Supreme Court Decision on Buy-Sell Agreements: What You Need to Know as a Business Owner

If you own a business with partners, you may likely have a buy-sell agreement in place. This important document acts like a prenuptial agreement for your business, spelling out what happens if an owner dies, becomes disabled, or wants to leave the company. Most business owners create these agreements to protect both their families and business partners, ensuring a smooth transition during difficult times.

A recent unanimous decision by the U.S. Supreme Court (June 6, 2024) has significantly changed how these agreements are valued for estate tax purposes when they're funded with life insurance. This ruling could have major implications for your succession plan and your family's financial security.

The case, Connelly v. United States, established that life insurance proceeds received by a business to fund a buy-sell agreement must be included in the company's value for estate tax purposes, and this value is not offset by the company's obligation to repurchase the deceased owner's shares.

What Happened in the Connelly Case

The case involved two brothers, Michael and Thomas Connelly, who owned a building supply company. Michael owned 77.18% of the business, and the company held a $3.5 million life insurance policy on his life to fund their buy-sell agreement.

After Michael's death, the IRS challenged the valuation of his estate, arguing that the company's value should include the life insurance proceeds without any reduction for the redemption obligation. The Supreme Court unanimously agreed with the IRS, effectively increasing Michael's estate tax liability by approximately $1 million.

Key Implications for Business Owners

This decision creates several important considerations for business owners:

1. Increased Business Valuation: Life insurance proceeds must now be counted as a corporate asset, potentially increasing the value of a deceased owner's interest for estate tax purposes.
2. No Offsetting Liabilities: The business's obligation to buy the deceased owner's interest cannot be subtracted as an offsetting liability when calculating the business's value.
3. Broad Application: This ruling applies to businesses of all types (corporations, LLCs, partnerships), not just family-owned businesses.
4. Entity Purchase Focus: The ruling specifically affects entity purchase arrangements (where the business buys out the deceased owner), not cross-purchase arrangements (where the other owners buy the interest).

Who Should Be Concerned

You should be particularly attentive to this ruling if:

• You have a taxable estate (currently over $13.99 million, but scheduled to drop by 50% in 2026)
• Your estate might become taxable in the future due to business growth
• You live in one of the 18 states with their own estate or inheritance taxes, which often have lower thresholds than the federal exemption
• Your buy-sell agreement is structured as an entity purchase (rather than cross-purchase) arrangement

Alternative Solutions to Consider

Fortunately, there are several alternative approaches that can help mitigate the impact of this ruling:

1. Cross-Purchase Agreements: The most straightforward alternative, where owners personally own insurance on each other rather than having the company own the policies.
2. Wait-and-See Arrangements: A hybrid approach that provides flexibility by giving the company first option to purchase shares, followed by the surviving owners, with any remaining shares required to be purchased by the company.
3. Trusteed Cross-Purchase: Using a trust to own the insurance policies, simplifying administration when there are multiple owners.
4. Split Dollar Arrangements: Using split dollar arrangements to fund the premium payments while maintaining the cross-purchase structure.
5. Additional Personal Coverage: Purchasing personal life insurance (ideally in an irrevocable trust) to cover the increased estate tax liability.

Action Steps for Business Owners

If you have a buy-sell agreement, we recommend:

1. Review Your Agreement: Schedule time to review your existing buy-sell agreement with your attorney and financial advisors.
2. Understand Your Structure: Determine whether your agreement is an entity purchase (where this ruling applies) or a cross-purchase arrangement.
3. Evaluate Tax Impact: Assess the potential tax impact based on your business structure, valuation, and personal estate situation.
4. Consider Restructuring: If appropriate, explore restructuring your agreement to mitigate the impact of this ruling.

Conclusion

Your buy-sell agreement is like a prenuptial agreement for your business—it's designed to protect your family and business partners by determining in advance how ownership transitions will occur. This Supreme Court decision adds an important new consideration to that planning process.

At Instrumental Wealth, we're committed to helping you navigate these complex issues. If you'd like to discuss how this ruling might affect your specific situation and explore potential solutions, please reach out to schedule a meeting.