Buy-sell agreements and estate tax consequences in the US

On June 6, 2024, the U.S. Supreme Court issued a unanimous opinion holding that life insurance proceeds paid to a corporation upon the death of a shareholder to redeem shares from the deceased shareholder's estate are treated as corporate assets for estate tax valuation purposes. This is the case, despite the seemingly offsetting obligation in the form of the redemption. The Supreme Court clarified that a corporation's obligation to redeem such shares is, in fact, not considered a liability that offsets the increase in value of the corporation due to the receipt of the life insurance proceeds. As a result of Connelly, a buy-sell agreement structured as a redemption that is funded by corporate-owned life insurance may have unexpected and detrimental estate tax consequences.

In this case, the two brothers were the sole shareholders of a small corporation. The brothers entered into an agreement providing that upon the death of either, the surviving brother would have the option to purchase the deceased brother's shares. If the surviving brother declined, the corporation would be required to redeem the shares from the deceased brother's estate. The corporation obtained a life insurance policy for each brother to ensure funds would be available upon the death of either of them. Upon the death of one brother, the surviving brother declined to exercise his option to purchase his deceased brother's shares. The corporation, as was required under the agreement, purchased the shares. The IRS objected to the value of the corporation on the deceased brother's federal estate tax return, arguing the value was insufficiently low because it did not include the life insurance proceeds. The estate, on the other hand, relying on the decision in Estate of Blount (an earlier case in a different circuit), argued that the life insurance proceeds did not need to be included in the value of the company for estate tax purposes, as the company's obligation to redeem the shares from the estate was an offsetting obligation. The lower court in Connelly sided with the IRS, and the Supreme Court took up this case to resolve the circuit split and determine whether, under these circumstances, the insurance proceeds should be included in the value of the company for estate tax.

Buy-sell agreements are commonly used as a part of a succession plan for a family-owned and closely held business. Generally, there are two kinds of buy-sell agreements. An entity-purchase agreement contractually requires the corporation to purchase shares owned by a shareholder upon the shareholder's death. Alternatively, a cross-purchase agreement requires the remaining shareholders to purchase the shares held by the deceased shareholder. In either buy-sell arrangement, the parties to the agreement will obtain a life insurance policy on the life of each shareholder to ensure funds are available upon a shareholder's death to fund the purchase.

In the context of a closely held business, a buy-sell agreement must meet certain criteria specified in the Internal Revenue Code to be respected by the IRS. If an agreement in the judgment of the IRS does not meet the test, the IRS can disregard the value set by the agreement for estate tax purposes. In Connelly, both the circuit court and the Supreme Court agreed with the IRS's position that the buy-sell agreement would not be respected. Because the value set by the agreement was not binding. For federal estate tax purposes, the IRS had the ability to revalue the company as of the deceased's date of death. In Connelly, the estate of the deceased shareholder incurred additional estate tax as a result of this revaluation.

A cross-purchase agreement avoids the estate tax consequences of Connelly because the shareholders, individually, are beneficiaries of the policies instead of the corporation. This means that the proceeds of a life insurance policy will not be included in a company's valuation for estate tax purposes because the company does not receive the proceeds. As an additional tax benefit to a cross-purchase agreement, the surviving shareholder would receive a higher basis in shares purchased from the decedent's estate for income tax savings. 

The structure and mechanics of any buy-sell agreement must be evaluated periodically to ensure the agreement will be respected for estate tax purposes, as well as to ensure the agreement is sufficient in light of changing business, legal, and tax circumstances, including increases to the value of the company. This is especially true in light of Connelly because any existing buy-sell agreement structured as a redemption could now be the source of additional and wholly unexpected estate tax risk. Moreover, the terms of such agreements must be respected by the participants – or they will almost certainly not be respected by the IRS. 

Please do not hesitate to contact your attorney at Withers Bergman LLP to discuss further the implications of this decision on your individual business and estate succession plan.