Business Owners Must Adapt to Connelly Impact on Estate Tax Plans

This article was originally published by Bloomberg Tax*. Reproduced with permission. Copyright 2024 Bloomberg Industry Group, Inc. (800-372-1033) bloombergindustry.com.

The US Supreme Court’s ruling in Connelly v. United States will impact owners of corporations. It also may affect other business entity types that use life insurance policies on owners as a funding mechanism for the corporation’s redemption obligation of the decedent’s shares through a buy-sell agreement. Business owners should review their succession plan in light of the ruling to try to best achieve owner succession goals and estate tax funding.

By including the life insurance proceeds in the estate tax value of the decedent’s ownership interest in the corporation, the decedent’s proportionate interest in the life insurance proceeds will increase the decedent’s estate tax liability if the value of the taxable estate is over the estate tax exemption amount.

The ruling is broad, with the court providing only one limitation in a footnote that concedes a corporation’s redemption obligation could reduce the value of the shares. The court-provided example involved a corporation that had to liquidate operating assets to raise the funds to execute on the promise to redeem.

The reduction in operating assets to produce income could impact the corporation’s valuation. While not exactly on point, Connelly may apply to other entity types as well.

Shareholders’ estates often look to the business to redeem the decedent’s shares so the estate has the liquidity to pay estate expenses, including estate taxes. Typically, the payment terms of the buy-sell agreement provides that the corporation will make a down payment with the life insurance proceeds, with the remaining payments amortized over a period of years.

These arrangements generally don’t qualify for Section 6166 estate tax deferral for qualifying closely held business interests, because the interests have been sold. If the life insurance proceeds don’t cover the estate tax liability associated with the decedent’s business interests, the decedent’s estate will have to find other estate assets to satisfy that liability—usually within nine months of the decedent’s death.

The current federal estate tax rate is 40% for amounts exceeding the decedent’s estate tax exemption amount, which is $13.61 million in 2024, reduced by the amount of lifetime gifts made by the decedent. The exemption amount is adjusted for inflation annually and was doubled in the 2017 Tax Cuts and Jobs Act, which is set to sunset at the end of 2025. There are also more than a dozen states that impose an estate or inheritance tax at lower exemption thresholds and rates as high as 20% for Hawaii and Washington.

For example, if a decedent in 2024, with the full estate tax exemption amount available, owned a 50% interest in a corporation valued at $10 million and other assets worth $5 million, the federal estate tax on a taxable estate of $15 million would be $556,000. If the corporation had $5 million in life insurance on the decedent, the estate’s 50% share of that would be $2.5 million, and potentially another $1 million in estate tax liability.

If the fair market value of the corporate shares is used to set the purchase price for the business to buy the interest from the owner’s estate, the estate may have cash flow to pay the estate tax liability depending on the down payment’s size. But if the agreement uses a different formula, such as book value or owner-set value to be updated periodically, the amount the estate is entitled to receive from the redemption agreement may be significantly less and create cash flow issues.

In response to Connelly, business owners and their advisers should review business buy-sell agreements with a focus on consequences of using life insurance. When appropriate, clients may need to consider restructuring their succession plans by:

• Revising the terms of existing agreements to ensure available cash flow for decedent owner estate taxes and ongoing business operations. They can do this by including the structure to allow for partial redemptions if a Section 6166 election is possible or using an appraised fair market value for the redemption obligation.
• Increasing the amount of business-owned life insurance to correspond with higher anticipated decedent-owner estate tax liabilities.
• Evaluating other alternative funding methods, such as a cross-purchase agreement in which owners personally hold life insurance on other owners.
  
  

When a decedent has a closely held business interest, it often is the primary asset in the estate. Planning to ensure funding for a redemption of the decedent’s shares by the corporation is essential to making sure the decedent’s family or other beneficiaries receive what the decedent intended.

The case is Connelly v. United States, U.S., No. 23-146, decided 6/6/24.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.