Connelly v. United States: Business Impact

Unintended consequences of not paying attention to the buy-sell agreement

On June 2, 2023, a three-judge panel in the Eight Circuit of the U.S. Court of Appeals ruled that life insurance proceeds that were originally earmarked to redeem the stock of a deceased shareholder “were simply an asset that increased shareholders’ equity,” affirming a September 2021 decision by the U.S. District Court for the Eastern District of Missouri. The ruling imposed a significant tax liability on the deceased shareholder’s estate and may have been avoided through proper adherence of an existing buy-sell agreement between the decedent and his brother who was the other shareholder.

How does this ruling impact the value of your business?

In order to mitigate going-concern risks related to the death of a shareholder, a company or its shareholders will purchase life insurance to redeem another shareholder’s interest in the event of his or her death, and this process is typically governed by a shareholder’s agreement (or buy-sell agreement).  Through proper planning, the agreement can be structured in order to mitigate an excess tax burden on a decedent’s estate.

Prior to the Connelly decision, the prevailing case regarding the administration of life insurance proceeds and its impact on the value of a business for estate tax purposes was Estate of Blount v. Commissioner which established that the value of a company would not be increased by the value of the death benefit of life insurance when its purpose is to provide liquidity to a company in order to redeem a decedent’s ownership interest. In other words, the value of the life insurance proceeds was offset by the entity’s redemption obligation. However, the panel in the Connelly matter rejected the approach taken by the Eleventh Circuit in the Blount matter.

While many may argue that this is a case of “bad facts,” company owners and advisors need to be aware of this case as it could be brought up in similar matters when an estate is challenged by the Internal Revenue Service (IRS). Business owners and their advisors should carefully review existing shareholder or buy-sell agreements to avoid similar unintended consequences.

In the Connelly matter, the existing buy-sell agreement noted two pricing mechanisms:

1) Annual certifications of value agreed by both parties, or

2) Appraisals of company value. However, both mechanisms were ignored by the shareholders according to the opinion.

Let’s examine the unintended tax burden

To demonstrate the unintended consequences due to the lack of adherence of the provisions in the buy-sell agreement, the following calculations demonstrate the facts above with hypothetical numbers.

In this hypothetical example, the shareholders are Bill (decedent) and Jill, and each owned 50% of the outstanding shares of ABC Co. The table below demonstrates how proceeds are distributed to Bill’s estate in two scenarios where the death benefit is treated as: 1) a corporate asset or 2) funding vehicle for repurchase. As demonstrated in the calculation, it is important to spell out the intentions of the parties, as the surviving shareholder may realize a windfall at the detriment of a deceased shareholder’s estate.

Now let’s assume similar facts as the Connelly matter, and the death benefit was intended to be a funding mechanism. Upon receipt of the insurance proceeds, the company remits the funds to the Estate to acquire the decedents shares. However, the shareholders never abided by the provisions in buy-sell agreement or conducted a valuation as of the date of death.

Fast forward, the death benefit is deemed to be a corporate asset, and therefore, the value of the estate is $750. Consequently, the estate may be burdened with an additional tax liability for the increased value of $750, but only received proceeds of $500.

Proceed with a plan

In summary, we urge business owners to review existing buy-sell agreements (or operating agreements) with their advisors on a regular basis and abide by the stated terms and conditions in order to avoid unintended consequences. In addition, the Connelly provides ammunition for the IRS to argue that life insurance proceeds are assets of the Company, even if the intention of those proceeds were to be a funding vehicle. Therefore, it is imperative to review the life insurance provisions in the buy-sell agreement and discuss the implications with your advisors.

Questions on your company’s buy-sell agreement? Contact your Keiter Opportunity Advisor or the Keiter VFS team |Call: 804.747.0000. We can help you review your buy-sell agreements and answer questions about how your life insurance proceeds may impact the value of your business.

Additional Business Succession and Valuation Resources

• Tax Victory S Corporation Valuation | Virginia Valuations (keitercpa.com)
• Key Man Discount | Virginia Succession Planning (keitercpa.com)