Limited liability corporations that use insurance-funded repayment arrangements can have to pay taxes, based on the Supreme Court. … [+]
Supreme Court rules in favor of the IRS
On June 6, 2024, the U.S. Supreme Court issued a unanimous decision on a case involving the valuation of a family business that may have significant implications for a lot of family-owned businesses and family-owned operations. Connelly v. United States, U.S., No. 23-146, Decision 6/6/24. The case handled the valuation of stock in a family-owned business and ruled that an organization’s obligation to purchase the stock of a deceased shareholder doesn’t diminish the worth of the insurance advantages the corporate receives to finance the buyout. The Supreme Court’s ruling resolves the conflict between the Connelly case and the Estate of Blount v. Commissioner, which had reached the alternative conclusion.
The case
Two brothers, Thomas and Michael Connelly, owned all of the stock in Crown C Supply, a constructing materials company. They had made provisions for the death of one in every of them by drafting a settlement agreement specifying the worth of the stock and the corporate’s obligation to purchase or repurchase the stock of a deceased shareholder. They were even prudent enough to work out the economics of how this obligation to purchase the stock of a deceased shareholder could be financed and had the corporate take out life insurance on each shareholder. The goal was to maintain the corporate within the family in case one in every of them died. They weren’t particularly careful or prudent in observing the formalities of the agreement, but that was not the crucial point within the Supreme Court’s rulings.
The key point that undermines many family business settlement agreements (i.e., when the business owns the life insurance and purchases the shares from the deceased owner’s estate) is that the life insurance the business owned to fund the settlement needed to be included in the worth of the business shares being purchased. In other words, the life insurance proceeds were considered business assets that increase the worth of the business shares within the deceased’s estate and should thereby increase the estate tax payable. This consequence seemed required under Treasury Regulation 20.2031-2(f)(2), which requires that non-business assets corresponding to life insurance that usually are not included within the fair market value of the business have to be included in the worth.
The company’s obligation to finish the buyout mustn’t be treated as a liability that will be used to scale back the worth of the shares bought out. Many advisers believed that the corporate’s obligation to pay the deceased shareholder’s estate should offset the worth of the life insurance policy. After the Supreme Court’s decision, taxpayers were out of luck. So the duty to purchase out a deceased shareholder’s shares isn’t treated as a discount in value, as could be the case with, say, a bank loan. An obligation to purchase out shares isn’t a standard liability, and the Supreme Court ruled that it mustn’t be treated as such. The Court reasoned that: “Repayment at fair market value has no effect on the economic interests of a shareholder. No hypothetical buyer purchasing Michael’s shares would have treated Crown’s obligation to buy back Michael’s shares at fair market value as a factor reducing the value of those shares.”
The court continued: “However, in calculating the estate tax, what matters is how much Michael’s stock was worth at the time of his death – before Crown spent $3 million on the redemption fee. See 26 USC §2033 (where gross estate is defined as “includes the worth of all property as much as the quantity of the decedent’s interest therein on the time of his death”). A hypothetical purchaser would treat the life insurance proceeds used to redeem Michael’s stock as net wealth.”
More specifically, that is how the above issues developed. The settlement agreement gave the surviving brother first right of purchase for the deceased brother’s shares. Thomas selected not to buy Michael’s shares, so the corporate’s obligation to buy the shares was triggered. The deceased shareholder’s son and Thomas, the surviving brother/shareholder and executor, agreed that the worth of the deceased’s shares was $3 million. The company paid this amount to the deceased brother’s estate. A federal estate tax return was filed for the estate, reporting the worth of the deceased’s ownership interest as $3 million. The IRS audited the return. During the audit, the executor obtained an independent appraisal that determined the worth of the corporate to be $3.86 million. This calculation excluded the $3 million in insurance proceeds used to redeem the shares. The reasoning was that the worth of the life insurance policy was offset by the contractual obligation to redeem the deceased brother’s interest. The IRS disagreed. It insisted that the corporate’s obligation to redeem the deceased brother’s property didn’t offset the life insurance proceeds. The IRS valued the corporate at $6.86 million ($3.86 million enterprise value + $3 million life insurance value). That’s a giant difference in valuation.
