Connelly Decision: Action Steps for Estate Planners to Consider

Introduction

On June 6, 2024, the United States Supreme Court issued a landmark ruling in Connelly v. United States, unanimously deciding that a closely held business’s obligation to redeem a deceased equity owner’s shares does not constitute a corporate liability which reduces the fair market value of the corporation’s shares for estate tax purposes. This decision overturns a prior lower Court decision that held that the redemption obligation reduces the value of life insurance proceeds included in the business valuation. It clarifies the valuation of corporate assets in estate planning and has significant implications for closely held businesses and both their existing and forthcoming buy-sell agreements. This article will explore the case and practical implications that practitioners may discuss with clients.

Background

Brothers Michael and Thomas Connelly owned Crown, a C Corporation, with Michael holding 77.18% of Crown and Thomas owning the remaining 22.82%. The two brothers entered into a buy-sell agreement, granting the surviving brother — Thomas in this case — the option to purchase the decedent brother’s (Michael’s) shares from his estate. If this option was not exercised, as occurred here, the corporation had a binding obligation to redeem the deceased brother’s shares.

To fund the buy-sell agreement, if the surviving brother chose not to exercise his option to purchase, the corporation obtained $3.5 million of life insurance. The stock purchase agreement provided two mechanisms for determining the redemption price of the shares. The primary mechanism employed a methodology commonly used in buyout arrangements for closely held businesses, a certificate of agreed value. With this approach, the shareholders were to agree on a value for the business at the end of each tax year and memorialize that agreed value in a certificate. If the brothers failed to agree on a set value, the secondary mechanism required that the brothers obtain two or more appraisals of fair market value. At the time of Michael’s death, the brothers had not executed either mechanism.

Upon Michael’s death, Thomas did not exercise his option to redeem Michael’s stock. Consequently, once the corporation received the life insurance proceeds, it redeemed Michael’s shares. As neither mechanism for determining the redemption price was utilized, the Connellys determined the corporation’s total value to be $3.89 million, with Michael’s interest valued at $3 million. The remaining $500,000 of the insurance payout was used to cover the corporation’s operating expenses.

The life insurance proceeds were deemed a corporate asset that increased the value of the entity interests held in the decedent’s estate and thereby may increase the estate tax due. This result was consistent with Treasury Regulations, which require that nonoperating assets, like life insurance, that are not included in the fair market value of the business worth be added to the business’s value. The inclusion of the life insurance proceeds was not in contention in the case, as apparently that had been agreed to by the parties. The issue that the Supreme Court had to address was whether the valuation of the business, inclusive of the life insurance proceeds, was offset or reduced in part by the obligation the company had to repurchase the deceased brother’s shares.

The Supreme Court held that “…redemption obligations are not necessarily liabilities that reduce a corporation’s value for purposes of the federal estate tax...” This holding distinguishes this type of buyout arrangement from a standard corporate liability, which would be taken into account for net asset value and offset the inclusion of insurance proceeds in the valuation of the decedent’s interest in the entity. It is interesting to note that the Supreme Court did not say that a buyout obligation could never reduce the value of the company.

Limits on the Connelly decision

The Court stated in footnote 2: “We do not hold that a redemption obligation can never decrease a corporation’s value. A redemption obligation could, for instance, require a corporation to liquidate operating assets to pay for the shares, thereby decreasing its future earning capacity. We simply reject Thomas’s position that all redemption obligations reduce a corporation’s net value. Because that is all this case requires, we decide no more.”

Implications of the Decision

Practitioners should consider communicating with clients to inform them of the Connelly decision so clients are not unintentionally subjected to the negative estate tax complications and results of the Connelly decision. This might take the form of direct communication to clients who the practitioner is aware have redemption arrangements in place, general newsletter and email blasts to client databases, and perhaps revising form agreements and form cover letters to note this issue so that clients will be informed.

While Connelly creates potential estate tax issues, most estates are not subject to the estate tax at all. With the exemption set at $13.61 million per person (2024), potential estate tax ramifications may not be, ignoring state estate or inheritance taxes, an actual issue. If the value of each equity owner’s estate is under the estate tax exemption, it may not be necessary to restructure the insurance-funded redemption agreement. The extent to which the life insurance adds to the entity’s value may not trigger federal estate tax. However, states with lower estate tax thresholds or an inheritance tax may cause a tax to be incurred. The redemption is scheduled to be reduced by half in 2026 and may be changed by future legislation, so caution is in order. Continued monitoring of the redemption agreement is necessary to evaluate tax law changes or valuation changes that may create future estate tax implications.

Is A Cross Purchase Arrangement Preferable Post-Connelly?

Some commentators have suggested that a cross-purchase arrangement is the solution to the Connelly issue. It may be, but the decision process is more nuanced and complex post-Connelly.

