The day after: What to do with redemption agreements funded with life insurance after the Supreme Court’s decision in Connelly

Background

On June 6, 2024, the proverbial ground underpinning buy-sell planning shook when the United States Supreme Court issued its decision in Connelly vs. United States. Contrary to the opinion formed by some tax professionals based on prior cases, the Supreme Court sided with the Internal Revenue Service (IRS) in finding that the obligation to redeem a shareholder’s stock pursuant to a stock redemption agreement is not a liability that offsets the increase in value from life insurance death benefit proceeds. 

Michael and Thomas Connelly were the sole shareholders of a building supply company. Upon Michael’s death, the company collected $3.5 million of life insurance proceeds paid on a corporate owned policy insuring Michael’s life. The company used $3 million to redeem Michael’s shares according to the company’s stock redemption agreement. On Michael’s estate tax return, Michael’s executor claimed the value of Michael’s shares was equal to the redemption amount.

The IRS disagreed. It insisted that the value of the company should be increased by the value of the life insurance proceeds paid to the company after Michael’s death, and that this value should not be offset by the redemption obligation. The Supreme Court ultimately ruled in favor of the government.

This article discusses the issues to be considered in light of Connelly, including alternatives if it is determined that changes to existing buy-sell arrangements are necessary.

Perspective

From a tax perspective, there are two main issues for shareholders of a corporation owning life insurance to consider following Connelly.

First, because life insurance proceeds are not offset by a corresponding redemption obligation, the value of a shareholder’s shares, for estate tax purposes, could be higher than expected. This will increase the deceased shareholder’s estate tax liability, which likewise would reduce the value passing to the deceased shareholder’s heirs. In some cases, the increased estate tax liability could exceed the amount received on redemption.

For example, ABC, Inc. is a cash basis S corporation owned 50% by Jane and 50% by Betty. The most recent appraisal of ABC was for $20 million. ABC’s stock redemption agreement provides that ABC will redeem a deceased shareholder’s shares for $10 million. ABC owns and is the beneficiary of two life insurance policies each with a death benefit of $10 million, one insuring Jane and the other Betty.