June 2024

The recent Supreme Court decision in the Connelly case was both as expected and a complete surprise. Where many had anticipated the Supreme Court upholding the lower Court’s decision, the commentary about the broad inclusion of death benefits in business valuations for estate tax purposes in the opinion authored by Justice Clarence Thomas was unexpected.

The fallout from that far reaching statement has created a flurry of analysis leading to an important conclusion: Stock redemption Buy/Sell agreements are in need of urgent review, particularly for clients who may be subject to an estate tax.

This is a tremendous opportunity for BGAs and advisors. The only outstanding question focuses on the remedy for buy/sell agreements that may be viewed similarly to the agreement in the Connelly case.

Supreme Court Upholds Connelly Decision: Implications for Entity Redemption Arrangements

Summary: On June 6, 2024, the Supreme Court, in a unanimous decision, affirmed the 8th Circuit Court of Appeal’s decision, supporting the IRS’s stance on the treatment of life insurance proceeds and redemption obligations for federal estate tax purposes. The court ruled that a corporation’s contractual obligation to redeem shares does not reduce the corporations’ value for estate tax purposes.

The following are considerations in light of the ruling in the Connelly case:

• Review Entity Redemption Agreements: Advisors should recommend that business owner clients review their entity redemption agreements, particularly those who have a potential federal and/or state estate tax liability.
• Revise Agreements if Necessary: If, upon review, it is determined that business owner clients have a federal and/or state estate tax liability, they may need to revise their agreements to help prevent life insurance proceeds payable to the business from adversely impacting the business’s value for estate tax purposes.
• Switch to Cross-Purchase Agreements for Estate Tax Concerns: A potential strategy for those business owners with potential estate tax issues is to switch to a cross-purchase agreement.2 For business owners that are corporations, such as S-Corp owners, the transfer of a policy to other business owners constitutes a transfer for value, so an exception to the transfer for value rule will.
• Life Insurance Partnership/LLC: A buy-sell partnership, often referred to as a Life Insurance Partnership or LLC, is sometimes used to facilitate a traditional cross purchase arrangement to address a multiple policy problem (e.g., 3 owners require 6 policies, and 4 owners requires 12 policies). The court in Connelly does not differentiate between different types of entities, and because a Partnership LLC is still an entity, the value of the entity would appear to be increased upon the death of an insured owner. This could result in an adverse estate tax consequence concerning the value of the pro rata share of the entity included in the deceased’s owner’s estate. The only sure safe way to avoid this potential issue may be to use a traditional cross purchase arrangement.
• Entity Redemption Advantages: Even after the Supreme Court’s decision in Connelly, entity redemptions funded with life insurance can still offer advantages for pass-through business owners (e.g., S-Corps, partnerships, and LLCs) who do not have a potential federal and/or state estate tax liability. The benefits will depend on each business owner’s specific facts and circumstances, but may include:
  • Requiring only one policy per owner,
  • Making the premium burden more equitable by having the business pay the premiums,
  • Avoid having other individuals personally own life insurance coverage on the life of an insured owner, and
  • Providing the owners with a basis increase upon the death of an owner equal to the amount of death benefit proceeds received by the business
• Proactive Agreement Review: Now is an excellent opportunity to reach out to clients to review all existing entity redemption agreements, helping them meet current goals, verify that businesses are properly valued, and confirm that agreements are adequately funded

By taking these steps, advisors, while working with a clients’ legal and tax team can help ensure that business owner clients’ agreements are properly aligned with their estate tax considerations and overall financial planning goals.

Some thoughtful discussion points (again these are opinions base don what we know so far and are subject to change):

If you change the ownership of a buy sell from an entity into a cross purchase:

1. Does the insurance carrier allow that ownership change on an inforce policy? A carrier will generally implement an ownership change for which the proper paperwork has been submitted.  So yes, we see no reason why a carrier wouldn’t process the ownership change request.
2. If yes, is there any tax consequences to either the entity or the new owner (partner)? This is a more complicated answer that depends on the type of entity that currently owns the policy(s):
   • If the entity is a C corp, any gain in the policy will be triggered at the corp. level at the time of the transfer of the policy, and the owner to whom the policy is transferred will be taxed on the fair market value (FMV) of the policy either as a dividend or as W-2 compensation.
   • If the entity is an S corp, any gain in the policy will be triggered at the corp. level at the time of the transfer of the policy (which flows through to the S corp owners based upon their pro rata ownership), and the owner “may” have tax consequences.  First, the FMV of the policy reduces the owners basis in the S corp. stock (but not below zero), and is considered a tax-free return of basis.  To the extent the FMV of the policy exceeds the owner’s basis in the stock, then the excess is treated as taxable capital gain.
   • If the entity is a partnership or LLC (taxed as a partnership), there there will be no tax consequences at either the entity or owner level.  Unlike with corps, gain in the policies is not triggered at the time of the transfers.  Similar to an S corp, the FMV of the policy reduces an owner’s basis in the entity (but not below zero).  However, to the extent that the FMV of the policy exceeds the owner’s basis in the entity, the excess, instead of causing taxable capital gain, reduces the basis of the property being distributed (i.e., the policy basis is reduced).  Thus, if the policy is later surrendered, it will have a lower basis and the tax consequences will be realized at that time (if ever).

1. 1. For more information, please see: https://www.supremecourt.gov/opinions/23pdf/23-146_i42j.pdf
   2. While leveraged (premium financed) entity redemption plans are not common, it is important for currently leveraged plans to assess options for the loan before considering any policy transfer. The corporation cannot transfer the policy while the bank holds a collateral assignment on the contract. To enable the transfer of the policy and loan to the individual insured, the bank will likely need to underwrite the insured, as they probably only assessed the corporation for the existing loan. Affected parties should consider discussing loan options with the lender.
   3. Whether an entity is a valid partnership for purposes of the transfer-for-value rule is determined by federal tax rules rather than state partnership law. Generally, a valid partnership must have a valid business purpose outside of holding the life insurance policies; for example, a partnership used for the purpose of owning a real estate investment property may be considered a valid partnership.
   4. A Life Insurance Partnership or LLC is essentially a cross purchase arrangement where a partnership is created to own the life insurance on the business owners. Upon the death of an insured partner, the death proceeds can be distributed to the remaining partners who can use the proceeds to purchase the business interest of the deceased owner pursuant to the terms of the cross-purchase agreement. Since all the owners are partners, transfer for value should not be an issue as long as the partnership owning the life insurance has a valid business purpose.

This material is for educational purposes only.

Original content produced by Pacific Life for producer use only June 2024. Pacific Life, its affiliates, their distributors and respective representatives do not provide tax, accounting, or legal advice. Any taxpayer should seek advice based on the taxpayer’s own particular circumstances from an independent tax advisor or attorney.
Pacific Life is a product provider. It is not a fiduciary and therefore does not give advice or make recommendations regarding insurance or investment products.