On June 6, 2024, the United States Supreme Court issued its opinion in Connelly v. United States. Justice Thomas, writing for a unanimous court, reshaped closely held corporations' relationship with life insurance in the context of funding redemption buy-sell agreements. After Connelly, closely held corporations have other considerations when using life insurance to fund a corporation's purchase of shareholder interests.
Facts
Crown C Supply is a closely held corporation owned by two brothers, Michael and Thomas Connelly. Michael owned 77% of the shares, while Thomas owned 23% of the shares. In 2001, the brothers, desiring to maintain control over the corporation in the event either brother died, entered a "redemption" buy-sell arrangement funded with life insurance policies to redeem either owner. The buy-sell agreement granted either brother a right of first refusal in the event the other died, but the failure to exercise this right created an obligation on Crown C Supply to purchase the decedent's shares. Crown C Supply acquired two life insurance policies, one on the life of each brother to fund the purchase of shares of a deceased shareholder. While the buy-sell agreement provided an appraisal mechanism to value the corporation's shares at either shareholder's death, the parties did not follow the terms of the agreement. Thomas, on behalf of the corporation and also in his capacity as fiduciary of Michael's estate, agreed on a price of $3 million for Michael's shares, which was less than the $3.5 million of life insurance proceeds the corporation received.
Michael died in 2013, and under the buy-sell agreement, Thomas declined to exercise his right to buy Michael's shares, triggering Crown C's obligation to purchase the shares. The redemption price was to be based on an outside appraisal. Rather than securing the appraisal, Michael's son and Thomas agreed that the value of Michael's shares was $3 million. Crown C then used $3 million of the $3.5 million of insurance proceeds to purchase the deceased brother's shares. Thomas, as executor of Michael's estate, filed an estate tax return valuing the shares at $3 million.
The IRS challenged the estate's $3 million valuation of Michael's shares. The IRS' position was that the life insurance policies were a corporate asset that increased Crown C Supply's value prior to the redemption. Connelly's position was that the buy-sell agreement created an offsetting obligation to purchase the estate's shares, a net neutral, where the receipt of the life insurance proceeds would be offset by the corresponding obligation. Both the Eastern District of Missouri and 8th Circuit Court of Appeals agreed with the IRS that the life insurance proceeds increased Crown C Supply's value prior to redemption. The Connellys filed and were granted certiorari by the Supreme Court.
Court's Decision and Reasoning
The Court framed the issue presented as one of valuation: is life insurance that funds a buy-sell Agreement a corporate asset? Unanimously, the Court said yes. The Court reached this conclusion by reasoning that the redemption was not a liability that reduced corporate value. The Court held that life insurance was a corporate asset since no willing buyer or willing seller would pay a depressed value when Crown C Supply had an influx of cash from life insurance proceeds. Therefore, because the life insurance proceeds were payable to the corporation, the Court held that life insurance proceeds were a corporate asset that increased the corporation value of Crown C Supply.
Consequences of Connelly
It is very common in closely held corporations in order to provide for orderly succession to plan for the death of a shareholder to maintain control within a family or those who are active in the business. The parties together with the corporation typically enter into a buy/sell agreement to address that contingency with many cases as in Connelly the corporation being obligated to purchase the deceased's shares through a redemption buy/sell agreement to avoid economic hardship including sale of the businesses or critical operating assets to fund that obligation, life insurance is used as a funding mechanism to address the obligation.
Connelly raises two key issues with life insurance funded by buy/sell agreements: corporations with existing life insurance arrangements, and prospective planning. First, all buy/sell agreements should be reviewed. Before taking any precipitous action consider if the current agreement is appropriate and if not consider the consequences of the buy/sell agreement. For example, if businesses transfer life insurance policies, the transfer for value rules may apply to curtail the tax-free receipt of life insurance proceeds. Future arrangements involving life insurance could include a cross-purchase arrangement, or potentially a special purpose life insurance LLC. All these options for existing and future arrangements require intricate planning. Further, while Connelly may seem to have the biggest impact on life insurance funded redemption agreements with individuals who have taxable estates, all closely held businesses with life insurance funded redemption agreements are affected by Connelly.
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