Understand these changes to avoid higher estate taxes for your business.
If you’re running a family-owned business, you likely have a plan in place for what happens when one of the owners passes away. Many of these plans involve life insurance proceeds to ensure a smooth transition.
However, a recent decision by the US Supreme Court in Connelly v. United States has altered how these plans are taxed, which could mean higher estate taxes for your business. Understanding these changes is crucial to protect your business and your family’s financial future.
The valuation of a closely held business for federal estate tax purposes must include the value of life insurance proceeds paid to the company, despite an obligation to use those proceeds to purchase the shares of the deceased owner. In the case at hand, the Court decided that when calculating federal estate taxes, the value of a family-owned business must include life insurance money paid to the company, even if that money is used to buy the shares of the deceased owner.
An Overview of Connelly
Michael Connelly and his brother, Thomas, were the sole shareholders of Crown C Supply Company (“Company”). As part of their succession plan, the Connelly brothers executed a buy-sell agreement. This allowed the surviving brother to purchase the deceased brother’s shares, or the Company would be required do so. The buy-sell agreement authorized the Company to purchase life insurance on each brother with the condition that the proceeds are used to finance the transaction.
After Michael’s passing in 2013, his brother declined to purchase Michael’s shares. The Company used the life insurance proceeds to purchase Michael’s shares from his estate for $3 million.
The Executor of Michael’s estate filed an estate tax return that reported the decedent’s shares as having a value of $3 million, but the IRS disputed this valuation contending that the life insurance proceeds used for the share redemption should be included in the valuation, significantly increasing the estate’s tax liability.
The Executor responded with an independent appraisal supporting the $3 million value listed on the estate tax return, but the IRS disagreed stating the life insurance proceeds are included in the Company’s value. On appeal, the Court agreed with the IRS that life insurance proceeds are included in the value of the decedent’s closely held business interests for estate tax purposes.
What Should Business Owners Do Next?
1. Review Existing Buy-Sell Agreements
Business owners should revisit existing buy-sell agreements and establish a clear methodology for valuing shares to avoid/minimize disputes during an audit. Moving forward, the use of company-owned life insurance policy to structure these agreements should be avoided.
2. Regular Business Valuations
Obtain regular business valuations and update buy-sell agreements accordingly. Professional appraisals have a far better chance of standing up to IRS scrutiny during an audit. Business owners should keep detailed records of valuations and related agreements to provide the IRS if there is an audit.
3. Consider Cross-Purchase Agreements
Each shareholder owns a life insurance policy on the other shareholders, with the proceeds used to purchase the deceased shareholder’s interest from their estate.
4. Review Existing Succession Plans
Business owners should review existing succession plans if life insurance will be used to finance buy-sell agreements. To minimize the likelihood of unintended tax consequences and promote a more seamless ownership transition at death, consult with your Estate Planning Attorney. Together you can explore alternative methods to structure these agreements in a manner that is consistent with the Court’s ruling in Connelly.
If you want to discuss how this new rule may affect your Business Succession Planning, contact Ed Twomey in our Corporate and Estates and Trusts Practice Groups at etwomey@lynchlaw-group.com or by calling (724) 776-8000.
