How the Supreme Court is Impacting Succession Planning

In June the U.S. Supreme Court issued a unanimous ruling in Connelly vs. United States determining that corporate-owned life insurance proceeds utilized to fund share redemptions upon a shareholder’s death must be included in the corporation’s estate tax value. This ruling has significant implications, as it increases estate taxes and reduces estate proceeds received by heirs.

This decision directly effects many built environment companies, where corporate-owned life insurance is a common method for funding corporate redemptions of stock from a deceased owner’s estate.

We’ll explore the key aspects of this court ruling and its potential effects and discuss how companies can adapt their business succession planning strategies considering this new legal landscape.

Case Background

Brothers Michael and Thomas Connelly jointly owned Crown C Supply, a building products supplier. Pursuant to their buy/sell agreement upon the death of either shareholder the surviving brother had the first option to purchase the deceased’s shares. If this option was not exercised, the company then had the right to redeem any remaining shares. To fund a potential purchase or redemption of shares, Crown C owned and was the beneficiary of $3.5 million life insurance policies for each partner.

In 2013 Michael passed away and Crown C used the life insurance proceeds to redeem his 77% ownership interest. The existing buy/sell agreement required a Certificate of Value or appraisal of the business, and Thomas and Michael’s estate representatives agreed to a total Crown C valuation of $3.86 million ($3 million for Michael’s 77% interest). Crown C only obtained a valuation of the business after submitting estate tax documentation to the IRS.

Michael’s estate filed a return with the IRS, valuing his shares at $3 million, not including the life insurance proceeds on the basis that the redemption liability would offset any life insurance proceeds. The IRS ultimately disagreed and valued the company at $6.86 million ($3.86 million valuation + $3 million insurance proceeds). The IRS contended that the redemption option did not offset the life insurance received by the corporation.

The IRS ruled that the corporate-owned life insurance was additive to the total valuation, resulting in an estate value of $5.29 million. This increased the estate tax burden (at 40%) and reduced the funds received by the estate.

The Supreme Court held that the appropriate estate tax valuation should be calculated on the date of death, before any actual repurchase of shares, thereby negating the potential offset in liability.

Impact and Path Forward

Given the current landscape of gift and estate taxation this will not impact all firms. The current individual estate tax exemption is $13.6 million due to inflation but is expected to sunset at $7 million in 2026. Total estates under these amounts will not be directly impacted; however, given certain uncertainty surrounding the long-term effects of this ruling, those in the construction industry need to be proactive with respect to their transition and estate planning.

Even if you have a preliminary idea or outline of a plan, it is essential to get ahead of planning for the future of your business and ownership, from both short-term and long-term standpoints. Addressing potential risks and unforeseen events will ultimately help you achieve your long-term goals.

Key aspects to consider:

• Evaluate Current Buy/Sell or Shareholder Agreements: Understand the mechanisms in place for purchasing shares upon the death of a shareholder. Certain aspects of buy/sell agreements may need to be updated as organizations evolve.
  • Clear Valuation: Ensure that your buy/sell agreement clearly specifies how and when the valuation is calculated.
  • Adherence to Agreements: Shareholders must follow the terms of their agreements. In the Crown C case, the shareholders did not obtain annual valuations or have a clearly defined valuation methodology, which hurt their case with the IRS.
• Review Existing Life Insurance Policies: Assess the ownership (corporate vs. personal), beneficiaries and coverage amounts to ensure they are sufficient for current valuation levels and align with corporate objectives.
  • Policy Transfer: Policies can be transferred from corporate ownership to beneficiaries; however, there could be certain tax implications depending on entity type.
  • Funding Buyouts: In situations where life insurance doesn’t fully fund a buyout, ensure that agreements stipulate how the estate can obtain value without immediately impacting the company.
• Consider Alternative Purchase Arrangements: There are a few potential means to purchase or redeem shares to avoid additional estate tax issues:
  • Cross-Purchase Agreements: Implementing a cross-purchase agreement in the event of a shareholder’s death may nullify the effects of the Supreme Court ruling. In practice, shareholders obtain life insurance policies on other shareholders as funding mechanisms. This is highly utilized yet can be cumbersome for broadly held firms.
  • Family Trusts: For family-owned businesses, transferring individual ownership to a trust prior to death can reduce certain estate tax affects. This requires thoughtful estate tax advice given certain tax and legal intricacies.
  • Other Alternatives: Other, more specialized alternatives exist such as trusts or special-purpose limited liability companies can hold insurance on behalf of shareholders.
• Consult With Tax Advisors: We recommend that you seek guidance from your financial, legal and accounting experts to further assist your current situation.

While the Connelly decision introduces challenges, it also provides businesses with an opportunity to reassess their succession strategies and consider more adaptable plans. By embracing these changes, companies can better position themselves for long-term success in an ever-changing business landscape.