By William G. Smith, LL.M., Alexander M. Parthemer, LL.M., and Richard C. Vaughan, LL.M.
In the recent U.S. Supreme Court decision Connelly v. United States, 602 US__ (2024), the Court tackled the complex issue of how redemption buy-sell agreements affect the valuation of a closely held business for estate tax purposes. The Court centered its analysis around whether the company’s contractual obligation to redeem the shares of a deceased owner creates a liability that offsets the value of the life insurance proceeds received by the company upon the owner’s death. The Court held that the obligation to redeem the deceased owner’s shares does not reduce the value of the company, affirming that the fair market value of the company as of the decedent’s death includes the value of the life insurance proceeds. The Court went on to state that its holding is purely a product of how the Connelly brothers structured their agreement, leaving room for alternative structures that may lead to a more favorable estate tax result.
In deciding Connelly the Court sought to resolve a circuit split, which occurs when two or more Federal Circuit Courts of Appeal have reached opposite conclusions on the same issue. For context, here is a timeline of decisions:
a. In 1999, the Ninth Circuit (Alaska, Arizona, California, Hawaii, Idaho, Montana, Nevada, Oregon, Washington) held life insurance proceeds received by a business may be offset by the obligation to redeem shares in the business. Estate of Cartwright, 183 F.3d 1034 (purchase of a deceased shareholder’s stock in a law firm).
b. In 2005, the Eleventh Circuit (Alabama, Florida, and Georgia) held the redemption obligation is an enforceable liability and may offset the value of any life insurance proceeds in valuing the company. Estate of Blount, 428 F.3d 1338 (11th Cir. 2005).
c. In 2023, the Eighth Circuit (Arkansas, Iowa, Minnesota, Missouri, Nebraska, North Dakota and South Dakota) rejected the offset argument and held no offsetting liability existed. Estate of Connelly, 70 F.4th 212 (8th Cir. 2023).
Crown C Supply (“Crown”), a small building and supply corporation, was owned and operated by two brothers, Michael and Thomas Connelly. As part of their succession planning, the brothers established a cross purchase/default redemption buy-sell agreement. In the agreement, the surviving shareholder had the option to purchase some or all of the deceased shareholder’s shares, and, to the extent the surviving shareholder elected not to exercise such option, Crown was obligated to redeem (purchase) the deceased shareholder’s shares. The purchase price was to be a price set annually by the shareholders or obtained via appraisals (neither was ever actually done). Crown purchased $3.5 million of life insurance on each brother to fund the redemption, and Michael died owning a little over 77.18% of the company (Thomas owned the remaining 22.82%). Thomas, as the executor of Michael’s estate, reached an agreement with Michael’s son that the value of Michael’s shares was $3 million, and therefore the value of the entire company was $3.86 million. Crown then redeemed Michael’s shares using $3 million of the life insurance proceeds, leaving Thomas as the sole shareholder. Thomas filed an estate tax return on behalf of Michael’s estate reporting that the value of Michael’s shares was $3 million on Michael’s date of death.
Under the estate’s argument that the obligation to redeem the shares is a liability that offsets the value of life insurance proceeds used to redeem the shares, the value of the company is not changed by the redemption of 77.18% of the shares. The Court rejected the estate’s argument, reasoning that a redemption requires the value of the company to change, quoting the District Court’s opinion while explaining that when a shareholder redeems his shares he “is ‘essentially cashing out’ his shares of ownership in the company and its assets” which necessarily reduces the company’s total value.
Ultimately, the Court concluded that a third-party purchaser, in an arms-length transaction, would disregard the contractual obligation under the redemption agreement. This prospective purchaser would be purchasing an asset that includes a share of the life insurance proceeds and the business assets.
Redemption buy-sell agreements historically have been utilized for their simplicity. Often the business will purchase life insurance policies on each owner, and upon an owner’s death, use those proceeds to redeem the shares. Cross-purchase agreements offer some unique advantages over the redemption agreement, including providing stepped-up income tax basis for the shares purchased by the surviving owners; however, when dealing with more than two owners, a cross-purchase agreement quickly becomes complicated, as each owner purchases a policy on the life of every other owner (e.g., a business with three owners would require six policies).
