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Using keyman insurance to fund equity redemptions is likely to increase estate tax liability.
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US Supreme Court holds that keyman insurance proceeds of company-owned policies are an asset of the company, regardless of a contractual obligation to fund an equity redemption.
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Cross-purchase agreements funded by insurance should avoid these estate tax liability issues.
Effective succession and exit plans commonly use insurance as a funding vehicle to protect the owners from the economic effects of the death or disability of one of the principals. If an owner dies or becomes disabled, the insurance kicks in to fund the cost of a buy-sell agreement, ensuring a smooth transition of ownership.
The reason: When business owners die, the transition of their shares will disrupt the company and create financial burdens for the surviving shareholders or the company itself unless the owners have a plan in place.
The Importance of Keyman Insurance to Closely Held Businesses
To address this need, closely held businesses often use keyman life insurance in conjunction with buy-sell agreements. These agreements ensure that ownership transitions smoothly, and the business continues operating without major financial strain. (Insurance and other financial vehicles are also effective means of funding a transition out of the business for retirement.)
However, the structure and tax implications of the insurance-funded plan can differ depending on whether it is used in a redemption agreement or a cross-purchase agreement. After a recent United States Supreme Court decision imposing a million-dollar deficiency on an estate, closely held business owners need to review any insurance-funded plans to ensure that they are not unwittingly taking on an estate tax burden.
The Supreme Court Upsets the Status Quo
The Supreme Court’s landmark decision in Connelly v. United States is unwelcome news for those closely held businesses that have purchased keyman policies to fund the company’s purchase, or redemption, of a deceased shareholder’s interest.
The solution to the problems created by Connelly is to restructure existing shareholder redemption arrangements funded by insurance to avoid negative tax consequences. It is a situation in which form really does triumph over substance.
Let’s start with a discussion of the difference between a cross-purchase agreement and a redemption agreement like the one in the Connelly case.
What Is a Cross-Purchase Agreement?
A cross-purchase agreement is a type of buy-sell arrangement where shareholders agree to purchase each other’s shares upon death or other triggering events like retirement. It ensures that ownership remains within the remaining shareholders without involving the company directly.
Here’s how a cross-purchase agreement works:
- Each shareholder buys life insurance policies on the other shareholders. If there are three shareholders (A, B, and C), A will own policies on B and C, B will own policies on A and C, and so on. A special purpose trust frequently purchases and owns the insurance policies with the intention of raising money to allow the remaining shareholders to buy out the deceased shareholder’s ownership stake in the company.
- Upon the death of a shareholder, the surviving shareholders use the life insurance proceeds to buy out the deceased owner’s shares from their estate.
- The remaining shareholders increase their ownership percentage using the insurance proceeds.
The Tax and Operational Advantages of Cross-Purchase Agreements
There are significant advantages to the owners of a closely-held business who use a cross-purchase arrangement. These include the ability to receive a step-up in basis for the purchased shares, potential tax deductions for the premium payments, and the flexibility to customize the agreement based on the individual needs of the shareholders.
- Tax-free proceeds: The insurance proceeds received by individual shareholders are generally tax-free.
- Step-up in basis: When surviving shareholders purchase the deceased’s shares, they get a “step-up” in the cost basis, reducing capital gains taxes when they sell the shares later.
- Avoids inflation of estate taxes: The Connelly decision created a risk that the company’s value will be directly affected by life insurance proceeds, creating a tax liability for the estate of a deceased shareholder.
Cross-purchase agreements can be complex to administer, particularly when there are many shareholders. There is , each needing multiple policies. Additionally, shareholders must cover the premium costs themselves, which can become expensive.
Funding a Share Redemption with Keyman Insurance
In a redemption agreement, the company buys life insurance on the shareholders, and when one dies, the company uses the insurance proceeds to buy back their shares. The shares are then either canceled or held as treasury shares, increasing the remaining owners’ stake in the company.
Here’s how the redemption works:
- The company buys and owns life insurance policies for each owner and pays the premiums.
- When an owner dies, the company, as the owner, receives the proceeds and uses them to redeem the deceased owner’s equity (shares, membership interests or partnership interests) from the owner’s estate.
- The remaining owner’s equity state increases as the shares are canceled or held as treasury shares.
Benefits that Make Redemption Agreements Attractive
The traditional redemption agreement had a number of benefits that have made them attractive to closely held business owners. In the event of an owner’s passing, they offer a precise and well-organized plan for the transfer of equity, which the company pays for as an operating expense. The benefit is their practicality and efficiency as a solution for addressing ownership transitions in closely-held businesses.
- Simplicity: The company handles everything, making it easier to administer, especially with multiple shareholders. The purchase and administration of the program does not require outside arrangements.
- Company funding: Unlike cross-purchase agreements, the company pays the premiums, reducing the financial burden on individual shareholders and has the option to do so with pre-tax or after-tax dollars. This is a simpler process than grossing up individual shareholder compensation to fund personally paid premiums.
How the Connelly Decision Affected Succession Planning
In Connelly v. United States, the U.S. Supreme Court ruled on a technical valuation issue: whether keyman life insurance proceeds used for a share redemption must be included in the company’s value when calculating estate taxes. The answer was bad news for many closely held business owners.
