Thomas Connelly v. United States was decided by the United States Court of Appeals in June 2023. The case involved a dispute over whether the value of a company should include the portion of life insurance proceeds used to buy the shares of a deceased shareholder. The court held that the value of the company must be determined without regard to the stock-purchase agreement; and, that the IRS did not err in including the insurance proceeds as part of the corporation’s fair market value, as the proceeds were a significant asset of the corporation at the time of Michael Connelly’s death.
The case has implications for the valuation of a company for buy-sell and M&A agreements, as it clarifies that the value of a company should be increased by the value of the death benefit of life insurance owned by the company, when its proceeds are used to buy a deceased shareholder’s shares. The case also highlights the importance of setting a clear value for a decedent’s interest in a business for estate tax purposes, as a buy-sell agreement that fails to do so may result in disputes over the value of the company.
The Connelly v. United States ruling has potential tax implications for buy-sell agreements. Here are the key implications:
1. Tax Liability: The ruling imposed a significant tax liability on the deceased shareholder’s estate. The IRS successfully argued that the value of the company for estate tax purposes was higher by $3.5 million due to the inclusion of the life insurance proceeds used to buy the shares.
2. Valuation Impact: The ruling clarifies that the value of a company for buy-sell agreements should include the portion of life insurance proceeds used to buy a deceased shareholder’s shares. The court held that the stock-purchase agreement did not affect the valuation of the company.
3. Fixed and Determinable Price: The court found that the buy-sell agreement in question did not set a fixed and determinable price for federal tax purposes. This is important because a buy-sell agreement that fails to establish a clear value for a decedent’s interest in a business may result in disputes over the value of the company.
4. Certification of Agreed Value: In the Connelly case, the taxpayers did not agree to a specific buyout figure and signed a certification stating that they did not have an agreed value. This highlights the importance of having a clear and agreed-upon value in buy-sell agreements to avoid potential tax issues.
There are some strategies to avoid having life insurance proceeds included in the valuation of the company, including:
1. Use a Cross-Purchase Agreement: In a cross-purchase agreement, each shareholder agrees to purchase the shares of a deceased shareholder. The life insurance policy is owned by each shareholder, and the proceeds are used to buy the shares from the deceased shareholder’s estate. This way, the life insurance proceeds are not included in the valuation of the company.
2. Use an Irrevocable Life Insurance Trust (ILIT): An ILIT is a trust that owns a life insurance policy. The Trust is irrevocable, meaning that the policy owner cannot change the terms of the trust or access the policy’s cash value. When the policy owner dies, the death benefit is paid to the trust, and the proceeds are not included in the owner’s estate. The trustee can then use the proceeds to buy the shares of the deceased shareholder.
3. Use a Buy-Sell Agreement with a Fixed Price: A buy-sell agreement with a fixed price establishes a clear value for a decedent’s interest in a business. The agreement should specify that the value of the company should not include the portion of life insurance proceeds used to buy a deceased shareholder’s shares.
4. Use Life Insurance Owned by the Investor: In this strategy, the outside investor, as the buyer of the shares, owns the life insurance policy. The investor pays the premiums and is the beneficiary of the policy. When the shareholder dies, the investor uses the death benefit to purchase the shares from the deceased shareholder’s estate. This way, the life insurance proceeds are not included in the valuation of the company.
Overall, the Connelly v. United States ruling emphasizes the need for careful consideration of the tax implications when structuring buy-sell agreements. It is crucial to establish a clear valuation method and ensure that the agreement complies with federal tax requirements to avoid unintended tax liabilities. Business owners should review their buy-sell agreements considering this ruling and consult with tax professionals to ensure compliance and mitigate potential tax risks.
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