Article

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

Aug. 1, 2024 · Authored by William Grady, Michael Lum

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.

Jane dies and ABC files the death benefit claim, receives the $10 million death benefit and subsequently uses the cash to redeem Jane’s shares. Under Connelly, the estate tax value of Jane’s shares is $15 million (50% of the company’s $30 million value: the $20 million appraised value plus the $10 million of life insurance proceeds). Note that because ABC is a cash basis S corporation, the same result will not occur if ABC redeems Jane’s stock prior to the receipt of the death benefit. 

Adding the $15 million to her nonbusiness assets of $1 million, Jane’s taxable estate is $16 million. Yet, the heirs of her estate will receive $11 million at most ($10 million via the redemption agreement and $1 million of other assets). 

The amount to Jane’s heirs and her estate tax liability are ultimately dependent on the federal estate tax rules in place at her death. Even with the current exemption of $13.61 million per person in 2024, there is significantly increased estate tax exposure. In Jane’s case, this would mean a possible estate tax of $956,000 (her $16 million estate less the $13.61 million exemption times 40% (the federal estate tax rate)), which will further reduce what her heirs receive from her estate. Of course, were the exemption to drop in the future, perhaps to $7 million come 2026 (or even $3.5 million or less), the outcome of Connelly could result in even more estate tax. 

Second, the increased value of the shares owing to the life insurance will increase the basis of the shares included in the deceased shareholder’s estate. If the redemption price is lower than the basis, the deceased shareholder’s estate will recognize a loss on the stock redemption. 

For example, if Jane’s estate receives a $10 million payment from ABC in exchange for her stock, but ABC is included in her estate at a value of $15 million, the stock’s basis is stepped-up to fair market value. $15 million of basis in ABC less the $10 million redemption payment results in a loss to the estate of $5 million. Depending on the specific facts and circumstances, Jane’s estate and/or the heirs of her estate might not be able to benefit from the loss.

Purchase of more life insurance to account for the additional estate tax inclusion

One might think a solution to account for the additional estate inclusion is to have the corporation purchase more life insurance. However, there are several significant drawbacks to doing so. First, insurability may be an issue given that the shareholders are older, potentially less healthy or perhaps no longer insurable. This will likely mean that additional insurance cannot be obtained or could be prohibitively expensive. Second, even if shareholders are insurable and can obtain good ratings from the insurance company, the overall cost of the insurance may not be affordable.

Continue to own the life insurance as key person insurance or for other purposes

Aside from the buy-sell agreement, there may be reasons to continue to own the insurance in the corporation, regardless of Connelly. While the buy-sell agreement might be changed as discussed elsewhere in this article, the entity-owned insurance may serve other purposes. 

The first — and most common — is for “key person” reasons. With key person insurance, the business is the owner and beneficiary of a life insurance policy on the life of a key employee, whether an owner or not. The death benefit is ear-marked to allow the business to better financially “survive” the loss of the insured. For example, the funds may be used to hire a replacement for the insured, to sustain its business operations impacted by the loss of the insured or for other reasons. Notably, the death benefit will increase the value of the business when received after the death of the insured, at least until it is spent.

Another reason to keep the insurance “as is” may involve loans or the lending capacity of the business, with the life insurance serving as collateral. Depending on the lending covenant and the lender’s preferences, the business may be required to retain ownership of life insurance.

One other common reason for ownership of life insurance by an entity is to provide a source of funds for the liability related to nonqualified deferred compensation (NQDC) arrangements. Typically, a permanent life insurance policy is owned by the entity, which allows it to access cash value during the life of the insured and to make payments to the employee under the terms of the NQDC agreement. Ownership of the policy can also be transferred to the insured as a form of payment, with the fair market value of the policy as the amount paid to the employee. In many cases, the business will hold the policy until the death of the insured and use the death benefit as a measure of “cost recovery” against the use of other cash or assets depleted to make payments on the agreement prior to the insured’s death.

