Connelly and Buy-Sell Agreements – Is it time for a new strategy?
On June 6, 2024, the Supreme Court of the United States decided the case of Connelly v. United States, 144 S. Ct. 1406. The Connelly decision significantly impacts business succession planning using buy-sell agreements funded with life insurance. The Court (i) disregarded the valuation determined under the redemption agreement because it did not qualify under one of the exceptions, (ii) agreed with the IRS that the proceeds of the life insurance increased the value of the business and (iii) that the value of the business was not offset by the obligation to redeem the deceased brother’s estate. Therefore, the valuation for estate tax purposes was equal to the appraised fair market value of the business plus any insurance proceeds owned and payable to the company, less any applicable valuation discounts.
General Rule.
In general, options, rights, agreements or restrictions in buy-sell agreements are disregarded for gift, estate or GST tax purposes, unless an exception applies. This means that even though an estate only receives the sum determined under an agreement at death, the IRS may include a greater value for estate tax purposes. Items that may cause an entity’s value to be greater than its redemption price include deferred income taxes and life insurance policies owned by the corporation.
Exceptions for certain Buy-Sell Agreements
There are exceptions to the general rule and extra care should be taken to ensure the the terms of the buy-sell agreement fall within one of the common exceptions to the rule: (i) the Unrelated Party exception, and (ii) the Bona Fide Business Arrangement exception, both of which allow a contract to set the price for estate tax purposes.
(1) Unrelated Party Exception. If less than 50% of the entity is owned by unrelated parties using a common ancestor analysis, the contract terms will set the value for estate tax purposes. See Treasury Regulation 25.2703-1(b)3). The definition of related party under this rule is any lineal descendant of the parents of the transferor or the transferor’s spouse (e.g. mom, dad, mother-in-law, father-in-law and all of their children, grandchildren and great-grandchildren). If this group owns more than 50% of the entity, this exception does not apply.
(2) Bona Fide Business Arrangement Exception. If the agreement satisfies three requirements: (a) it is a bona fide business arrangement, (b) is not a device to transfer property to the natural objects of the transferor’s bounty for less than full and adequate consideration, and (c) the restrictions are similar to arrangements in arm’s length transactions, the contract terms will set the value for estate tax purposes. See IRC 2703(b). The Bona Fide Business Arrangement exception has been the subject of much tax litigation. Courts have added additional rules that also must be taken into consideration. The Court created rules include:
- The contract must contain a fixed or determinable price.
- The agreement must be legally binding on the decedent’s life and the decedent’s estate after death.
- The price set for selling the shares during the decedent’s lifetime cannot be higher than the price that would be required by the estate on the decedent’s death.
- The restrictive agreement must have been entered into for a bona fide business reason and must not be a substitute for a testamentary disposition for less than full and adequate consideration.
Effectively, the safe harbor provisions require that the redemption agreement make a certain amount of business sense, is not a means to transfer an asset to a family member for less than its value and is similar to other contracts. The agreement must apply during the shareholder’s lifetime and after the death of the shareholder, and the estate cannot be entitled to a lower price than the shareholder would have been entitled to during their lifetime. The contract must also contain a fixed or determinable price.
What do business owners need to consider after Connelly?
- Follow the terms of your agreement. In Connelly, the agreement required the brothers to execute a “Certificate of Agreed Value” every year to decide upon a proper valuation for the corporation and provided for an additional appraisal mechanism should they fail to decide upon an agreed value. The brothers did not update the value each year and did not hire an appraiser, therefore the Bona Fide Business Arrangement exception did not apply and the Court was free to value the company without regard to the terms of the agreement. The Court subsequently included the proceeds of a life insurance policy in the valuation.
- If the owners are relying on the Unrelated Party Exception, they should closely monitor redemptions and other transactions to ensure that less than 50% of the entity is owned by unrelated parties.
- All corporations owning, or designated as the beneficiary of, life insurance on its owners should minimize the amount of life insurance held by the Company. This could be simply from attrition, distributing the policies to the shareholders, repurposing policies (binding the company to a compensation package that reduces the value of the company commensurately), and re-writing policies if economically feasible.
- All corporations owing, or designated as the beneficiary of, life insurance on its owners should consider alternative mechanisms to minimize the risk of the Connelly The Court recommended the “cross-purchase agreement” approach, in which shareholders, rather than the corporation, agree to purchase a deceased shareholder’s interest, funded by the shareholders’ purchase of life insurance. Additionally, it may be feasible to hold policies outside of the estate through a trust or limited liability company taxed as a partnership.
- If one or more of the owners of a closely held business subject to a buy-sell agreement has a taxable estate, the owners should carefully review how the agreement impacts their overall estate plan and estate tax obligations. In certain circumstances, transferring the ownership of the business during lifetime may be more tax efficient.
The Court’s decision in Connelly stresses the importance of lifetime planning as a means to minimize potential estate tax and succession issues involving business interests. If you would like to discuss your buy-sell arrangements in further detail, please contact my office to schedule a time to meet and determine what changes, if any, may be beneficial to you and your business.