On June 6, 2024, the US Supreme Court issued a decision in the case Connelly v. US, establishing that the life insurance proceeds used in entity buy-sell agreements for the shares of a closely held corporation need to be included in the fair market value (FMV) of the corporation and its shares when determining the amount of estate tax owed on a decedent’s estate. This decision was crafted somewhat narrowly, specifically affecting closely held corporations which are those owned by a small group of shareholders who often are members of the same family.
In this case, the Connelly brothers, Michael and Thomas, were the two shareholders of a closely held corporation. They wanted to keep the business in the family and decided to enter into an entity buy-sell agreement where when one brother passes the other has the option to purchase their shares, and in the event the surviving brother decides not to purchase, then the corporation would be required to purchase the decedent’s shares. To ensure there were enough funds for this, the corporation bought a $3.5 million life insurance policy for each brother, where the proceeds would be used to redeem the shares. Michael passed away in 2013, and Thomas chose not to purchase the shares; so, the corporation was obligated to do so. Thomas and Michael’s heirs did not get an official appraisal of the shares. Instead, they agreed that they were valued at $3 million, deciding not to include the proceeds from the life insurance policy. The corporation then used $3 million from the proceeds to purchase the shares from Michael’s estate.
The IRS challenged this valuation, arguing that the $3.5 million life insurance proceeds should have been included in the FMV of the corporation and shares as an asset, which would lead to a higher value and consequently more estate tax owed. The lower courts agreed with the IRS, and the US Supreme Court did as well, finding that the FMV of shares in a closely held corporation must include the value of the life insurance proceeds since such proceeds do not act as a liability but rather increase the value of the corporation as an asset.
The Court’s reasoning was that when a corporation is obligated to purchase the shares, by considering the proceeds as a liability and not taking them into account for the FMV of the business and its shares, the company is effectively being valued after the death of the decedent, where the proceeds would have already been used to buy the shares. Rather, the FMV of the business and the decedent’s shares should be considered for what they were at the time of the decedent’s death, meaning it would include the life insurance proceeds as they would not have yet been used to purchase the shares.
For shareholders who do not expect to surpass the current estate tax exemption threshold of $13.61 million for individuals and $27.22 million for married couples (expected to halve in 2026 to approximately $7 million and $14 million, respectively), this decision is not especially impactful as estate taxes may not be a concern. However, for those above or near the estate tax threshold whose assets include illiquid, closely held businesses, it is essential that this new decision be considered. These individuals may wish to consider amending their buy-sell agreements as a result of the Connelly decision.
Alternatively, owners of closely held businesses might consider cross-purchase agreements where the shareholders themselves purchase the life insurance policy for each other instead of the corporation. This lets the proceeds go directly to the shareholder, but it would force them to directly pay the premiums on the life insurance.
Every type of agreement has its pros and cons, and in the face of an ever-changing legal landscape, updates and amendments are almost always necessary. That is why it is essential to be up to date with new laws and court decisions when drafting legal documents and planning for the future.