Fund a cross-purchase arrangement

Going back to the ABC example, two options exist to provide some certainty for both shareholders, regardless of what happens to the federal estate tax. First, Betty and Jane can consider a cross-purchase agreement in lieu of a redemption agreement. To fund a cross-purchase agreement with life insurance, the existing insurance can be transferred from ABC to the shareholders. Specifically, Jane’s policy will be distributed from ABC to Betty and Betty’s policy will be distributed from ABC to Jane. Betty will name herself as beneficiary of the policy on Jane’s life, and vice versa. In the event Jane dies, Betty will collect the death benefit and will use it to purchase Jane’s stock in ABC. One significant advantage of structuring the buy-sell as a cross-purchase is the additional basis Betty will obtain in ABC — $10 million in this case — as a result of her purchase. This alternative arrangement will avoid the Connelly implications.

While this may sound good conceptually, there are several considerations prior to making such a change. This is, of course, in addition to terminating the existing legal agreement and executing a new one.

1) Current income taxation to ABC.  The first factor to consider with the transfer of the life insurance policies from ABC is that the transfer is a sale or exchange and could result in ordinary income to the corporation if the fair market value (FMV) of the policy exceeds the corporation’s basis in the policy.  In the ABC example, assume that the fair market value and basis of the two policies are as follows:

With ABC being an S corporation, the $200,000 gain on Jane’s policy will be passed through pro rata to both Jane and Betty.  Also of note is the fact that there is a loss on the policy on Betty’s life, since the basis exceeds the fair market value. However, losses on life insurance are not deductible and nor can the loss be used to offset the gain on Jane’s policy.

2) Taxation to the recipient of the life insurance. The second step in the analysis of the tax consequences of transferring life insurance from a corporation relates to the taxation to the recipient of the policies. Depending upon the recipient’s relationship to the entity, the transfer can be characterized either as a payment to an owner, or as a payment to an employee.

With ABC, let’s assume that both Jane and Betty are employed by ABC and receive W-2 income in addition to being owners. One option is for the transfer to be treated as payment to each as employees. Assuming that these amounts are reasonable compensation, and the deduction is justifiable, ABC will deduct an additional compensation expense of $1,750,000, Jane will have $750,000 of additional ordinary income as a result of her receipt of Betty’s policy and Betty will have $1,000,000 of ordinary income as a result of her receipt of Jane’s policy. 

It is important to highlight that most insurance companies do not issue a 1099-R upon change of ownership, so tax reporting will not be a guide as to what amounts are taxable (or whether they are taxable). For similar reasons, Jane and Betty should personally track their respective basis in the policies after the transfers, including the amount each was taxed on with the transfer of the policies.

An alternative is to treat the transfers as payments to Jane and Betty as shareholders of ABC. Given that ABC is an S corporation, and that ABC is owned 50/50, this results in pro rata distributions to Jane and Betty of $875,000 each. Depending upon whether ABC has any accumulated earnings and profits (AE&P) and their respective basis in ABC, the distributions may or may not be ordinary income. 

Let’s assume that ABC has always been taxed as an S corporation and that there is not any AE&P. As seen below, the distributions will result in a reduction of each shareholder’s basis in ABC but will not produce additional tax.

If ABC operated as a C corporation prior to making its S-election — and there is AE&P — each shareholder’s Accumulated Adjustments Account (“AAA”), Previously-Taxed Income (“PTI”) and AE&P accounts, in that order, will be relevant to calculating the taxation of distributions, if any.

3) Transfer-for-value and reportable policy sale. Beyond the possible immediate income tax consequences discussed above, there are also rules that apply to transfers of life insurance that could result in the death benefit over and above the basis in the policy being taxable as ordinary income. These rules are triggered upon the transfer of a life insurance policy — or an interest therein (e.g., naming a co-shareholder as beneficiary, endorsement of death benefit, etc.) — for valuable consideration. Essentially, with anything outside of a gratuitous transfer, analysis of these rules is paramount to avoiding taxable death benefit.

Fortunately, there are a number of exceptions to the transfer-for-value rule that will ensure the tax-free nature of the death benefit:

• Gain or loss in the hands of the transferee is determined in whole or part by reference to such basis in the hands of the transferee (“carryover basis”)
• Transfer to the insured
• Transfer to a partner of the insured
• Transfer to a partnership in which the insured is a partner
• Transfer to a corporation in which the insured is a shareholder or officer

With the example above, Jane receives ownership of the policy on Betty’s life and Betty receives ownership of the policy on Jane’s life. Of note, with the transfer-for-value rule, there is no exception for a transfer to a co-shareholder. Unless Jane and Betty are partners in a partnership or members in an LLC taxed as a partnership — this could be a partnership or LLC that is entirely unrelated to ABC — there does not appear to be an exception to the transfer-for-value rule, and any tax professional will recommend against these transfers. If Jane and Betty decide to create a partnership or LLC taxed as a partnership, it must be in existence at the time the life insurance is transferred from ABC.