In short, it makes no difference that at the moment that the benefits are paid, they are subject to an offsetting obligation to the estate of the deceased owner. The life insurance proceeds go onto the books of the company as an asset, increasing the value of the equity interest for estate tax purposes
The Underlying Facts in Connelly
Michael and Thomas Connelly were the sole shareholders of Crown C Supply, a family-owned business in Missouri. Michael owned 77.18% of the shares, and Thomas owned the remaining 22.82%. The brothers executed a buy-sell agreement that provided the surviving brother could either purchase the deceased’s shares or the company would redeem the shares using life insurance proceeds. To fund this arrangement, the company purchased $3.5 million in life insurance policies on each brother.
Michael died in 2013. Thomas elected not to buy Michael’s shares. Instead, the company paid $3 million for the shares, with the keyman policy funding the transaction.
Crown was appraised at $3.86 million (excluding the life insurance proceeds), which led to a final value of Michael’s shares being approximately $3 million. The estate reported the shares’ value accordingly.
Procedural History
The IRS disagreed with the estate’s valuation and argued that the life insurance proceeds used for the redemption must be included in the company’s fair market value for estate tax purposes. The IRS recalculated the company’s total value as $6.86 million—$3.86 million in business value plus $3 million in life insurance proceeds. According to this updated valuation, the IRS determined that Michael’s shares were actually worth $5.3 million (77.18% of $6.86 million), not the $3 million the estate had stated.
As a result, the IRS assessed a deficiency of $889,914 in additional estate taxes. The estate paid the deficiency and subsequently sued the government in federal district court, seeking a refund. The federal district court ruled in favor of the estate, resulting in a refund of the assessed deficiency. The estate prevailed at the trial court and in the Eighth Circuit of Appeals. The United States District Court for the Eastern District of Missouri granted summary judgment in favor of the government, ruling that the life insurance proceeds should be included in the company’s value for estate tax purposes. The court reasoned that the redemption obligation did not reduce the value of the company. The life insurance proceeds, which were used to redeem the shares, remained an asset that increased the company’s overall value at the time of Michael’s death.
The estate appealed to the United States Court of Appeals for the Eighth Circuit, which affirmed the district court’s ruling. The appellate court agreed that the life insurance proceeds were properly included in the company’s fair market value for estate tax purposes.
The estate then petitioned the U.S. Supreme Court for review, and the Court granted certiorari to resolve the issue.
The Supreme Court Reverses Trial Court in Landmark Opinion
In a unanimous opinion written by Justice Clarence Thomas, the Supreme Court ruled that the life insurance proceeds used to redeem shares must be included in the company’s fair market value for federal estate tax purposes.
The central issue was whether the company’s contractual obligation to use life insurance proceeds to redeem a deceased shareholder’s shares constituted a liability that reduced the company’s value. The estate argued that the redemption obligation should offset the life insurance proceeds and prevent them from contributing to the company’s value.
The Court rejected this argument, holding that redemption at fair market value does not affect the economic interests of the shareholders. The life insurance proceeds, earmarked for the redemption of shares, were still part of the company’s total assets at the time of the decedent’s death and must be included in its valuation.
The Court held that the life insurance proceeds payable to the company were an asset that increased the company’s fair market value.
The Court reasoned that the redemption at fair market value did not diminish the total value of the company’s assets or reduce any shareholder’s economic interest. It provided the following illustration: Consider a company with $10 million in assets, with two shareholders holding 80% and 20%, respectively. If the company redeems the 20% shareholder’s shares at fair market value, the remaining 80% shareholder’s interest remains worth $8 million.
Thus, a redemption at fair market value does not diminish the total value of the company’s assets or reduce any shareholder’s economic interest. Similarly, in the Connelly case, Crown’s obligation to redeem Michael’s shares at fair market value did not reduce the company’s overall value.
The Court reasoned that for estate tax purposes, the $3 million in life insurance proceeds were a net asset that increased Crown’s overall value. This was a significant departure from prior the interpretation of the Eleventh Circuit Court of Appeals in Estate of Blount v. Commissioner, where similar life insurance proceeds were excluded from the company’s valuation.
Conclusion: After Connelly
The Connelly decision has notable implications for succession and exit planning in closely held businesses.
The decision removes any ambiguity on the issue of whether life insurance proceeds payable to the closely held company are an asset. They are an asset, regardless of whether they are designated for a particular liability.
Most importantly for owners, the life insurance proceeds go onto the balance sheet as an asset that increases the company’s fair market value and increases the estate tax liability of the deceased owner whose interest is redeemed.
A cross-purchase agreement should not affect estate tax liability. As the Supreme Court noted in its decision, the Connelly brothers could have opted for a cross-purchase agreement, which would have avoided the increased valuation issue.
Business owners should weigh the tax consequences of different buy-sell agreements and consider whether a redemption or cross-purchase agreement is more appropriate. With the potential for increased estate taxes under a redemption agreement, many businesses may now reconsider their approach to using keyman life insurance for succession planning.