Connelly v. United States recently held that life insurance payable to the company and intended to be used to “fund” a buy-sell agreement would increase the value of the company for estate tax purposes.
Prior to this, the Blount case [Estate of Blount v. Commissioner, 428 F.3d 1338 (11th Cir. 2005)] excluded life insurance proceeds from a company’s valuation for estate tax purposes. The post-Connelly landscape underscores the necessity for businesses and estate planners to reconsider their existing arrangements.
For decades, I have exclusively used cross-purchase agreements instead of stock redemption agreements. My reasoning was rooted in a “basis step-up” purpose. With a stock redemption agreement (where the company buys the stock or membership units back), the remaining shareholders get an increase in their equity in the company, but not in their stock basis.
With the Connelly ruling, a stock redemption agreement can still work and not add to the value of the company, but to do so, the buy-sell agreement must effectively fix the estate tax value of the stock, and in a way that is not a random number or a “let’s agree to a new valuation number each year” provision.
The practical side of this is that a buy-sell agreement, once signed, is almost never reviewed again until someone dies, and thus the valuation language is often not consistent with what Connelly would be requiring.
With Connelly in mind, the best practice should always be to use a cross-purchase agreement, and if you have more than one owner, consider the use of an LLC to facilitate the ownership of the policies. This approach not only aligns with current legal interpretations but also optimizes tax outcomes for shareholders.
Example #1:
Three owners of ABC Inc.
Value of company agreed to in redemption buy-sell agreement is $3 million.
Life insurance of $1 million purchased on all three owners and owned and paid for by the company (note the payment of the insurance premiums by the company is not tax deductible).
Owner dies and company uses life insurance to redeem the stock of the deceased owner’s stock.
Result: The two remaining owners now own 50% of the equity of the company, but without any additional basis in their 50% ownership.
Example #2:
Same facts as Example #1, except the life insurance is not owned by the company, but instead is owned by a separate partnership that is formed to own a life insurance policy on each owner’s life. See Letter Ruling 200747002 (issued June 21, 2007; released Nov. 23, 2007). In this ruling the LLC-owned life insurance is used to fund a cross-purchase buy-sell agreement of a company with all the shareholders of the company being the members of the “insurance” LLC.
Result: The two remaining owners now own 50% of the equity of the company (same as Example #1), but the insurance proceeds used to purchase the decedent shareholder’s stock is deemed to be the asset of the two remaining owners, thus giving each surviving shareholder a $500,000 increase (step-up) in their stock basis when “they” (the surviving owners and not the company) purchase the deceased owner’s stock.
If this was a California company with California shareholders, and the two surviving owners eventually sell their stock to a third-party buyer, the cross-purchase agreement will have saved the two shareholders together over $300,000 in federal and state capital gains taxes. Imagine if we had the same facts but it was a $30 million company, and not a $3 million company. Then our “savings” from the cross-purchase would be over $3 million.
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By: Jamie Hargrove, Attorney/CPA, Hargrove Firm LLP with over 200 attorneys across all 50 states