Under current law, two variations of a cross-purchase agreement offer potential solutions: the trusteed buy-sell agreement and the special purpose buy-sell insurance LLC. Both variations call for the use of a separate entity to purchase a single policy on each owner’s life. These variations simplify the cross-purchase agreement in some ways but also introduce potential new difficulties.
In a trusteed buy-sell agreement, a Trust purchases life insurance policies on each of the owners. To pay the insurance premiums, the participating owners make contributions to the Trust. Upon the death of an owner, the Trustee of the Trust receives the insurance proceeds and distributes them to the surviving owners. Using the distribution from the Trust, the surviving owners then purchase the ownership interest from the deceased owner’s estate pursuant to the cross purchase agreement.
Careful consideration should be taken to avoid any potential income tax consequences or estate tax inclusion consequences. While life insurance proceeds are generally exempt from income taxation, the “transfer for value” rule provides that when a life insurance policy is transferred for something of value, the death benefit is subject to tax as ordinary income. Exceptions to the transfer for value rule include transfers to a partnership by a partner, to a partner (from a partnership or another partner), and to a corporation by a shareholder or officer; however, notably missing are transfers from a corporation to a shareholder. Corporations which currently own life insurance policies must be cautious in shifting from a redemption-based buy-sell agreement to a cross purchase agreement. It may be easier to terminate the policies and obtain new ones, if possible. Concern is not only with the initial transfer, though, as the IRS could argue that upon the death of the first owner, the remaining owners increase their beneficial interest in the remaining policy. The IRS has not yet taken such a position, and it would not apply to partners in a partnership, but it is worth noting.
On the estate tax side, life insurance proceeds are included in an insured’s taxable estate when the insured had incidents of ownership in the policy. To avoid incidents of ownership in a trusteed buy-sell arrangement, the insured-owner cannot have the right to revoke or amend the trust. Additionally, if the insured is able to serve in the capacity of Trustee, the insured has incidents of ownership and therefore the proceeds are included in the insured’s taxable estate upon death. Using an irrevocable trust while limiting the power to remove and replace the Trustee to an independent party could solve the estate tax inclusion problem.
Similar to the trusteed buy-sell agreement, the insurance-only limited liability company (LLC) uses a separate entity, an LLC, to purchase and manage the life insurance policies on the business owners. The members of the LLC are the business owners, and the manager is an independent party. By default the LLC is treated as a partnership for tax purposes.
Each member of the LLC is required to make contributions to the LLC equal to the premium on any life insurance policies contributed by the member (or similar arrangement). This allows the manager to maintain a capital account based on the contributions and to allocate the life insurance proceeds only to the member(s) who contributed the premiums (avoiding the issue in Connelly, if careful records are maintained). There are several methods of allocating the contributions and the death benefit proceeds (generally, the method used for the contributions should be the same as the method used for the death benefit proceeds), and consideration should be given to each, based on the facts and circumstances of each situation.
The same care must be taken to avoid estate tax inclusion as with a trusteed buy-sell agreement: keep control in an independent manager (to avoid incidents of ownership) and do not vest any interest in a policy on the insured-member (if a member opts out, the distribution rules in the LLC operating agreement should restrict funding the redemption with the policy on the insured-member’s life).
Treatment of an insurance-only LLC as a partnership under the Internal Revenue Code, and, ultimately, the application of the safe-harbor exception to the transfer for value rule when contributing life insurance policies to the insurance-only LLC, are not guaranteed, with the IRS potentially challenging the valid business purpose of the LLC and the control held by the owners. Further, in Revenue Procedure 2022-3, the IRS provided that it will not issue a ruling on either issue. However, several private letter rulings predating the Revenue Procedure contain reasons for taxpayers to believe that the insurance-only LLC will be a valid partnership for tax purposes. PLR 200747002 even considers terms that can be included in an LLC operating agreement for an insurance-only LLC that will help taxpayers avoid one member being deemed to have incidents of ownership in a policy on the life of another member. In light of Connelly, the IRS may look to attack this LLC structure by determining that the allocation of life insurance proceeds to the surviving members lacks the “substantial economic effect” required by the partnership tax regulations for an allocation to be respected.