What this implies for family businesses and small businesses
Act now. Review the structure and terms of your severance agreement. If your severance is structured as a buyback, where the corporate purchases the deceased equity investor’s shares, you possibly can be affected by the Supreme Court’s recent decision.
If the worth of every shareholder’s estate is safely below the estate tax exemption, you could decide to let the insurance-funded buyout agreement stand. The extent to which the life insurance increases the worth of the business wouldn’t trigger federal estate tax. Be cautious, nonetheless. If an owner lives in a state with a lower estate tax threshold or an inheritance tax, a tax may indeed apply. Also, evaluate along with your attorney how the Supreme Court ruling might affect the formula and terminology within the buyout documentation. Continue to observe the buyout agreement in case of changes in tax law, valuation, etc. You might even consider purchasing additional insurance to cover estate tax costs should they arise after Connelly.
If including the worth of the insurance held by the business would trigger estate taxes, it could be preferable to restructure the settlement agreement as a cross-purchase agreement. In a cross-purchase, the shareholders own life insurance policies on one another which can be used to fund the settlement. In any such structure, the worth of the insurance has no impact on the business’s value. Additionally, in a cross-purchase, the surviving shareholders receive a better tax basis for the equity purchased. Before making such a change, business owners must consider the fee of all recent paperwork for the brand new cross-purchase agreement, the fee of terminating the prevailing give up agreement (you don’t need to impose a double give up obligation on the business), and the fee and availability of recent life insurance. Also, consider the several economic impacts. In a cross-purchase agreement, each shareholder must pay insurance premiums on the lives of other shareholders. Will they do that? How will this be monitored? Some business owners feel safer that the life insurance will actually stay in force if needed, knowing that the corporate pays those premiums. It is probably not an easy change to an organization’s policies in a cross-purchase structure. Additional and even different insurance coverage could also be required. Additionally, if the give up agreement has been in place for a while, review the corporate’s valuation and the economics of the buyout to see if changes to coverage amounts are warranted.
If the amounts involved are quite large, consider the potential estate tax implications of the cross-purchase arrangement and confer with your advisors the potential advantages of using a special LLC to own the life insurance policies intended for the cross-purchase buyout.
For more background on the history of the Connelly case, see: “Business Owned Buyout Life Insurance Raises Tax Issues,” forbes.com, June 28, 2023.
Reality check: The value of a typical family business
The average value of a family business is about $1.5 million. In fact, most family businesses usually are not helpful enough, and their owners’ estates probably aren’t helpful enough, to trigger an estate tax, even after the Connelly case ruled in favor of the IRS and against the taxing business owners on that issue. Therefore, an easier repossession agreement could be satisfactory for a lot of. But even in such cases, it is smart to review the general agreement, evaluate the lack of basis for the surviving equity owners, and comply with the formalities of the agreement.
Limits of the Connelly decision
The Court stated in footnote 2: “We do not hold that a redemption obligation can never reduce the value of a company. For example, a redemption obligation could force a company to liquidate operating assets to pay for the shares, thereby reducing its future earning power. We simply disagree with Thomas’s position that all redemption obligations reduce the net worth of a company. Since that is all that this case requires, we no longer choose.”
Diploma
The Supreme Court’s decision in Connelly is a positive IRS decision that presents one other challenge for family businesses. Just this yr, the FTC issued a ban on nearly all non-compete agreements, that are essential to succession planning for a lot of family businesses. Reporting requirements under the Corporate Transparency Act have to be filed by the top of this yr for many family businesses that existed before 2024. And planning for the estate tax exemption to be cut in half after 2025 requires immediate planning. The burdens on family businesses and family-owned corporations are burdensome and growing. Keep all of those points in mind.
