Many corporations, partnerships, and limited liability companies have adopted buy/sell agreements that address transactions and transfers upon the occurrence of specifically defined events. Often, buy/sell agreements address what happens when an owner (a member, shareholder, or partner) becomes disabled, divorces a spouse, files for bankruptcy, or separates from the company. Additionally, buy/sell agreements usually restrict an owner from transferring an interest without first obtaining the entity’s consent or offering the interest to the other owners. However, a buy/sell agreement’s principal purpose is to specify the terms for the transfer of an owner’s interest upon the owner’s death. Typically, the agreement identifies the potential buyer(s) of a deceased owner’s interest, the value of the interest, and the purchase method (promissory note, loan, or cash).
Life insurance is often sold to fund buy/sell obligations on account of the death of an owner because it provides income tax-free proceeds at the exact moment when cash is required. Buy/sell arrangements funded with life insurance fall into two general categories:
- Redemption Agreements
With a Redemption Agreement, an entity owns life insurance policies on the life of each owner. When the owner passes, the entity purchases or redeems the deceased owner’s interests.
- Cross-Purchase Agreements
In a cross-purchase arrangement, each owner purchases policies on all other owners. When an owner dies, the remaining owners collect the proceeds of the policies insuring the deceased owner’s life and use those proceeds to purchase the deceased owner’s interest. The remaining owners receive some tax benefits with this type of arrangement. However, as the number of owners increases, the arrangement becomes difficult to manage, as the total number of policies required rapidly increases. As a result, it has been common for entities with more than 2 owners to enter into Redemption arrangements.
Planners have often questioned the effect of life insurance proceeds on the entity’s value for transfer tax purposes. The value of an entity must increase upon receiving life insurance proceeds, because the company has received an influx of cash. However, planners assumed that the increase in the entity’s value would be offset by the entity’s obligation to use the insurance proceeds to purchase the deceased owner’s interest. The insurance proceeds would flow into the entity and flow out to the estate of the deceased owner. In a recent United States Supreme Court case, that assumption was proved wrong.
In the 2024 case Connelly v. Commissioner, the U.S. Supreme Court held that insurance proceeds increased the value of the entity without a deduction for the purchase of the deceased owner’s interest. The result was that the deceased owner’s estate was larger and had a significantly greater estate tax liability. The ruling in Connelly directly overrules Estate of Blount v. Commissioner, a 2005 Federal Circuit Court of Appeals case that concluded insurance proceeds should not be included in the value of an entity where the proceeds are used to redeem a deceased owner’s interest.
Interestingly, the buy/sell agreement in Connelly determined the entity’s value either by the annual agreement of the two owners or by averaging two or more appraisals. In Connelly, the owners did neither. Instead, they agreed to a value for the interest that was very close to the insurance proceeds received by the entity. Although the U.S. Supreme Court did not mention the failure to follow the agreement as a factor in reaching its decision, one cannot help but question whether it was a factor in overruling Blount and including the insurance proceeds in the entity’s value.
So now what?
Many entities with Redemption Buy-Sell Agreements now face the prospect of paying transfer tax on the entity’s insurance proceeds. These entity owners should consult with their counsel and advisors, because there are ways to remedy this situation. The first, and perhaps the most obvious, step is to remove the insurance from within the entity. How these proceeds are removed depends on the intersection of the type of insurance policy and the type of entity. Nevertheless, there are two basic methods: distribution from the entity to an owner (e.g., dividends, partnership distributions, etc.) or sale of the policy by the entity to the other shareholders. To alleviate the multiple-owner problem, entity-owned life insurance can be sold or transferred to a specially-drafted Trust or Partnership that will own all the policies and distribute death benefit proceeds according to the Trust or Partnership Agreement, allowing the remaining owners to purchase the deceased owner’s interest. When moving insurance policies, care must be taken to comply with exceptions to the Transfer-for-Value Rule (IRC §101). Violating the Rule causes death benefit proceeds to be taxed as ordinary income.
Connelly has changed the buy-sell landscape, making Redemption-based arrangements less desirable. For new entities, trusts and insurance partnerships can be used to address the multiple-policy problem. However, for existing Redemption arrangements, owners must consider the best way to move policies from the entity without violating the Transfer-for-Value Rule.
Christopher R. Gray is a Member of Norris McLaughlin, P.A. in the firm’s Allentown office, practicing Taxation and Estate Planning and Administration & Wealth Preservation. In addition, Christopher is experienced in corporate matters, business transactions, exempt organizations, health care governance, and elder law.
