The Connelly Case: Why Buy/Sell Agreements Matter to Your Business

As a business owner or high-income executive, securing the future of your company is paramount. When it comes to the longevity of a closely held business, a well-drafted buy/sell agreement plays a vital role. It ensures that in the event of an owner’s death, disability, or decision to sell their shares, the business remains operational and transitions smoothly.

A recent development, however, has raised significant questions regarding these agreements. The Supreme Court’s decision in Connelly v. US (the Connelly Decision), has profound implications for how life insurance is treated in buy/sell agreements. This newsletter will explore why buy/sell agreements matter, what the Connelly case changes, and what you should consider to protect your business.

What is a Buy/Sell Agreement?

A buy/sell agreement is a legally binding contract outlining how a business owner's interest will be transferred upon death, disability, or departure. Typically, these agreements are funded using life insurance policies, which provide the necessary liquidity for the surviving owners or heirs to buy out the departing owner’s shares.

Buy/sell agreements can take different forms, such as:

• Entity Purchase Agreements: The business itself buys the departing owner’s interest.
• Cross-Purchase Agreements: The remaining owners individually purchase the departing owner’s shares.
• Cross-Endorsement or General Partnerships: A partnership ensures all stakeholders have access to the necessary funds for ownership transfer.

Each of these approaches has its own benefits and tax implications. However, in light of the Connelly Decision, the structure of these agreements may need careful review.

The Connelly Case: A Game Changer

The Connelly v. US case revolved around how life insurance proceeds should be treated in buy/sell agreements for federal estate tax purposes. Previously, life insurance death benefits received by a company were often excluded from the valuation of an owner’s interest for estate tax calculations. This allowed companies to exclude large sums from tax calculations, thus reducing their overall estate tax liability.

However, the Connelly Decision changed the game by ruling that life insurance proceeds are now considered an asset of the business. Therefore, when calculating the value of a deceased owner’s interest in the business, their pro-rata share of the death benefit must be included. This ruling directly impacts how buy/sell agreements are structured and executed, particularly concerning tax planning and funding methods.

How Does It Affect You?

If your business has a buy/sell agreement funded by life insurance, the Connelly Decision could mean that a portion of those death benefits will now be included in the deceased owner's taxable estate. This could potentially increase the estate tax burden and reduce the amount of money available to execute the buyout or for the heirs of the deceased.

While not all businesses will be impacted, it’s crucial to assess whether your existing agreement is affected.

Evaluating Your Buy/Sell Agreement

Given the implications of the Connelly case, business owners need to re-evaluate their existing buy/sell agreements, particularly those funded with life insurance. Even if you believe your agreement isn't directly impacted by this decision, it is a timely reminder that agreements should be reviewed regularly to ensure they comply with the latest legal environment.

Here are a few key considerations when reviewing your agreement:

1. Is Your Buy/Sell Agreement Funded by Life Insurance?

If so, this ruling may have significant tax implications. The life insurance proceeds could be taxed as part of the deceased owner’s estate, which could disrupt the liquidity needed to fund the buyout.

2. Entity Purchase vs. Cross-Purchase

The structure of your agreement plays a role in how the life insurance proceeds are handled. Under an Entity Purchase Agreement, the business purchases the owner's shares and the life insurance proceeds are treated as part of the business's assets. In contrast, a Cross-Purchase Agreement might offer more flexibility, as each owner holds policies on the others.

However, restructuring an agreement into a Cross-Purchase model may come with its complications, such as the Transfer for Value problem, where existing policies may be subject to income taxes if transferred incorrectly.

3. Potential Need for Restructuring

Depending on your current buy/sell agreement, you may need to explore restructuring options to protect your business from the Connelly Decision's tax implications. Some possible solutions include:

• Revising the Entity Purchase Agreement: Updating the valuation clause to include life insurance proceeds, potentially coupled with a strategy to pay the excess over time using installment notes.
• New Cross-Purchase Agreements: These can avoid some complications, but come with challenges, such as the large number of policies required in businesses with many owners.
• Cross-Endorsement Agreements: In this structure, owners hold policies on their own lives, endorsing portions of the death benefit to other owners. While this resolves some issues, it could lead to inclusion in the taxable estate.

What’s Next?

Even if your agreement seems unaffected, it's crucial to remember that business and tax environments are constantly evolving. Regular reviews are essential to ensure your buy/sell agreement continues to meet your needs and minimize any tax liabilities.

For those affected by the Connelly Decision, there are several steps to take:

1. Consult with Experts

Consult with your financial advisor, tax professional, and legal team to evaluate your current buy/sell agreement. This is especially important if your agreement was established before the Connelly ruling, as the decision could necessitate restructuring to remain compliant.

2. Consider the Future of Your Business

Review other aspects of your buy/sell agreement, such as ownership shares, valuations, and liquidity needs. If any significant changes have occurred in your business, such as new ownership stakes or shifts in company value, it may be time to update the agreement.

3. Explore Funding Alternatives

If your buy/sell agreement is heavily reliant on life insurance, you might explore alternative funding methods to minimize exposure to estate taxes. Some businesses may choose to supplement life insurance with installment agreements or leverage other financial products to protect liquidity.

Final Thoughts

The Connelly Decision underscores the importance of regularly reviewing and updating your buy/sell agreements to reflect changes in law, business dynamics, and tax policy. While buy/sell agreements have always been a key tool for business continuation planning, this ruling brings new challenges to the forefront.

By taking proactive steps now—working closely with your advisors and evaluating your current agreements—you can ensure that your business remains protected for the long term and that your legacy is safeguarded.

At Fire Financial Partners, we specialize in helping business owners navigate complex financial planning issues like these. Our team is ready to help you assess your current buy/sell agreement and determine whether the Connelly case impacts your business. Contact us today to schedule a consultation and explore how we can help secure your business's future.

With the Connelly v. US ruling, business owners must stay vigilant in maintaining the effectiveness of their buy/sell agreements. Whether you need to restructure or simply review your existing setup, it’s essential to act now to avoid unnecessary risks and ensure the security of your business.