If including the value of the entity-owned insurance could trigger estate tax, it might be preferable to restructure the buyout arrangement as a cross-purchase arrangement as an alternative to a redemption agreement. In a redemption agreement, the entity buys back the economic interest of the deceased shareholder. In contrast, a cross-purchase agreement involves the shareholders purchasing the shares directly of a deceased shareholder. In a cross-purchase agreement, however, the insurance policy proceeds are not included in the valuation of the company, so the Connelly issue would seem to be avoided. In that type of structure, the value of the insurance will not affect the entity’s value as the entity has no interest in the life insurance policies.

Additionally, the surviving partner benefits from a step-up in the cost basis to fair market value upon the death of the shareholder whose shares he is obliged to purchase. This distinction is particularly important for smaller clients, given the high estate tax exemption. As many clients are unlikely to exceed the exemption threshold, practitioners should evaluate the income tax consequences of the client’s buy-out arrangement.

However, before undertaking such restructuring, business owners need to consider the costs associated with new documentation for the cross-purchase arrangement, the costs of unwinding the existing redemption agreement, and the costs and availability of new life insurance.

Cross-purchase agreements also require each equity owner to pay insurance premiums on the lives of other equity owners. With little in the way of security and ensured compliance, business owners may feel more secure that the life insurance premiums will be paid and the policy enforced when the entity is paying.

Further, cross-purchase agreements can be unwieldy, especially as the number of shareholders increases. For instance, twelve life insurance policies would be required for a cross-purchase agreement in a company with four shareholders, making the arrangement costly and complex to maintain and impractical to execute.

The number of policies required may be potentially reduced by creating an insurance partnership or limited liability company (“LLC”) to own the policies. The life insurance LLC should be formed as a partnership to avoid any transfer for value issues under section 101(a) of the Internal Revenue Code. If the proceeds are payable to an LLC and allocated to the surviving partners for a cross-purchase buyout rather than to the company, at first look, it might seem that the Connelly problem has been avoided. However, that does not appear to be the case, as the Connelly reasoning would seem to apply to the insurance partnership or LLC, and a pro-rata portion of the insurance partnership or LLC would have to be included in the deceased shareholder’s estate.

Evaluate Formulas

A careful review of the structure and terms of the client’s buyout arrangement is imperative. Was an existing redemption buy-sell agreement drafted with different assumptions prior to Connelly? What might the impact of that be? For example, if a buy-sell redemption agreement establishes the valuation at the fair market value as determined for estate tax purposes, that will now result in the inclusion of the insurance with no offset for the redemption obligation. Prior to Connelly, the equity holders may have assumed that a different economic result would have occurred.

For example, if a corporation is valued at $10 million and the insurance payout is worth $5 million, because the value of the insurance policy is included in the value of the company, half of the equity interests in the company would be worth $7.5 million. The company would then be required to pay the estate based on this inflated value. Therefore, the wording of the buyout arrangement is crucial. Practitioners may consider advising clients that every redemption agreement be reread to ensure that the client is paying what they anticipate.

Tax Allocation Considerations

Finally, practitioners may wish to communicate with clients to ensure that they are aware of any tax apportionment issues. Clients must consider which beneficiaries/bequests they intend to bear the burden of any estate tax and address that in their will or revocable trust. What if, post-Connelly, there is a phantom value included in the estate that is not paid for in the buyout? Does the client want that heir to bear the estate tax on the phantom buyout price? The instrument could stipulate that whoever receives the insurance payout must pay apportioned estate tax.

Another Reminder of The Importance of Adhering to Formalities

The Connelly case also serves as a reminder to practitioners, and especially to clients, that the formalities of business and estate planning arrangements must be respected by the parties if the taxpayers expect the IRS to respect the arrangements. Although these issues were not of note in the Supreme Court’s ruling, which was generally limited to the question of the redemption obligation not offsetting entity value, they were discussed in the lower Court opinions. The arrangements the brothers agreed to required that they memorialize a value each year in a certificate. They did not do that. The agreement required obtaining an appraisal. They did not do that either. There has been no shortage of recent cases reminding taxpayers of the vital importance of respecting formalities and arrangements. Cases have also reminded taxpayers of the importance of independence. In Connelly, the surviving brother was also the executor and the sole surviving shareholder. He orchestrated most of the events in the case and came to a valuation determination with the deceased brother’s family. There was no independence. That is not prudent. In contrast, in the Levine case, the taxpayer victory was in part based on the use of independent and capable fiduciaries. So, while the Supreme Court holding and this discussion have focused on the issue of no assured reduction in value for the redemption obligation, the important practical practice lessons from the history of the Connelly case should not be overlooked.

Conclusion

There are several estate planning implications from the Connelly decision that practitioners should consider addressing with clients. Among these considerations is the inclusion when valuing the company of redemption buyouts funded with insurance proceeds payable to the company without any offset in value for the redemption obligation, the benefits and drawbacks of substituting a redemption buyout with a cross-purchase agreement, and the potential of creating an insurance LLC to try and mitigate the complexity of a cross-purchase agreement. There is also the risk of the inclusion of a pro-rata portion of the insurance LLC in the deceased owner’s gross estate inflated by the insurance value and not reduced by the buy-out obligation.

Careful planning and drafting may help mitigate some of the implications raised by the Connelly decision.