There is also the matter of avoiding another rule that can create taxable death benefit that occurs when there is a “reportable policy sale.” A reportable policy sale refers to the acquisition of a life insurance policy where the acquirer does not have a substantial family, business or economic interest in the life of the insured. Like transfer-for-value, this is intended to ensure that owners of life insurance have an insurable interest in the life of the insured. Generally speaking, in a business context where policies are being transferred to other owners or to an entity to fund a buy-sell agreement, there should not be a reportable policy sale given the business and/or financial interests involved. 

With the current redemption agreement, ROR is the owner, beneficiary and premium payer of the four policies and each of the four owners shares in the overall premium equally with each bearing the cost of $192,500. In assessing the costs of converting the existing agreement to a cross-purchase, the premium payments will not be borne equally. Instead, here is an example of the prospective cost from Andi and Gene’s perspectives:

As reflected by the example above, the disparate cost of premium payments when insureds are of different ages and rating classes must be considered with a cross-purchase arrangement. Moreover, of greater concern is the situation where a shareholder departs, and the policies must be transferred among the remaining shareholders. This “shifting” of policy interests will require splitting the policies, payment of fair market value and are transfers for value. 

Let’s assume that Gene dies and his stock in ROR is purchased by the remaining shareholders. Subsequently, the life insurance for the surviving owners must be reallocated to continue to fully fund the cross-purchase. Below is a snapshot from Dave’s perspective of the ownership of life insurance after Gene’s death, given that each of the surviving owners now own 33.33% of the corporation, as opposed to 25% prior:

To obtain the additional insurance on John and Andi, Dave will need to purchase the requisite amount of insurance from Gene’s estate. Andi and John will need to do the same. Presumably, this will be after the three policies that Gene’s estate owns are split, resulting in two policies on each remaining shareholder’s life (six in total). In our example, Dave will purchase one policy on Andi’s life and one policy on John’s life, both from Gene’s estate. The parties should obtain the fair market value of the policy from the insurance company or from an appraiser and pay Gene’s estate that amount. As previously mentioned, this purchase will trigger transfer-for-value and, in the event that the purchaser does not otherwise meet an exception, the death benefit of the policies purchased will be income taxable.

To resolve many of the issues noted above, ROR should consider the creation of an LLC taxed as a partnership, to be owned equally by the existing shareholders. The LLC will be subject to the buy-sell agreement — which for all intents and purposes is a cross-purchase — and the LLC will be the nominal owner and beneficiary of the life insurance policies, as well as the premium payer. Only one policy per insured is required, as opposed to multiple policies with a cross-purchase as highlighted above. Notably, the shareholders can share in the aggregate premiums equally as they are paid by the LLC, putting them back in the same position they were in when the corporation paid the premiums.

Through book-keeping, the manager of the LLC will allocate the appropriate percentage of death benefit on each policy to the underlying shareholders. With ROR, it is relatively straightforward in that 1/3 of the death benefit on the life of each insured will be earmarked for each of the other owners. Upon the death of a shareholder, the manager will collect the death benefit in escrow and pay 1/3 of it to each of the surviving shareholders via a partnership distribution. The shareholders in turn will use the proceeds to purchase stock from the deceased shareholder.

Just as with a cross-purchase, the policy death benefit will need to be re-allocated upon the death or departure of a shareholder. In the case of ROR, the manager will re-allocate the death benefit on the lives of Dave, John and Andi so that Dave owns 1/2 of the death benefit on the lives of John and Andi, and so on. If this re-allocation triggers transfer-for-value — arguably it does not since the LLC continues to be the nominal owner and beneficiary of the policies, regardless of bookkeeping — the exception for “transfer to a partner of the insured” should save the day, regardless, since the LLC is taxed as a partnership.

Conclusion

The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.