The Connelly Decision: Have You Reviewed Your Buy Sell?

Introduction

The recent Supreme Court decision in Connelly v. Department of Treasury has sent ripples through the world of buy-sell agreements and estate planning. This landmark ruling has highlighted the potential inclusion of life insurance proceeds in business valuation, creating significant implications for closely held businesses. As life insurance advisors, understanding the nuances of this decision is crucial in guiding clients through effective buy-sell planning.

This ruling quite literally means that every small business owner should review their buy-sell agreement to ensure the life insurance death benefit isn’t going to increase the tax value of their business.

Understanding the Connelly Case

The Connelly case involved a closely held business owned by two brothers, Michael and Thomas Connelly. Upon Michael’s death, the business received a substantial life insurance payout intended to fulfill a buy-sell agreement.

However, the IRS argued that the life insurance proceeds should be included in the estate’s taxable value, resulting in a significant increase in estate taxes owed.

This decision challenges the previous assumption that redemption obligations and life insurance proceeds offset one another for estate tax purposes.

It underscores the necessity of carefully structured buy-sell agreements and highlights the risks associated with stock redemption agreements.

Key Takeaways from the Connelly Decision

• Valuation of Life Insurance Proceeds: The court’s decision emphasized that life insurance proceeds may be included in the valuation of a business for estate tax purposes. This impacts business owners relying on stock redemption agreements.
• Need for Regular Review: The ruling highlights the importance of regularly reviewing and updating buy-sell agreements to ensure they reflect current valuations and legal standards.
• Exploring Alternative Structures: Business owners should consider alternative buy-sell agreement structures, such as cross-purchase agreements, cross-endorsement buy-sells, trusteed buy-sells, or Insurance LLCs, to mitigate potential risks.

The Role of an Insurance LLC In a Buy Sell

One effective strategy to address the potential pitfalls highlighted by the Connelly decision is using an Insurance LLC. This structure can provide additional flexibility and protection when managing life insurance policies intended for buy-sell agreements.

What is an Insurance LLC?

An Insurance LLC is a limited liability company specifically created to own life insurance policies on behalf of business owners or partners. Instead of the business or individuals directly owning the life insurance policies, the LLC holds the policies, making it a separate legal entity. This approach can help mitigate the risks associated with the inclusion of life insurance proceeds in the business’s estate valuation.

How Does an Insurance LLC Work?

1. Ownership of Policies: The life insurance policies are owned by the LLC, not by the individual partners or the business itself. This separation can help keep the proceeds from being counted as part of the business’s value during estate valuation.
2. Flexibility in Beneficiaries: The LLC can be structured to distribute the life insurance proceeds according to the buy-sell agreement, ensuring that the surviving partners or the business can buy out the deceased partner’s shares without inflating the business’s value.
3. Tax Benefits: Because the Insurance LLC is a separate entity, the life insurance proceeds may not be included in the deceased partner’s estate for tax purposes. This can potentially reduce the estate tax burden, depending on the specific structure and jurisdiction.
4. Control and Management: The LLC can be managed by the business owners themselves or by a trusted third party, providing flexibility in how the policies are administered. This can also ensure that the buy-sell agreement is followed precisely, reducing the risk of disputes.

Example Case: The Roberts Consulting Group

Consider the Roberts Consulting Group, a partnership between three owners. After reviewing the implications of the Connelly decision, their advisor suggested forming an Insurance LLC to hold the life insurance policies intended for their buy-sell agreement. By transferring ownership of the policies to the LLC, the Roberts partners ensured that the proceeds would not inflate the company’s estate value. The LLC agreement also clearly outlined how the funds would be used to purchase shares from the deceased partner’s estate, protecting the remaining partners from unexpected tax liabilities.

Result: The Insurance LLC provided the Roberts Consulting Group with a clear, tax-efficient structure that maintained the integrity of their buy-sell agreement while mitigating the risks associated with estate valuation.

