Redemption Buy-Sell for Your Business? Proceed with Caution. And Call Your Attorney for Tailored Advice.

Much has already been said about the June 6, 2024, case of Connelly v. Internal Revenue Service, where the U.S. Supreme Court held that a corporation’s contractual obligation to redeem shares was not a liability that reduced the value of the shares for federal estate tax purposes. The Supreme Court took a different approach than circuit courts that have previously considered similar scenarios (see, e.g., Estate of Blount v. Commissioner, a 2005 case where the Eleventh Circuit Court of Appeals held that the corporate obligation to redeem shares offsets the value of the insurance used to pay for the redemption).

In Connelly, two brothers and shareholders of a closely held corporation entered into a redemption arrangement where the entity purchased insurance policies on their lives. At the first brother’s death, the corporation used a portion of the proceeds to redeem the decedent’s shares. When the IRS audited the decedent’s estate, it augmented the entity’s value by the insurance proceeds used in the redemption. This determination resulted in nearly $1 million in additional estate taxes to the deceased brother’s estate.

The Supreme Court sided with the IRS and held that the decedent’s shares should have been valued at the time of death before the redemption occurred. Since the brothers used redemption arrangement and made the corporation the owner and beneficiary of the life insurance policies, the life insurance proceeds were an asset of the corporation. The court noted that the brothers could have used a cross-purchase arrangement to avoid this result.

Key Takeaways

Following the ruling, some business owners may feel compelled to limit themselves to a cross-purchase structure.? However, as with all things legal, the devil is in the details.

In a cross-purchase, the individual business partners are the owners and beneficiaries of the insurance policies, and each partner purchases a life insurance policy on the other partner(s). ?In a redemption structure, the entity administers the policies and pays the premiums.

What are the pros of the cross-purchase arrangement? ?The value of the life insurance stays out of the corporation, and the surviving owners receive a full step-up in basis on a deceased owner’s interest. The cons? ?Each owner must purchase a policy on all other owners and pay the insurance premiums. Thus, three partners in a business would hold six policies collectively. The administration of six independent policies is complex, and the risk of nonpayment and potential coverage lapses are very real. Additionally, differences in the health and age of the owners may lead to premium disparities among the partners.

Many businesses favor redemption as a more practical arrangement even though a step-up in basis may not always be achievable, and the policy value may be exposed to the creditors of the business.?Now, the Supreme Court’s decision in Connelly v. Internal Revenue Service casts an additional shadow on its utility.

Several factors influence the choice of a buy-sell structure and the end result, including the following:

1.????? Available estate tax exemptions. The size of each owner’s estate must be judged against the available exemptions. The 2024 federal estate tax exemption amount is $13.61 million for individuals and $27.22 million for married couples. While for many, the exemption amount is large enough to shield the estate from taxes, this exemption will sunset after 2025 and may be significantly reduced in 2026. Some states impose a separate estate tax, and the applicable state exemption amount is much lower than the federal exemption. In Maryland, for example, the estate tax threshold is $5 million as of 2024. This means that if a Maryland business owner dies with a total estate (including the owner’s share in the business) worth more than $5 million, the estate will owe state estate taxes.

2.????? Fair Market Valuation. Any agreement obligating a closely held company to redeem the owner’s interest upon death must be for fair market value. Otherwise, the IRS can ignore the owners’ agreement and assess an estate tax based on its own determination of value. This is precisely what happened in Connelly, where, instead of securing an outside appraisal that would provide a fixed and determinable price for the shares, the surviving brother and the executor of the deceased brother’s estate simply agreed on the value of the deceased brother’s shares. What is a “determinable price”? It is a value conclusively established on either (i) an accounting formula (based on the company’s financial statements), (ii) a valuation-based formula (e.g., multiple of the company’s EBITDA), or (iii) an independent professional appraisal. Any valuation formulas should be implemented consistently and periodically reassessed for accuracy and currency.

3.????? Other Available Arrangements. Cross-purchase and redemption buy-sell are not the owners' only options.?The owners can form a trust to own the life insurance policies and have an independent trustee manage and maintain all policies. ?Another solution is an “insurance-only” LLC, where the LLC owns the policies on the business owners. ?When an owner dies, the LLC redeems the decedent’s membership interest from the estate and then collects the insurance proceeds and distributes them to the remaining members of the LLC.? The LLC members, in turn, use the proceeds to purchase the deceased owner’s equity in the business. Neither arrangement is free of risks or tax complications, but they do provide flexibility beyond traditional cross-purchase/redemption scenarios.

4.????? Family Versus Unrelated Business Owners. Connelly involved family-owned business. If more than 50% of the business entity is owned by unrelated parties, a safe harbor rule for valuing the business interest for estate tax purposes could potentially apply (see Treasury Regulations Section 25.2703-1). Note that the Court in Connelly did not explicitly address whether its holding extends to unrelated owners.

A well-structured, properly funded buy-sell agreement offers peace of mind for the owners by providing a mechanism for buying out the deceased partner’s interest. Closely held businesses should consult with their legal and tax advisors to ensure that their buy-sells are technically sound and up to date. However, those with company-held insurance policies should resist the temptation to amend their agreements until their advisors carefully review owners’ personal circumstances and offer tailored advice.