Buy-Sale Agreements: Not as Simple as They Seem

In recent years, buy-sale agreements funded by life insurance policies have become a popular strategy by which small, closely-held businesses have ensured a smooth transition of ownership upon the death of one of the owners. However, the recent Supreme Court decision in Connelly v. United States has resulted in significant implications for business owners that have entered into these agreements, with ramifications that could result in substantial increased estate taxes if not addressed properly.

A buy-sale agreement (also known as a buyout agreement) is a contract entered into between a company and its owners, pursuant to which, the owners agree to sell, and the company agrees to purchase, the ownership interest of each owner upon their respective deaths.  In connection with entering into such agreement, the company will purchase life insurance policies on the lives of each owner.  The business pays the premiums on the policies and is therefore the owner and beneficiary of the policy.  So when an owner passes, the business can use the payout from the death benefit to fund the purchase of the deceased owner’s interests.

Michael and Thomas Connelly were the sole owners of a building supply corporation and were parties to such a buy-sale agreement.  When Michael died, the company used the proceeds from a $3.5 million death benefit that it received from the life insurance policy it had taken out on Michael to repurchase Michael’s shares from his estate for $3 million.  Michael’s estate reported the shares’ value at $3 Million to the IRS.  However, the IRS disagreed with the estate’s position, arguing that the $3.5 million in insurance proceeds should be included in the company’s value as a corporate asset.

The District Court and Eighth Circuit Court of Appeals sided with the IRS, and their decision was thereafter affirmed by the Supreme Court. In a unanimous decision by the Justices, the Supreme Court determined that the value of the company for tax purposes must be determined at the time just prior to the owner’s death, before the buy-sale agreement is triggered, at which point, the insurance proceeds remain an asset on the company’s books.  The Supreme Court further rejected the estate’s argument that the buy-sale agreement is a liability of the company that should offset the value of the life insurance proceeds.  As a result of the Supreme Court’s decision, Michael Connelly’s estate was required to pay an additional $889,914 in estate taxes.

The Supreme Court’s decision in Connelly highlights to the importance of careful estate planning for business owners and the value of periodic review of business succession plans to account for fluid legal developments. In light of the Connelly case, alternative business succession structures, such as the use of cross-purchase agreements between business owners, may be a superior alternative to traditional buy-sale agreements for many business owners.

If you are a business owner, and have a buy-sale agreement in place to facilitate the transition of ownership upon you or your business partners’ death, your attorneys at Hoge Fenton can assist you in determining the potential tax impact of such agreements in light of the Connelly decision.  We’re here to assist and advise on the best courses of action to avoid unintended tax pitfalls and help you achieve your business succession objectives.