By Alexander Canacci, Alonso Munoz
The U.S. Supreme Court released their decision in Estate of Connelly vs. United States on June 6th, which will have a meaningful impact on the taxation of future buy-sell agreements.
Key Takeaways:
- Impact on the taxation of buy-sell agreements – especially when stock redemption buy-sell agreements are funded by life insurance.
- Decision allows IRS to tax the buy-sell agreement stock redemption and death benefits.
- May also impact income and capital gain taxes related to buy-sell agreements.
- Family businesses may have increased IRS scrutiny.
- Reminder: Estate tax exemption scheduled to sunset from $13.61 million in 2024 to approximately $7 million in January of 2026, per individual taxpayer.
Impact on Buy-Sell Agreements
A well-crafted buy-sell agreement is critical for identifying the terms upon which business ownership interests are transferred following certain triggering events. Such events include an owner’s retirement, passing, disability, divorce, financial troubles, or termination of employment. When properly constructed, a buy-sell agreement can significantly reduce operational friction, minimize potential conflicts, and ensure the long-term success of a business. Alternatively, a poorly written agreement can lead to operational issues or even forced liquidation.
The Supreme Court decision in Estate of Connelly vs. United States demonstrates a change from previous tax guidance regarding stock redemption buy-sell agreements. These agreements, often funded with life insurance, may now face tax implications. In this case, two brothers, both business owners, established a buy-sell agreement dictating that the business would redeem the shares of a deceased owner (a stock redemption buy-sell agreement). To fund this obligation, the business purchased life insurance policies on each owner. When one brother passed in 2013, the business received the insurance payout and used it to purchase the deceased brother’s shares from his estate.
The primary tax question in the Connelly case revolved around the valuation of the deceased owner’s shares for estate tax purposes. The Supreme Court addressed two issues in this case:
- Whether the value of the deceased owner’s shares should include the proceeds from the life insurance policy.
- Whether the agreement’s requirement of the business to redeem the deceased owner’s shares should be considered a debt that would reduce the value of those shares.
In a shift from previous District Court decisions, the Supreme Court agreed with the IRS, determining that the value of the deceased owner’s shares should include the life insurance payout. Furthermore, the redemption obligation did not reduce the shares’ value. As a result, the estate had a significantly higher tax liability.
The Connelly decision highlights the necessity of taking both legal and tax considerations into account for buy-sell agreements. Business owners should ensure that their agreements are thoroughly written and legally reviewed to avoid unintended tax consequences. Comprehensive planning can help ensure that buy-sell agreements are written to address a multitude of scenarios and reflect the most up-to-date tax laws and regulations. It is critical to be aware of the tax implications that life insurance proceeds and redemption obligations can have on share valuations for estate tax purposes.
Estate Tax Exemption Reduction
Gift and Estate taxes play a crucial role in the transfer of wealth, which can include money, property, and other assets both during an individual’s lifetime and posthumously.
Prior to 2018, the exemption amount for gift and estate taxes was set at $5 million per taxpayer. However, significant changes came into effect with the 2017 Tax Cuts and Jobs Act, which raised this exemption to $13.61 million. This adjustment represents a considerable increase, allowing for greater tax-free transfers of wealth. It is important to note that starting January 1, 2026, the exemption will revert to its pre-2018 level, adjusted for inflation, which is anticipated to be approximately $7 million per taxpayer.
In November 2019, the IRS issued important guidance concerning the use of the increased exemption during the period from 2018 to 2025. This clarification ensures that individuals making substantial gifts within this timeframe will not face a disadvantage when the exemption decreases in 2026. Under the clarified regulation, estates have the flexibility to use the higher exemption amount available at the time of the gift or the lower amount applicable at the time of death—whichever is more favorable. This rule effectively preserves the tax benefits for those who engage in significant gift transfers before the exemption reverts. For those considering large gifts, this IRS guidance provides a strategic advantage. As always, careful consideration and consultation with legal and financial advisors is recommended to tailor strategies to individual circumstances.
Estate and Gift Tax FAQs | Internal Revenue Service (irs.gov)
23-146 Connelly v. United States (06/06/2024) (supremecourt.gov)
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