Why Insurance Proceeds Typically Don’t Create a Valuation Increase in an Insurance LLC

The idea behind using an Insurance LLC to hold life insurance policies in the context of a buy-sell agreement is to separate the ownership of the life insurance policies from the operating business itself. This separation is key to managing how the insurance proceeds are treated for estate and business valuation purposes. Here’s why the insurance proceeds typically do not create a valuation increase for the operating business when using an Insurance LLC:

1. Separate Legal Entity:
   • Ownership: The Insurance LLC is a separate legal entity from the operating business. It owns the life insurance policies, and as such, the life insurance proceeds are technically an asset of the LLC, not the operating business.
   • Valuation: When the insured individual dies, the proceeds are paid to the LLC, not the operating business. This means that the operating business’s balance sheet does not directly reflect the increase in cash or assets from the life insurance payout.
2. Purpose of the LLC:
   • Sole Purpose: The Insurance LLC is typically created with the sole purpose of owning life insurance policies and managing the payout for specific purposes, such as funding a buy-sell agreement. The LLC’s structure can be designed to pass the insurance proceeds directly to the remaining partners or to the deceased partner’s estate without impacting the valuation of the operating business.
   • No Operating Revenue: Since the Insurance LLC doesn’t generate revenue or profit from operations, the life insurance proceeds are not considered as income or an operational asset, which could otherwise increase the value of the business.
3. Tax Treatment:
   • Estate Tax Implications: The separation provided by the LLC can help in reducing the estate tax implications for the operating business. If the life insurance policy were owned by the business itself, the proceeds might be considered part of the business’s estate, potentially increasing its valuation for estate tax purposes. By placing the policy within an LLC, the proceeds stay out of the operating business’s estate valuation.
   • Pass-Through of Proceeds: The LLC can be structured so that the life insurance proceeds are passed directly to the beneficiaries (such as the other business owners or the deceased owner’s estate) without the proceeds being included in the value of the operating business.
4. How It Works in Practice:
   • Buy-Sell Funding: Upon the death of an owner, the Insurance LLC receives the life insurance payout. The LLC then uses those proceeds according to the terms of the buy-sell agreement, typically by paying the other partners to purchase the deceased owner’s shares or by distributing the funds to the deceased owner’s estate.
   • No Impact on Business Value: Since the proceeds are handled within the LLC and used for the specific purpose of fulfilling the buy-sell agreement, they do not inflate the value of the operating business. The business itself does not receive the proceeds directly, so the cash influx doesn’t affect its valuation.
5. Avoiding Connelly-like Outcomes:
   • Avoiding Estate Inclusion: The Connelly case highlighted the risk of life insurance proceeds being included in the value of a business for estate tax purposes. An Insurance LLC helps mitigate this risk by keeping the proceeds separate from the business’s estate, thus avoiding a valuation increase that could trigger higher estate taxes.

Summary

The key benefit of using an Insurance LLC in this context is the separation of life insurance proceeds from the operating business. By placing the life insurance policies in an LLC, the proceeds do not directly enter the business’s balance sheet, thereby preventing an increase in the business’s valuation. This approach also provides tax efficiency, particularly in the context of estate planning and buy-sell agreements, as it helps avoid the inclusion of insurance proceeds in the business’s taxable estate.

This structure is especially useful for high-value businesses where estate tax concerns are significant, and where the business owners want to ensure that the life insurance proceeds are used specifically for succession planning without unintended tax consequences.

Action Steps for Advisors

• Conduct Regular Reviews: Encourage clients to review their buy-sell agreements annually to ensure compliance with current laws and reflect accurate business valuations.
• Educate Clients on Alternatives: Explain the benefits of alternative structures, such as cross-purchase agreements, Insurance LLCs, or trusteed buy-sells, which can provide greater flexibility and protection.
• Collaborate with Legal and Tax Experts: Work closely with legal and tax professionals to develop comprehensive solutions tailored to each client’s unique circumstances.

Conclusion

The Connelly decision serves as a pivotal reminder of the complexities involved in buy-sell agreements and estate planning. As advisors, it is our responsibility to guide clients through these changes, ensuring their agreements are structured to minimize risk and maximize protection. By staying informed and proactive, we can help clients navigate the evolving landscape of business succession planning with confidence.