Supreme Court Shakes Up Succession Plans
It’s Time to Rethink Your Business Succession Plans
The U.S. Supreme Court certainly carries some reputation for bringing major shifts to government policies, and it has been another headline and political year for the Supreme Court. Buried beneath all of the political news and more attention-grabbing headlines is a significant June decision that greatly impacts business ownership and succession planning: Connelly v. United States.
Case Facts
Michael and Thomas Connelly were co-owners of a corporation. Michael, who owned a majority of the business, passed away back in 2013, and his brother was the executor and sole surviving business owner. Their company (Crown C) purchased a $3.5 million life insurance policy on each brother (Crown C was the owner and beneficiary of the policy and each brother was the insured name), and each brother had agreed to purchase out the ownership of the business from the estate of the other brother who passed away.
Michael passed away, and the life insurance paid out to Crown C. Thomas then agreed to buy out Michael’s stake for $3 million dollars (they did not do a formal valuation). A later valuation when challenged by the IRS pegged it at $3.86 million.
When the case went to the Supreme Court, the Supreme court not only found that the business valuation should be $3.86 million, but they also ruled that the insurance proceeds ($3M) was also includable into Crown C’s value bringing it to $6.86 million. This resulted in an increase in estate tax due by almost $890,000 given estate tax rates in 2013!
Major Take Aways
The requirement to buy a deceased owner’s shares should not be treated like a liability or debt, but rather an exchange of shares for dollars which provides something of value to the firm (i.e., the buyback requirement does not offset the cash proceeds of life insurance)
Review any buy-sell agreements you may have in place at your company. Make sure you follow what it says (is a valuation needed?) Ensure you understand who or what entity owns and is the beneficiary of life insurance – is it includable in the estate or in the business valuation?
The death of buy-sell agreements. It’s likely the buy-sell agreement that may be in place is no longer the optimal structure for protection your business or estate.
A Better Option
For businesses with a few owners, a better choice to fund any estate liquidations would be a Cross-Purchase Agreement. The mechanics of a cross-purchase agreement are a bit more complicated but carry a few more strategic advantages.
Each owner enters into a cross-purchase agreement with all the other owners to buy outstanding shares from a deceased member or owner.
Each owner purchases and pays for a life insurance policy on all the other owners. (Note: this moves the value of the insurance into the estate of the policy owner, and they need to be making the premium payments)
On death, each surviving owner receives an insurance payout and uses the proceeds to buy the deceased owner’s interest.
On death, this would keep insurance from inflating the value of the business for redemption purposes and estate value purposes which may be includable in a Buy-Sell agreement.
On death, this allows the other owners to receive an increased basis on their ownership as they are buying shares at the current value rather than the entity redeeming the shares directly which would occur within a Buy-Sell agreement.
Image Source: www.yourlifeinsurance101.com
There are some difficulties with cross purchase agreements as well. More insurance contracts need to be bought with a cross-purchase structure compared to a buy-sell agreement. Whereas a buy-sell agreement would have N contracts (n being the number of owners), a cross-purchase agreement requires N x (N – 1) contracts. The more owners there are, the more complicated this structure becomes. If you have a significant owner base, it may make more sense to set up an LLC structure to hold the life insurance of owners rather than every individual.
Another difficulty would be the disparate costs between individuals. If your ownership has a large age gap, the insurance costs could be significantly different. Your planning would need to address the impact on current cash flow and potentially different impacts across your ownership structure.
The Bottom Line
This decision is a major change to how business succession planning has been done historically and could have significant impact on your current structure or how you should design your business structure. If you have any questions or feel like you need to address your business succession planning, reach out to us, and we’ll be happy to discuss how Connelly may impact you.
Read more about Connelly here: The Supreme Court Blows Up a Popular Small-Business Succession Plan - WSJ
Read more about Cross-Purchase Agreements here: Cross Purchase Agreement - Overview, How It Works, Example
