corporate Finance Institute, https://corporatefinanceinstitute.com/resources/equities/cross-purchase-agreement/ (last visited Jan. 3, 2024), (explaining further that life insurance policies in cross purchase agreements must be personally funded, which is often challenging to resource, especially when there is an unexpected death).
[29] See id.
[30] See id. (providing similar example on how cross-purchase agreements are executed).
[31] See id.
[32] See Chandra Wallace, Supreme Court Hands IRS a Win on Life-Insurance-Funded Redemptions, taxnotes (June 7, 2024), https://www.taxnotes.com/featured-news/supreme-court-hands-irs-win-life-insurance-funded-redemptions/2024/06/06/7k9g3.
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