How does Connelly affect buy-sell agreement planning?

After Connelly, businesses using redemption agreements funded by corporate-owned life insurance face higher estate tax valuations because the insurance proceeds are counted as a corporate asset. Business owners should consider restructuring to cross-purchase agreements or using an LLC to hold insurance policies.

Supreme Court Decides Connelly v. United States: Life Insurance and Estate Tax Valuation | Lynch Law

Q: What did the Supreme Court decide in Connelly v. United States?

The Supreme Court unanimously held that life insurance proceeds payable to a corporation to fund a stock redemption agreement increase the value of the decedent's shares for estate tax purposes. The ruling affects millions of closely held businesses using corporate-owned life insurance for buy-sell planning.

In Connelly v. United States, the Supreme Court unanimously resolved a question that has divided estate planners and the IRS for decades: whether life insurance proceeds held by a corporation to fund a stock redemption agreement increase the value of the decedent's shares for estate tax purposes. The Court's answer — yes, they do — has immediate and far-reaching implications for the millions of closely held businesses that use corporate-owned life insurance to fund buy-sell agreements.^[1]

The Facts

Michael and Thomas Connelly were the sole shareholders of Crown C Supply, a building materials company organized as an S corporation. The brothers entered into an agreement providing that, upon the death of either shareholder, the surviving brother would have the option to purchase the deceased brother's shares. If the surviving brother declined, the corporation would redeem the shares. To fund the potential redemption, Crown C purchased $3.5 million in life insurance on each brother's life.

Michael died in 2013. Thomas declined to purchase Michael's shares personally, triggering the corporate redemption obligation. Crown C received $3.5 million in life insurance proceeds and used the funds to redeem Michael's shares for $3 million (a price the brothers had previously agreed upon). On the estate tax return, the estate valued Michael's shares based on the agreed-upon price, without including the life insurance proceeds in the corporation's value.

The IRS disagreed. It argued that the life insurance proceeds were a corporate asset that increased the fair market value of Crown C — and therefore increased the value of Michael's shares — at the moment before the redemption occurred. The estate countered that the life insurance proceeds were offset by the corporation's obligation to redeem the shares, so the proceeds should not increase the corporation's net value.

The Court's Analysis

The Supreme Court sided with the IRS. Writing for a unanimous Court, Justice Thomas held that the fair market value of Michael's shares must be determined immediately before his death, at which point Crown C held $3.5 million in life insurance proceeds (or the right to receive them) as a corporate asset. The corporation's obligation to redeem the shares did not offset the insurance proceeds because, as the Court explained, a redemption obligation does not reduce the value of the company — it merely changes who holds the economic interest. Before the redemption, Michael owned shares in a company worth $3.5 million more than it would have been worth without the insurance. After the redemption, Thomas owned 100% of a company that was $3.5 million poorer (having paid out the redemption price) — but Michael's shares must be valued before the redemption, not after.^[2]

The Court drew an analogy to a simple hypothetical. If a company has $100 in assets and two equal shareholders, each shareholder's interest is worth $50. If the company then uses $50 to redeem one shareholder's shares, the remaining shareholder owns 100% of a company now worth $50. The redeeming shareholder received $50 — exactly the value of their 50% interest before the redemption. The redemption did not create or destroy value; it merely transferred it. The same logic applies when the $50 comes from life insurance proceeds: the proceeds are a corporate asset that increases the company's value, and the redemption obligation does not offset them.

Why This Matters

The practical impact of Connelly is significant. Millions of closely held businesses use corporate-owned life insurance to fund redemption agreements. Under the Court's holding, the insurance proceeds are included in the corporation's value for estate tax purposes, which increases the value of the decedent's shares and, consequently, the estate tax owed. For businesses with substantial life insurance policies, this can mean hundreds of thousands or even millions of dollars in additional estate tax.

Consider a corporation with $5 million in operating assets and a $5 million life insurance policy on its majority shareholder. Under Connelly, the corporation is worth $10 million at the shareholder's death (operating assets plus insurance proceeds). If the shareholder owned 60% of the corporation, the estate tax value of the shares is $6 million — not the $3 million that would result from valuing only the operating assets. At a 40% estate tax rate, the difference is $1.2 million in additional estate tax.^[3]

What To Do Now

Business owners with existing corporate-owned life insurance and redemption agreements should review their arrangements immediately. The Connelly decision does not prohibit the use of corporate-owned life insurance, but it changes the estate tax calculus significantly. Several alternatives may mitigate the estate tax impact.

The most straightforward alternative is a cross-purchase agreement, in which each shareholder purchases life insurance on the other shareholders' lives individually (rather than having the corporation purchase the policies). When the insured shareholder dies, the surviving shareholders receive the insurance proceeds personally and use them to purchase the deceased shareholder's shares from the estate. Because the insurance proceeds are never a corporate asset, they do not increase the corporation's value for estate tax purposes. Cross-purchase agreements have their own complexities — particularly when there are more than two shareholders — but they avoid the Connelly problem entirely.

Another option is to hold the life insurance policies in a separate entity — such as an LLC owned by the shareholders — rather than in the operating corporation. The LLC receives the insurance proceeds and uses them to purchase the deceased shareholder's interest. This achieves the same result as a cross-purchase without requiring each shareholder to own individual policies on every other shareholder.

For existing redemption agreements, the transition requires careful planning. Transferring corporate-owned policies to individual shareholders or to a separate entity may trigger transfer-for-value rules under IRC § 101(a)(2), which can cause the death benefit to become taxable income. Exceptions to the transfer-for-value rule exist for transfers to the insured, to a partner of the insured, or to a partnership in which the insured is a partner — but these exceptions must be navigated carefully.^[4]

Every closely held business owner with a buy-sell agreement funded by corporate-owned life insurance should consult with estate planning counsel to assess the impact of Connelly and determine whether restructuring is appropriate. The decision is unanimous, the rule is clear, and the stakes are high. Waiting is not a strategy.^[5]

References

^[1] Connelly v. United States, 602 U.S. ___ (2024) (unanimous; Justice Thomas writing for the Court). The decision resolved a circuit split on the treatment of corporate-owned life insurance in the estate tax valuation of closely held stock.
^[2] Id. at slip op. 8-12. The Court rejected the estate's argument that the redemption obligation was a corporate liability that offset the insurance proceeds, holding that the obligation to redeem shares does not reduce the value of the corporation.
^[3] IRC § 2031 (gross estate includes the fair market value of all property in which the decedent had an interest at death); Treas. Reg. § 20.2031-2(f) (valuation of closely held stock considers all relevant factors, including corporate assets).
^[4] IRC § 101(a)(2) (transfer-for-value rule: death benefits become taxable if the policy is transferred for valuable consideration, subject to enumerated exceptions).
^[5] See our earlier discussion of the estate tax implications of corporate-owned life insurance: Estate of Connelly: When Life Insurance Increases Your Estate Tax Bill.