Do You Have Life Insurance in Your Buy-Sell Agreement? Consider the Connelly Case

Buy-sell agreements are a common tool for manufacturers and wholesale distributors with multiple owners. One possible triggering event is the death of one of the owners. Upon the death, the surviving owners may have a contractual obligation to purchase the deceased owner’s business interest.

Buy-sell agreements are typically structured in one of two ways. Under a “cross-purchase agreement,” the surviving owner(s) purchase the interest of the deceased, individually. Under a “redemption agreement” , however, the business entity is obligated to purchase the interest of the deceased owner.  Often, the entity may own a life insurance policy on the deceased, the proceeds of which can be used to purchase the interest.

In the case Connelly v. United States,  the United States Supreme Court ruled that the life insurance proceeds paid to the business entity in a “redemption agreement” increased the “business value” of the entity. This impacted the deceased’s estate. There was no offsetting liability for the purchase of the deceased’s ownership. The court ruling stated “that a hypothetical third-party buyer would be willing to purchase the affected ownership based on the full value of the business including the life insurance proceeds”.  This was despite a contractual purchase obligation to acquire the deceased owner’s interest.

The  facts of the case are the following:

• Thomas Connelly and Michael Connelly were brothers and the owners of “Crown C Supply”, a corporation.
• Their buy-sell agreement stated that when one of the brothers passed away, the surviving brother had the first option to purchase the shares of the corporation.
• If the surviving brother declined, the corporation would be obligated to redeem the deceased owner’s shares using the company owned life insurance that was in place.
• The redemption price was to be determined by an outside valuator using “Fair Market Value” as the standard of value. Michael Connelly passed away in 2013.
• Thomas Connelly, despite the buy-sell agreement, did not have a business valuation performed. Thomas and his deceased brother’s son agreed on the redemption amount of  $3,000,000.
• The corporation then used $3,000,000 of the $3,500,000 life insurance proceeds to redeem Michael’s shares.

The Internal Revenue Service (IRS) audited the estate and had a different view of the corporation’s value. The IRS believed the life insurance proceeds received by the corporation increased the value of Crown C Supply.  The estate’s argument was that the corresponding redemption liability would offset the value of the life insurance received, and there should be no net increase in the value of Crown C Supply.

The District Court granted a summary judgement in favor of the IRS. Upon appeal, the Eighth Circuit Court of Appeals affirmed. This meant that the buy-sell agreement should be disregarded, and the life insurance proceeds should be included in the value of Crown C Supply.  There was no offsetting purchase obligation to decrease the value, according to the courts.

The United States Supreme Court considered the issue and upheld the decision of the lower courts. Thus, the Supreme Court ruled that the life insurance proceeds used to purchase the deceased owner’s share of the business was not reduced by the redemption obligation. The Supreme Court’s decision was unanimous.

There are additional questions that the Connelly decision did not address, such as:

• What if an actual business valuation was prepared?
  • What if the business owners were not related?
  • What are the implications of IRC Sections 2703(a) and 2703(b) that address business valuation?.

Implications of the Connelly Decision:

Closely held businesses should immediately revisit their buy-sell agreement to verify if it is a “redemption agreement” versus a “cross purchase agreement.”  The Connelly case only addresses redemption agreements.

The estate tax exemption is currently $13,990,000. If one’s estate value is under this threshold, the Connelly case may not be an issue. It would still allow for the possibility of a higher step-up in basis of the stock, which could be a benefit.

 Planning Strategies:

Owners of manufacturers and wholesale distributors should think carefully about their buy-sell agreements and life insurance policies.  Unfortunately, just transferring a life insurance policy out of the business is not as easy as one would believe. The complicated “transfer for value” rules of IRC Section 101(a)(2) need to be considered. If certain considerations are not addressed, the insurance proceeds may become taxable upon being transferred.

There are alternative structures to consider:

• Cross-Purchase Agreements: Owners buy and own life insurance on each other, avoiding the “redemption” issue.
• Irrevocable Life Insurance Trust (ILIT): Keeps the insurance proceeds out of the estate entirely.
• Special Purpose LLC: A separate entity owns the life insurance, removing it from the operating company’s value.
• Life Insurance Transfers: Though possible, these require careful review because of the “transfer for value” rules.

Each option has advantages and complexities. The right solution depends on your goals, ownership structure, and tax situation.

Take Action Before It’s Too Late

The Connelly case is a wake-up call. Succession plans must adapt to changes in law and tax treatment. Don’t wait until an audit—or worse, a death—exposes the flaws in your agreement.

The professionals at HBK Manufacturing Solutions Group can review your buy-sell agreement and help ensure your plan still meets your goals.

Call 330-758-8613 or email manufacturing@hbkcpa.com to start the conversation today.