Funding a buy-sell agreement with life insurance after Connelly

A buy-sell agreement only works if someone has the cash when an owner dies, becomes disabled or leaves. Life insurance is the most common way to supply it, because it pays out at the moment the obligation arises, in an amount that does not depend on the business's cash flow that year. Since the Supreme Court decided Connelly v. United States on June 6, 2024, how the policies are owned has a direct effect on the company's value for estate tax purposes, and many existing entity-redemption agreements deserve a second look.

What funding has to solve

The agreement fixes three things: who must sell, who must buy, and at what price. Funding answers the fourth question, which is where the money comes from. Triggering events are usually death, disability, retirement, divorce, bankruptcy and termination of employment. Life insurance addresses death directly. The others need separate planning, since a living owner's buyout cannot come from a death benefit.

Without funding, surviving owners are left with the options of paying from cash flow, borrowing or selling to an outsider. A family that is owed a six- or seven-figure price may wait years for installments from a business that has just lost its leader.

The funding tools

Most plans mix them: life and disability insurance for the sudden events, and a note for any gap between the price and the proceeds.

Who owns the policies

This is where Connelly matters.

• Entity redemption (stock redemption). The company owns a policy on each owner, pays the premiums and collects the proceeds, then uses them to redeem the deceased owner's shares.
• Cross-purchase. Each owner buys a policy on every other owner, pays the premiums personally and collects the proceeds, then buys the deceased's shares directly from the estate. With many owners, the number of policies grows fast, which is why people sometimes use a trust or a partnership to hold them. See cross-purchase vs entity redemption buy-sell plans for the comparison.
• Hybrid or "wait-and-see". The agreement decides at death who buys, such as the company first and then the surviving owners.

What Connelly v. United States decided

The Court's opinion by Justice Thomas, joined unanimously on June 6, 2024, affirmed the Eighth Circuit and held that a corporation's contractual obligation to redeem a shareholder's shares is not a liability that reduces the value of the corporation for federal estate tax purposes (opinion text).

The facts:

• Two brothers owned Crown C Supply, a St. Louis building supply company. Michael held about 77% of the shares.
• Their agreement let the survivor buy the deceased brother's shares and, if he declined, required the company to redeem them. Crown bought $3.5 million of life insurance on each.
• When Michael died, the company used $3 million of the proceeds to redeem his shares. The estate reported the shares at $3 million, and valued the company at $3.86 million without counting the insurance proceeds.
• The IRS counted the proceeds, valued Crown at $6.86 million and Michael's shares at about $5.3 million, and assessed additional estate tax of $889,914.

The Court reasoned that a redemption at fair market value leaves each shareholder's economic position the same, so a buyer valuing the shares at death would treat the insurance proceeds as an asset and the obligation to use them as offsetting nothing. The result: the insurance proceeds increased the company's value, and the estate tax value of the decedent's shares rose with it.

The Court also said it was not holding that a redemption obligation can never reduce a corporation's value. A footnote gives the example of an obligation that would force the company to liquidate operating assets, which could reduce its future earnings capacity. And the Court noted that a cross-purchase agreement, where the surviving brother would have owned the policies and collected the proceeds, would have avoided the problem, though it has its own drawbacks, such as owners having to pay each other's premiums.

What it means for your agreement

1. Entity-redemption agreements funded with company-owned insurance. For a closely held business, the proceeds may now be counted in the company's value at the owner's death. The agreed price in the buy-sell may not control the value the IRS uses, unless it meets the requirements for setting value for estate tax purposes. Estate tax exposure depends on the size of the estate, current exemption amounts and state estate or inheritance taxes.
2. Valuation clauses. If your agreement says the price is a formula or "fair market value," ask your attorney how insurance proceeds are treated in that formula, and whether the estate and the company would end up taking inconsistent positions.
3. Cross-purchase or an insurance LLC or trust. Owners often move policy ownership to the owners, to a trust or to a separate entity. Each option has tradeoffs; the transfer of a policy can trigger the "transfer for value" rule under IRC 101(a)(2), which can make death benefits taxable unless an exception applies (a transfer to the insured, to a partner of the insured or to a partnership in which the insured is a partner is generally excepted).
4. Review dates. Many agreements were written decades ago. Calendar a review every two or three years, and after any change in ownership, value, tax law or health.

This is an area where a business attorney and a CPA need to work together with the insurance advisor. Neither the Court's opinion nor this guide replaces their advice on your facts.

Sizing the insurance (hypothetical)

Say three equal owners of a Wisconsin engineering firm value the business at $6 million by formula. Each owner's interest is worth $2 million. Under cross-purchase, each owner needs a policy on each of the other two, with a $1 million face on each, so that the surviving two can each pay half the price and each ends up owning half of the deceased's shares: six policies, each owner paying two premiums. Under entity redemption, the company would buy three policies of $2 million each. The cross-purchase structure takes more administration but keeps the proceeds out of the company's value. Run your own numbers with the buy-sell agreement funding calculator.

Practical points

• Premium deductibility. Premiums are generally not deductible, whoever pays them. Proceeds are generally income-tax-free when the transfer-for-value rule does not apply.
• Employer-owned policy rules. If the company owns insurance on the owners, the notice-and-consent requirements of IRC 101(j) apply, and Form 8925 is filed annually. See Employer-owned life insurance: notice and consent rules under IRC 101.
• Keep coverage matched to value. Update the face amount as the business grows, or the proceeds will fall short and the gap becomes a note.
• Coordinate with key person coverage. A key person policy is owned by the business and pays the business; the buy-sell policy pays for ownership transfer. Do not use one to fill the other's role. See key person insurance: protecting the business from a loss of talent.
• Underwriting. Health problems of an owner can make a policy costly or unavailable; start early. See how insurers underwrite business life insurance.

Key takeaways

• Insurance gives a buy-sell agreement liquidity at death; disability and living-owner events need other funding.
• Connelly v. United States (June 6, 2024) held that a corporation's obligation to redeem shares does not offset life insurance proceeds in valuing the company for estate tax.
• Entity-redemption plans with company-owned policies deserve review; cross-purchase or trust-owned structures avoid that valuation problem but add administration and transfer-for-value cautions.
• Review the agreement, the valuation formula and the policy ownership with an attorney and a CPA at least every few years.