In a major unanimous decision (Connelly v US) sure to cause revision of many business succession plans, the US Supreme Court earlier this month on June 6, 2024, rejected use of a corporate redemption obligation as an estate deduction.
While the Court pointed out in a footnote that the decision did not necessarily preclude deduction for corporate redemption in all cases, for example where terms require the redemption to be made by liquidating assets, the vast majority of these business succession agreements involve use of life insurance to supply funds. The difference is that those funds are automatically deemed to increase the value of decedent’s shares at death, before redemption is made.
This case involved two brothers owning a supply business they wanted to keep in the family. Their agreement was that upon death of one of them, the other was to buy the decedent’s shares. Failing that, the corporation was to redeem the shares. Corporation purchased life insurance to fund this ability. As noted above, the death of one of them caused insurance proceeds to accrue to the corporation, increasing the value of all shares including decedent’s.
The above method has been commonly used since it was blessed under the 2005 case of Estate of Blount, despite concerns leading to its rejection by SCOTUS. Too often, industry inertia takes over with financial planners and some attorneys go along too easily as non-lawyers devise these structures that make no legal sense.
The other common method of business succession planning involves a cross-purchase agreement under which both brothers would agree to buy and maintain life insurance on each other, for use to buy each other out. This avoids the proceeds accruing immediately to the corporation and therefore the decedent’s estate, as happens with corporation-owned policies. Also, the purchaser enjoys increased tax basis. There are drawbacks with this method as well, as one shareholder may fail to maintain a policy, and the arrangement may become unwieldly with a large number of shareholders.
There are hybrid methods available that are often a better choice than the two basic options of redemption and cross-purchase. One of my favorites is that allowed under PLR 200747002: an LLC with an independent manager is set up to own the life insurance policies in such a way that the proceeds are kept out of the owners’ taxable estates, to a degree (the proceeds will be in the insurance LLC which is owned by the company shareholders, so their estates increase — including decedent’s — but minority shares in the LLC are entitled to substantial valuation discounts for lack of marketability and control). Another benefit is that the proceeds are shielded from creditors of both the owners and the operating business, rather than one or the other.
Although estate tax exclusions are high now, under current law they will be cut in half and may be cut even further given budget concerns, so I expect many business owners to revise their succession plans ASAP, or at least consider doing so. Shares in the subject company may also be eligible for minority valuation discounts for lack of marketability and control, but the hybrid solutions may offer more advantages.
