Buy-Sell Agreements After Connelly v. United States

A recent estate tax case, Connelly v. United States¹, provides two key lessons about buy-sell agreements, namely:

1. If you have a buy-sell agreement, it is important that it be well drafted and that you follow its terms.
2. There may be unintended estate tax consequences if your buy-sell agreement is funded with company-owned life insurance.

A brief refresher on buy-sell agreements

For any closely held business with two or more owners, a buy-sell agreement is an often overlooked but critical component of the business’s continuity and overall succession plan. Typically, ownership of a closely held business is concentrated among a small group of owners who tend to be actively involved in operating the business, or at least in making major business decisions, and who tend to have personal connections with one another, whether familial or not.

A thoughtfully crafted buy-sell agreement can provide a number of benefits, including:

• Protecting existing owners from unwanted future business partners
• Providing a fair price and payment structure to an outgoing owner without unfairly burdening the business or its remaining owners
• Creating a mechanism to deal with conflicts and deadlocks among owners
• Ensuring compliance with tax rules

At its core, a buy-sell agreement defines the rights and obligations of the business and its owners upon the occurrence of agreed-upon triggering events, such as an owner’s:

• Death
• Disability
• Retirement or other termination of employment with the company
• Divorce or other involuntary creditor proceedings
• Voluntary transfers, gifts and pledges of ownership interests in the company

To be effective, a buy-sell agreement should clearly address what happens when a triggering event occurs. Although not an exhaustive list, threshold considerations include:

• Who will purchase an exiting owner’s interest in the business?
• Should the purchase be obligatory or optional?
• How will the purchase price be determined?
• How will the purchase be funded and paid?

Two important precursors to Connelly

Section 2703 of the Internal Revenue Code²

This section was enacted to ensure that buy-sell agreements are not used to artificially reduce the value of a closely held business interest for estate tax purposes.

When the requirements of this section are satisfied, the value of a closely held business interest as determined under a buy-sell agreement also establishes the value of the business interest for federal estate tax purposes.

This is beneficial since it avoids the cost of obtaining a separate estate tax valuation and, more importantly, because it results in a deceased owner’s estate being subject to estate tax only on the actual value received for the ownership interest (rather than a separate, hypothetically higher estate tax value).

To qualify for this treatment, a buy-sell agreement must meet the following requirements:

• It is a bona fide business arrangement
• It is not a device to transfer such property to members of the decedent’s family for less than full and adequate consideration in money or money’s worth
• Its terms are comparable to similar arrangements entered into by persons in an arm’s length transaction

Estate of Blount v. Commissioner³

This case was decided in 2005 by the Eleventh Circuit Court of Appeals, which ruled that the value of company-owned life insurance is included in the company’s value for estate tax purposes but that value is offset dollar-for-dollar to the extent the company is obligated to use the proceeds to redeem the ownership interest of a deceased owner.

In other words, this case stands for the proposition that a company’s obligation to redeem a deceased owner's ownership interest using the proceeds of company-owned life insurance is estate tax neutral.

Until the Connelly case made its way through the appellate process and ultimately to the Supreme Court, the Blount case was understood by most practitioners to be the law of the land.

Returning to Connelly

The Connelly case involved a company owned by two brothers, Michael (77% owner) and Thomas (23% owner), who entered into a buy-sell agreement. Upon one brother’s death, the agreement provided that the surviving brother would have the option to purchase the deceased brother’s ownership interest in the company and, if the surviving brother declined to do so, then the company would be obligated to redeem (i.e., purchase) the deceased brother's ownership interest. The company purchased two $3.5 million insurance policies, one on each brother's life, to fund its redemption obligations under the agreement.

The agreement provided two methods for determining the purchase price for a deceased brother’s ownership interest. Each year, the brothers could create a so-called “certificate of agreed value” reflecting their agreed-upon value of the company, in which case the most recent certificate would be used after a brother’s death, or if that was not done, then the price would be determined by the average of two fair market value appraisals obtained after a brother's death.

Upon Michael’s death, Thomas opted not to purchase Michael’s ownership interest, which meant the company was obligated under the agreement to redeem Michael’s ownership interest. During Michael’s lifetime, the two brothers never created any annual certificates of agreed value, and, following Michael’s death, Thomas failed to obtain two fair market value appraisals. Instead, Thomas agreed with Michael’s son that the company had a value of approximately $3.9 million, giving Michael’s ownership interest a value of approximately $3 million.

On Michael’s estate tax return, Micheal’s estate reported that his ownership interest in the company was worth $3 million. The IRS disagreed with that value and asserted that the value of the insurance policy on Michael’s life ($3.5million) should have been included in the value of the company, which would increase the value of Michael's ownership interest by approximately $2.7 million and result in his estate owing another $1 million of estate tax.

The case worked its way through the courts over the next 11 years. In brief, the district court and the Eighth Circuit Court of Appeals determined that:

1. Section 2703 did not apply, not only because the brothers failed to abide by the terms of their buy-sell agreement, but also because the buy-sell agreement did not adequately provide for a “fixed or determinable” price for Michael’s ownership interest.
2. For purposes of determining the estate tax value of Michael’s ownership interest, the value of the company-owned insurance on Michael’s life should be included in the company’s value, without any offset for the company's obligation to redeem Michael’s ownership interest.

On June 6, 2024, the Supreme Court of the United States delivered a unanimous opinion affirming the lower courts’ decisions, effectively overruling the Blount case and sending a wake-up call to closely-held business owners.

Time to take action

As a business owner, where do you go from here?

• If you already have a buy-sell agreement, now is a great time to review it with your professional advisors to make sure it is still a good fit in light of Connelly.
  • Keep the requirements of section 2703 in mind. Make sure your buy-sell agreement clearly and thoroughly addresses how the purchase price for an exiting owner’s interest will be determined. If possible, avoid using a valuation method that requires the owners to come up with an agreed upon value periodically. In practice, most owners forget to do so.
  • Understand the implications of company-owned life insurance. As stated in the Connelly decision, the value of company-owned life insurance should be included in the value of the company for purposes of determining the tax- able estate of a deceased owner, without any offset for the company’s obligation to redeem the deceased owner’s interest in the company. If your buy-sell agreement currently requires the company to redeem a deceased owner’s interest using company-owned life insurance, and this result was not your intention, it may make sense to consider alternatives, such as a cross-purchase style agreement in which life insurance policies are owned by the individual business owners (or one or more irrevocable trusts for their benefit), rather than the company.
  • Periodically review life insurance policies. Company values grow. Exit plans evolve. Review existing life insurance policies to make sure they are still in good shape. For example, is the death benefit large enough, is the remaining term long enough, and is the policy owned by the right party? If you do not already have a buy-sell agreement in place, work with your professional advisors to create one that fits the unique needs of your business and ownership group.