For decades, closely held businesses have used corporate-owned life insurance to fund buy-sell agreements. The arrangement is straightforward in concept: the corporation purchases a life insurance policy on each shareholder, and when a shareholder dies, the insurance proceeds fund the corporation’s redemption of the deceased shareholder’s stock. The arrangement provides liquidity, ensures a smooth ownership transition, and—or so the conventional planning wisdom held—does not increase the decedent’s estate tax liability because the insurance proceeds belong to the corporation, not the estate.
The Eighth Circuit’s decision in Connelly v. United States has disrupted that assumption in a way that demands the attention of every business owner with a corporate-owned life insurance arrangement.[1] The court held that the life insurance proceeds received by the corporation increased the fair market value of the decedent’s shares at the moment of death, resulting in a higher estate tax liability than the estate had anticipated. The decision—now under review by the Supreme Court after the grant of certiorari—has significant implications for estate planning, business succession, and the structuring of buy-sell agreements involving life insurance.
The Facts and the Dispute
Crown C Supply, a Missouri S corporation, was owned by two brothers, Michael and Thomas Connelly. The corporation held life insurance policies on both shareholders, and the shareholders’ agreement provided that upon the death of either brother, the surviving brother had the right of first refusal to purchase the deceased brother’s shares. If the surviving brother declined, the corporation was obligated to redeem the shares at an agreed price.
Michael Connelly died in 2013. Thomas declined to purchase the shares personally, triggering the corporate redemption obligation. The estate and the surviving brother agreed on a value of $3 million for Michael’s shares, and the corporation redeemed the shares using the $3.5 million in life insurance proceeds it had received. On the estate tax return, the executor reported the value of Michael’s shares at $3 million—the agreed-upon redemption price.
The IRS disagreed. It argued that the fair market value of Michael’s shares had to account for the life insurance proceeds that the corporation received upon his death. Because the corporation held $3.5 million in insurance proceeds at the moment of Michael’s death—before the redemption occurred—those proceeds were a corporate asset that increased the value of all outstanding shares, including Michael’s. The IRS determined that Michael’s shares were worth approximately $5.3 million and assessed additional estate tax accordingly.
The Eighth Circuit’s Analysis
The Eighth Circuit agreed with the IRS. The court applied the standard federal estate tax valuation framework, which requires that property be valued at its fair market value on the date of death. Under Treasury Regulation § 20.2031-1(b), fair market value is the price at which property would change hands between a willing buyer and a willing seller, neither being under any compulsion and both having reasonable knowledge of relevant facts.
The court reasoned that at the moment of Michael’s death, the corporation’s assets included the $3.5 million in life insurance proceeds. A hypothetical willing buyer purchasing Michael’s shares would consider those proceeds in valuing the company. The fact that the corporation was obligated to use those proceeds to redeem Michael’s shares did not reduce the value of the shares themselves—the obligation to redeem and the insurance proceeds were, in the court’s view, offsetting items.[2]
The estate argued that the redemption obligation was a liability that reduced the corporation’s net asset value, but the court rejected this reasoning. A corporate obligation to repurchase its own stock at fair market value is not a liability in the traditional sense—it does not reduce the amount available to shareholders because the shares being redeemed are cancelled. The corporation pays out cash and simultaneously reduces its outstanding share count, leaving the per-share value for remaining shareholders unchanged. What the court found was that the insurance proceeds inflated the per-share value of all shares at the moment of death, including those held by the estate.
Why This Matters for Closely Held Businesses
The Connelly decision exposes a fundamental tension in a common estate planning structure. Many closely held businesses use corporate-owned life insurance precisely because the proceeds are intended to fund a transition—not to enrich the estate. But the Eighth Circuit’s analysis treats the insurance proceeds as a corporate asset that increases share value for estate tax purposes, regardless of how those proceeds will ultimately be used.
The practical impact is significant. Consider a corporation worth $5 million before insurance, with two equal shareholders. If the corporation owns a $5 million life insurance policy on each shareholder, the death of one shareholder triggers a $5 million insurance payout. Under the Connelly analysis, the corporation’s total value at the moment of death is $10 million ($5 million of operating value plus $5 million of insurance proceeds), and the decedent’s 50% interest is worth $5 million—not the $2.5 million that the pre-insurance operating value would suggest. The estate tax is calculated on the inflated value even though the proceeds are used to redeem the shares and the estate ultimately receives only the redemption price.
This creates a circular problem. The more insurance a corporation carries to fund a buy-sell redemption, the higher the estate tax liability becomes. The insurance that was supposed to provide liquidity for a smooth transition instead generates a larger tax bill that may require additional liquidity to pay—liquidity that the estate may not have after the shares have been redeemed.
The Supreme Court Review
The Supreme Court granted certiorari in Connelly, and the case is set for argument in the Court’s current term. The petition raises the question of whether the value of a decedent’s shares in a closely held corporation should reflect the corporation’s contractual obligation to redeem those shares. If the Court reverses the Eighth Circuit, corporate-owned life insurance arrangements may retain their traditional tax treatment. If the Court affirms, the decision will reshape how buy-sell agreements and life insurance are structured for closely held businesses across the country.[3]
Planning Alternatives
While the Supreme Court’s decision remains pending, business owners should evaluate their existing arrangements and consider alternative structures that may avoid the Connelly problem. The most straightforward alternative is a cross-purchase agreement, under which each shareholder individually owns a life insurance policy on the other shareholders. When a shareholder dies, the surviving shareholders use the insurance proceeds to purchase the decedent’s shares directly. Because the insurance proceeds are received by the individual shareholders rather than the corporation, they do not inflate the corporation’s asset value and therefore do not increase the value of the decedent’s shares for estate tax purposes.
Cross-purchase agreements have their own complications, particularly when there are more than two shareholders. With three shareholders, six policies are needed; with four, twelve. Insurance trusts or partnership arrangements can reduce this complexity, but they add administrative requirements and costs. For businesses with multiple shareholders, the trade-offs between redemption and cross-purchase structures must be evaluated carefully in light of the Connelly analysis.
Another alternative involves structuring the life insurance arrangement so that the proceeds are used to retire debt or fund a deferred payment arrangement rather than a lump-sum redemption. If the corporation borrows to fund the redemption and uses insurance proceeds to repay the loan, the timing and characterization of the transaction may produce a different valuation result—though this approach has not been tested under the specific framework the Eighth Circuit applied.
For existing corporate-owned life insurance arrangements, the most prudent step is to obtain an updated valuation analysis that incorporates the Connelly framework. Understanding the potential estate tax exposure under the current arrangement allows business owners and their advisors to evaluate whether restructuring is warranted and, if so, which alternative best fits the business’s ownership structure and succession objectives.[4]