August 6, 2024
Rembolt Ludtke Business Formation, Governance and Succession Planning Practice Group
If you are a small-business owner, now might be a good time to review the succession planning framework that you have in place for your business. As a result of the U.S. Supreme Court’s recent decision in Connelly v. United States, released earlier this summer, a common succession planning strategy involving life insurance used by scores of small-business owners across the country has become significantly more complicated and risky. Under this common planning strategy, the business itself owns and pays for life insurance on its owners to create liquidity for the business to repurchase a deceased owner’s stock after he or she passes away. Additionally, as part of this planning, there is generally some buy-sell agreement or share repurchase agreement in place mandating the corporation to carry through with the repurchase.
Prior to Connelly, the prevailing legal precedent suggested that the life insurance proceeds received by the business for the purpose of funding a share repurchase would not be included in the value of the business, per se, for purposes of valuing the deceased owner’s share of the business for estate tax calculation purposes. The supposed reasoning behind this initial precedent was that the value of such proceeds was offset by a corresponding liability on the books of the business represented by the business’s legal obligation to repurchase the deceased owner’s shares. However, in Connelly, the Supreme Court ruled that such life insurance proceeds do increase a business’s value without a corresponding cancelling liability, which in turn can increase the estate tax burdens for the estate of the owner who has passed. Therefore, this ruling might result in unexpected tax ramifications for certain small business owners who do not review and potentially restructure their business succession planning in light of this recent decision.
In the Connelly decision, the Court’s ruling significantly impacted the estate and tax liability for a deceased individual who co-owned a building-supply corporation with his brother. The corporation had purchased a $3.5 million life insurance policy on each brother, and the proceeds from one of the policies was used by the corporation to repurchase the deceased brother’s shares in the corporation after his death. As a result of the Court’s ruling, the value of the corporation on the date of the brother’s death was increased by the amount of the life insurance proceeds that the corporation received, which in turn increased the value of the deceased brother’s ownership interest in the corporation, and thereby unexpectedly raised the estate tax liability for the deceased brother by nearly $900,000. Such an unexpected tax bill will significantly reduce the value that passes onto a deceased person’s heirs and beneficiaries and could prove destabilizing to the closely-held business as well.
In short, while having a small business take out life insurance on its owners provides a secure way to ensure premiums get paid and buyout mechanisms are properly implemented upon the death of a key owner, the new tax liabilities that could result from a situation similar to that in the Connelly decision must now also be factored into the planning analysis.
As the decision in Connelly shakes up common succession planning practices, small business owners should consider available options and make succession plan changes if necessary to best meet expectations and business needs moving forward. In terms of whether your own small-business succession planning framework is in need of updates or modifications in light of the Connelly decision, you should consider consulting immediately with your estate and
business planning attorney at Rembolt Ludtke LLP to make sure you avoid the same unpleasant surprise that befell the small business owners in the Connelly case.
Supreme Court opinion: https://www.supremecourt.gov/opinions/23pdf/23-146_i42j.pdf
This article is provided for general information purposes only and should not be construed as legal advice. Those requiring legal advice are encouraged to consult with their attorney.
