Connelly v. United States—Changes to Tax Law Regarding Company-Owned Life Insurance

Earlier this summer, the United States Supreme Court issued its opinion in Connelly vs. United States—a case which could have significant federal estate tax consequences for closely-held businesses owning life insurance on one or more of its owners.

In Connelly, two brothers owned a closely-held business. As part of their business succession plan, the brothers entered into a buy-sell arrangement which provided that, upon the death of one of the brothers, the company would be obligated to purchase the deceased owner’s shares from such owner’s estate. To finance the redemption obligation, the company purchased life insurance policies on the lives of each brother.

In 2013, one of the brothers passed away, resulting in the payment of life insurance proceeds to the company and triggering the company’s redemption obligation. Three million dollars ($3,000,000) of life insurance proceeds were utilized to purchase the deceased brother’s shares. The deceased brother’s estate filed a federal estate tax return with the IRS in which the value of the company did not include the $3,000,000 life insurance proceeds. The IRS audited the federal estate tax return and subsequently issued a notice of deficiency. In doing so, the IRS argued that the value of the company as reported on the federal estate tax return should have included, in part, the $3,000,000 value of the life insurance proceeds received as a result of the brother’s death and utilized to purchase the deceased brother’s shares. The brother’s estate disagreed, arguing that the “asset” of the life insurance proceeds should be offset by the “liability” of the redemption obligation.

The Supreme Court determined that a redemption obligation generally is not an “ordinary corporate liability,” even if such obligation is pursuant to a buy-sell arrangement entered into by the owners of a company. Accordingly, the Supreme Court held that the redemption obligation did not offset the life insurance proceeds, resulting in a net increase in the value of the company and correspondingly increasing the value of the deceased owner’s estate for federal estate tax purposes.

How Does This Impact You?

The decision in Connelly represents a reversal of prior precedent with respect to the application of life insurance proceeds in business valuations for federal estate tax purposes when the business is obligated to repurchase a deceased owner’s interests in the business. If you are party to a redemptive buy-sell arrangement which is financed by company-owned life insurance, or if you have an interest in a company which owns such life insurance policies, you may need to review and revise the ownership of such policy(ies) moving forward. Please contact one of the attorneys in our Estate and Wealth Planning Practice Group to discuss further.