How can business owners restructure buy-sell agreements after the Connelly decision?

Business owners should consider switching from redemption agreements to cross-purchase agreements, where individual shareholders rather than the corporation own the life insurance policies. Another option is using a partnership or LLC as the insurance holder to avoid the value-inclusion problem identified in Connelly.

What is the difference between a cross-purchase and a redemption buy-sell agreement?

In a cross-purchase agreement, individual shareholders buy insurance on each other and purchase the departing owner's shares directly. In a redemption agreement, the corporation owns the insurance and redeems the shares. After Connelly, redemption agreements create estate tax problems because insurance proceeds inflate share value.

After Connelly: Restructuring Your Buy-Sell Agreement to Avoid the Estate Tax Trap | Lynch Law

The Supreme Court's unanimous decision in Connelly v. United States has sent a clear message to closely held business owners across the country: if your buy-sell agreement is funded by corporate-owned life insurance and structured as a redemption agreement, the insurance proceeds will increase the value of your shares for estate tax purposes. The decision does not change the substantive rules — but it resolves the question definitively and eliminates any doubt about how the IRS will treat these arrangements going forward. The question now is what to do about it.^[1]

Understanding the Problem

The core issue identified in Connelly is straightforward. When a corporation owns a life insurance policy on a shareholder's life, the death benefit becomes a corporate asset at the moment of the shareholder's death. This increases the fair market value of the corporation, which in turn increases the estate tax value of the decedent's shares. The corporation's obligation to use the proceeds to redeem the shares does not offset the increase in value, because the redemption merely transfers value from the corporation to the estate — it does not reduce the total value of the enterprise.

For many closely held businesses, the magnitude of this problem is substantial. A corporation with $5 million in operating value and a $5 million life insurance policy is worth $10 million at the shareholder's death. If the decedent owned 50% of the corporation, the estate tax value of the shares jumps from $2.5 million (based on operating value alone) to $5 million (including the insurance). At a 40% estate tax rate, the additional estate tax is $1 million — payable from the very insurance proceeds that were supposed to fund a smooth ownership transition.

Cross-Purchase Agreements

The most direct alternative to a corporate redemption agreement is a cross-purchase agreement. In a cross-purchase arrangement, each shareholder individually purchases life insurance on the lives of the other shareholders. When a 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. The estate tax value of the decedent's shares is based on the corporation's operating value, without the insurance overlay. This is the fundamental advantage of the cross-purchase structure: it removes the insurance proceeds from the corporate valuation equation entirely.^[2]

Cross-purchase agreements also provide a basis step-up advantage. When the surviving shareholders purchase the decedent's shares, they take a cost basis equal to the purchase price. In a redemption, by contrast, the surviving shareholders do not acquire the redeemed shares — they simply own a larger percentage of the corporation — and no basis step-up occurs. If the surviving shareholders later sell the corporation, the basis difference can be significant.

The primary disadvantage of cross-purchase agreements is complexity. If a corporation has three shareholders, each shareholder must own policies on the other two — for a total of six policies. With four shareholders, the number jumps to twelve. The administrative burden of maintaining multiple policies, coordinating premium payments, and ensuring that policies remain in force can be significant, particularly as shareholders are added or removed over time.

The Partnership or LLC Solution

To address the complexity of multi-party cross-purchase agreements, many practitioners recommend using a separate partnership or LLC to hold the insurance policies. Each shareholder is a member of the LLC, and the LLC purchases and owns the life insurance policies on each shareholder's life. When a shareholder dies, the LLC receives the insurance proceeds and uses them to purchase the deceased shareholder's shares from the estate (or distributes the proceeds to the surviving shareholders for that purpose).

This structure combines the estate tax advantage of a cross-purchase (the insurance proceeds are not a corporate asset) with the administrative simplicity of having a single entity own and manage the policies. The LLC approach also avoids the transfer-for-value problems that can arise when policies need to be transferred as shareholders join or leave the business, because transfers to a partnership in which the insured is a partner fall within a statutory exception to the transfer-for-value rule.^[3]

Transitioning from Redemption to Cross-Purchase

For businesses with existing corporate-owned policies and redemption agreements, the transition to a cross-purchase structure requires careful planning. Transferring a life insurance policy from the corporation to an individual shareholder or to an LLC triggers the transfer-for-value rule under IRC § 101(a)(2), which generally causes the death benefit to be included in the transferee's gross income when the insured dies. This can transform a tax-free death benefit into a fully taxable receipt — a potentially catastrophic result.

The transfer-for-value rule has several exceptions, and the transition strategy must be designed to fit within one of them. Transfers to the insured are exempt. Transfers to a partner of the insured, or to a partnership in which the insured is a partner, are exempt. And transfers that constitute a carryover-basis transaction (such as a contribution to a partnership in exchange for a partnership interest) are exempt. A properly structured transition — typically involving the creation of a new LLC, the transfer of policies to the LLC, and the amendment of the buy-sell agreement — can accomplish the restructuring without triggering the transfer-for-value rule.^[4]

Other Considerations

The choice between redemption and cross-purchase involves considerations beyond the estate tax. State law may affect the analysis: some states impose restrictions on a corporation's ability to redeem shares (such as requiring the corporation to have sufficient surplus), while others impose different rules on cross-purchase transactions. The C corporation versus S corporation distinction matters as well: in a C corporation, a redemption can create dividend income to the redeemed shareholder if the redemption does not satisfy the requirements for sale-or-exchange treatment under IRC § 302. And the existing buy-sell agreement may contain provisions — such as fixed-price clauses or right-of-first-refusal provisions — that need to be addressed in the restructuring.

For Mississippi business owners, the Connelly decision is a call to action. Every existing buy-sell agreement funded by corporate-owned life insurance should be reviewed, and the estate tax implications under Connelly should be quantified. The restructuring options — cross-purchase agreements, LLC-owned policies, and hybrid arrangements — should be evaluated in light of the specific facts of the business and its shareholders. The cost of restructuring is modest compared to the potential estate tax savings, and the planning should be done now, while all shareholders are living and the transition can be accomplished without urgency.^[5]

References

^[1] Connelly v. United States, 602 U.S. ___ (2024). See our analysis of the decision: Supreme Court Decides Connelly.
^[2] In a cross-purchase arrangement, the insurance proceeds are owned by the individual shareholders, not the corporation. Because the proceeds are not a corporate asset, they do not factor into the valuation of the corporation under IRC § 2031.
^[3] IRC § 101(a)(2)(B) (transfer-for-value exception: transfers to a partner of the insured or to a partnership in which the insured is a partner).
^[4] IRC § 101(a)(2)(A)-(B) (transfer-for-value exceptions: transfers for a carryover basis, transfers to the insured, transfers to a partner of the insured). The transition must be structured to qualify under one of these exceptions to preserve the tax-free treatment of the death benefit.
^[5] See also our earlier discussion of the pre-Connelly landscape: Estate of Connelly: When Life Insurance Increases Your Estate Tax Bill.