The Supreme Court’s Connelly Decision, along with the estate tax exclusion sunset is a recipe for unwelcome surprises. Here’s what it could mean for your business owner clients.
Earlier this year, the Supreme Court made a ruling that caused a major shake-up in planning for buy-sell arrangements. In the case of Connelly v. United States, two brothers, who were the sole shareholders in a closely held corporation, had a buy-sell agreement in which each brother had the right to purchase the other brother’s shares in the event of death. If the surviving brother did not exercise his right to purchase, the corporation, which held life insurance policies on each brother to fund the buy-sell agreement, was required to redeem the deceased brother’s shares.
Upon the death of one of the brothers, the surviving brother declined to exercise his right to purchase the shares. The corporation received the life insurance proceeds and redeemed the shares at an agreed-upon price of $3 million. As the executor for his deceased brother, the surviving brother filed a federal estate tax return where he reported the value of the shares at a $3 million redemption price, not including the life insurance death benefit.
The Supreme Court ruled that a corporation’s contractual obligation to redeem shares is not a liability that reduces a corporation’s value for purposes of the federal estate tax. In other words, SCOTUS held that the life insurance owned by the corporation on the deceased shareholder increased the value of the corporation with no offsetting reduction due to the redemption obligation.
This “phantom” increase in estate asset value, along with the estate tax exclusion sunset under the TCJA is a recipe for unwelcome surprises. Having life insurance owned by a limited liability company or corporation can significantly affect a shareholder’s estate tax liability. This means corporations should review their buy-sell agreements and consider restructuring.
Use this easy-to-follow flowchart to determine if your business owner clients will be affected by the Connelly Decision.
There are several options for restructuring, including cross-purchase agreements where shareholders or trusts purchase insurance on each other. Because the owners of the business are the owners of the life insurance policies, the transfer of wealth will not be subject to income tax and the proceeds from the policy are not subject to creditors’ claims.
If you’re ready to dive in, your Palladium Group team is ready to provide you with the expertise and support you need to help your clients protect their assets.