Business Succession Planning After Connelly
You started a business and did everything right.
You consulted an attorney and had the proper paperwork drawn up to ensure that you were formed correctly and had a plan in place if you passed away or became incapacitated. You purchased a life insurance policy to fund any transition. You audit your plan every year.
What could go wrong?
A recent decision by the United States Supreme Court in Connelly v. United States has altered how these plans are taxed which could mean higher estate taxes for your business. Higher taxes at death could ultimately lead to the demise of the business. Let’s take a closer look at the case.
The Facts of Connelly
Michael Connelly and his brother, Thomas, were the sole shareholders of Crown C Supply Company (“Company”). As part of their succession plan, the Connelly brothers executed a stock-purchase agreement. This allowed the surviving brother to purchase the deceased brother’s shares, or the Company would be required do so.
The stock-purchase agreement authorized the Company to purchase life insurance on each brother with the condition that the proceeds would be used to finance the transaction after the death of the first brother.
Michael passed away in 2013. His brother declined to purchase Michael’s shares consistent with their agreement. The Company then used the life insurance proceeds to purchase Michael’s shares from his estate for $3 million.
The Executor of Michael’s estate filed an estate tax return that reported the decedent’s shares as having a value of $3 million, but the IRS disputed this valuation contending that the life insurance proceeds used for the share redemption must be included in the valuation, significantly increasing the estate’s tax liability.
The Executor responded with an independent appraisal supporting the $3 million value listed on the estate tax return, but the IRS disagreed stating the life insurance proceeds are included in the Company’s value. On appeal, the Court agreed with the IRS that life insurance proceeds are included in the value of the decedent’s closely held business interests for estate tax purposes.
Consequently, the business was not worth a total of $4 million, but rather it was worth $6.86 million ($3.86 million before death + $3 million in insurance proceeds). This required Michael’s estate to pay an additional $889,000 in taxes.
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What is Next for Business Owners?
Review Existing Agreements
Business owners should revisit their agreements and establish a clear methodology for valuing shares to avoid and minimize disputes during an audit. The use of company-owned life insurance policies to structure these agreements likely needs to be revisited.
Regular Business Valuations
Business owners should obtain regular business valuations and update buy-sell / stock-purchase agreements on a consistent basis. It is highly recommended that owners obtain a professional appraisal.
Consider Cross-Purchase Agreements
The Supreme Court noted in its decision that the brothers could have instead utilized a cross-purchase agreement rather than a stock-purchase agreement. In this scenario, each shareholder owns a life insurance policy on other shareholders, with the proceeds used to purchase the deceased shareholder’s interest from their estate. This avoids the company owning the insurance policy thus ensuring that it is not counted to increase the value of the company at death.
Review Existing Succession Plans
To minimize the likelihood of unintended tax consequences and reduce the risk of costly and protracted litigation, business owners should consult their attorney, tax professionals, and financial advisors. Together you can explore alternative methods to structure any agreements in a manner that is consistent with the Court’s ruling in Connelly.
Conclusion
The Connelly decision has reshaped the landscape for business succession planning, making it clear that careful attention must be paid to how agreements are structured and how life insurance proceeds are handled in the valuation of closely held businesses. While the ruling presents challenges, it also offers business owners an opportunity to revisit their plans and ensure they are in compliance with current legal standards.
By reviewing your existing agreements, regularly appraising your business, and exploring alternatives such as cross-purchase agreements, you can better protect your business from unintended tax liabilities. Consulting with a team of legal, tax, and financial professionals is essential in ensuring that your succession plan remains effective and minimizes potential risks.
At Nalls Davis, we are dedicated to helping business owners navigate these complex issues with confidence. Contact our experienced team today to review your business succession plan in light of the Connelly ruling and safeguard your business for the future.
Nalls Davis is a law firm with offices in Dayton and Cincinnati. We are committed to navigating complex legal issues in the areas of business, real estate, and estate planning. Contact us today at (937) 813-3003 or www.nallslaw.com.
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