The special purpose buy-sell insurance LLC provides a familiar structure to business owners and allows for an alternative to the redemption buy-sell agreements in light of Connelly; however, there are significant administrative hurdles and costs associated with such an agreement. The insurance-only LLC will need to make annual filings with the secretary of state in its state of organization, maintain proper books and records to reflect proper capital account allocations, prepare annual minutes, file a Beneficial Ownership Information Report under the Corporate Transparency Act, and file annual income tax returns.
Accordingly, while several options exist for small business owners after the Connelly decision, the issues raised by the Court, recent regulations, and even the Corporate Transparency Act present a host of issues that must be considered when creating new policies or altering existing policies for compliance with current law.
This article originally appeared in the Best Lawyers® “Best Law Firms” 2025 publication on November 7, 2024. For additional information or questions regarding estate planning and tax planning, we urge you to contact the authors of this article or a representative of Jones Foster here.
The information provided in this article does not, and is not intended to, constitute legal advice; it is for general informational purposes only. No reader of this article should act or refrain from acting on the basis of this information without first seeking legal advice from counsel in the relevant jurisdiction to ensure the information contained herein – and your interpretation of it – is applicable or appropriate to your particular situation.
Jones Foster shareholder Bill Smith is vice chair of the Corporate & Tax practice group and a member of the Private Wealth, Wills, Trusts & Estates team who concentrates his practice in the areas of estate planning, estate and trust administration, taxation, and transactional corporate law. He provides counsel to businesses, private foundations, and charities in matters that include business succession planning, transfers of business interests, LLC and S corporation creation, governance documents, mergers, and Treasury Regulation compliance.
Bill earned his Master of Laws (LL.M.) in Taxation degree from the Graduate Tax Program at the University of Florida. He has been consistently selected by his peers for inclusion in The Best Lawyers in America for Corporate Law and Trusts and Estates in the West Palm Beach metro area.
Jones Foster attorney Alex Parthemer is a member of the Corporate & Tax and Private Wealth, Wills, Trusts & Estates teams who focuses his practice in the areas of estate planning, probate and trust administration, tax planning, business planning, and transactional corporate law.
He represents business owners and family offices in a wide range of corporate matters, including corporation, LLC, and LP entity formation, mergers and acquisitions, buy-sell agreements, dissolutions, tax-free reorganizations, conversions, and annual filings.
Alex holds a Master of Laws degree (LL.M.) in Taxation from the Graduate Tax Program at the University of Florida.
Jones Foster attorney Richard C. Vaughan is a member of the Corporate & Tax and Private Wealth, Wills, Trusts & Estates teams and concentrates his practice in estate planning, trust and estate administration, business planning, and transactional corporate law.
He is experienced in creating and maintaining corporate structures within the context of a client’s estate plan, including drafting operating agreements, buy-sell agreements, entity restructuring, and related agreements among shareholders and partners.
Richard earned his Master of Laws degree (LL.M.) in Estate Planning from the Heckerling Graduate Program at the University of Miami School of Law.
Jones Foster is celebrating its Centennial year as a full-service commercial and private client law firm headquartered in West Palm Beach, Florida, with offices in Palm Beach and Jupiter. Tracing its roots back to 1924, the firm has served as an integral part of South Florida’s growth and prosperity. Through a relentless pursuit of excellence, Jones Foster delivers original legal solutions that help clients, colleagues, and the community to move forward. A significant number of attorneys have received the designation of Board-Certified Specialist by The Florida Bar in their specific practice area. The firm’s practice groups include Complex Litigation & Dispute Resolution; Corporate & Tax; Land Use & Governmental; Private Wealth, Wills, Trusts & Estates; Real Estate; and Trust & Estate Litigation. For more information, please visit www.jonesfoster.com.
