In the wake of the July 6, 2024 U.S. Supreme Court ruling on Connelly v. United States, closely held business owners with redemption buy-sell agreements may now face higher estate taxes.
Many closely held business owners enter into buy-sell agreements to define how their business interest will be transferred at death. Redemption buy-sell agreements direct the company to purchase the deceased owner’s interest. A common approach to funding this agreement is for the company to purchase life insurance on the owner(s). The Supreme Court ruled that when a business owner dies, the life insurance proceeds payable to the company increase the company’s fair market value (FMV). Consequently, an increase in fair market value will increase the size of the business owner’s estate.
Factors to Consider:
- The ruling may increase the size of your estate, but your estate may still fall within the federal estate tax exemption amount ($13.61 million individual; $27.22 million for married couples in 2024). Keep in mind, this exemption amount is expected to be cut by roughly half in 2026. Furthermore, certain states impose a state estate tax with a much lower exemption amount.
- It is nearly guaranteed that the Connelly ruling will apply to family-controlled businesses with redemption buy-sell agreements.
- Unrelated business owners may fall into the safe harbor rule for valuing the business interest for estate tax purposes. This rule is satisfied if more than 50% of the rest of the business is owned by people other than members of the deceased owner’s family (see Treasury Regulation Section 25.2703-1).
Alternatives for Redemption Buy-Sell Agreements:
- Cross-purchase buy-sell arrangement
- Each co-owner buys a life insurance policy on each of the other co-owners. The co-owners pay the annual premiums and are the named beneficiaries of the policies.
- Escrow buy-sell arrangement
- Cross-purchase arrangement where a trustee or escrow agent holds each owner’s stock certificates and owns one life insurance policy on each owner.
- Life Insurance LLC
- LLC is created to own a life insurance policy on each owner. The LLC has a third-party manager and the business makes distributions to the owners, who can then make capital contributions to the LLC to pay policy premiums.
- Endorsement split dollar
- Business owners purchase policies insuring their own lives and endorse the death benefit to their co-owners via a split dollar agreement.
If you are a business owner concerned about estate taxes, it is an opportune time to review your buy-sell agreement with your advisors to determine if the Connelly ruling applies to your estate plan. EBN is prepared to assist with the specific needs of your succession and estate plans, helping you develop tailored strategies to achieve your goal and to understand how the Connelly ruling impacts your business.
Source: https://www.supremecourt.gov/opinions/23pdf/23-146_i42j.pdf