Connelly v. IRS Makes Buy-Sell Agreements More Important

Future advisor with briefcase on the road to success

Buy-sell arrangements, designed to ensure the orderly transfer of business ownership upon specific triggering events like death, disability, or retirement, have become increasingly critical in today's complex business environment.

For business owner clients, now is the time to review and possibly update their buy-sell arrangements, ensuring that they are adequately funded and aligned with current legal standards.

This proactive approach is especially important in light of the Supreme Court's recent decision in Connelly v. IRS, which highlights the significance of well-drafted and properly funded agreements.

The Supreme Court Ruling

A buy-sell agreement eliminates uncertainty by establishing a guaranteed buyer for an owner's shares and setting a fair selling price.

The Connelly v. IRS case focused on a critical issue: whether a company's contractual obligation to redeem a deceased person's shares at fair market value offsets the value of life insurance proceeds committed to funding that redemption.

The Supreme Court sided with the IRS. It ruled that a corporation's contractual obligation to redeem shares is not necessarily a liability that reduces a corporation's value for federal estate tax purposes.

This ruling has far-reaching implications for business owners, who may face extra estate taxes due to the effects of life insurance proceeds.

The Role of Life Insurance

The ruling shows the necessity of buy-sell agreements that not only facilitate business transitions but also offer protection against adverse tax consequences.

If a business owner passes away without a buy-sell agreement, the remaining owners could find themselves in business with a deceased owner's family, leading to operational and financial turmoil.

Conversely, a well-structured agreement, often funded with life insurance, ensures liquidity and fair value distribution, providing peace of mind for all parties involved.

Funding is a critical component of any buy-sell agreement.

Life insurance provides immediate liquidity, essential for buying out the departing owner's interest.

This is particularly beneficial, as it prevents the need for the business or surviving owners to scramble for funds or take on significant debt.

Life insurance proceeds are generally income tax-free, making them a cost-effective solution compared to other funding methods, such as loans or installment payments.

The types of buy-sell agreements vary, including entity purchase agreements, cross-purchase agreements, and hybrid models, like LLC insurance.

Each has its own advantages and complexities, but all aim to ensure that business ownership transitions smoothly and that the business remains viable.

In light of the Supreme Court's decision in Connelly v. IRS, it's clear that many insurance-funded buy-sell agreements need to be reviewed.

Reviewing and updating your buy-sell arrangements – and the insurance that funds the plan – can safeguard your business and provide financial security for your family and co-owners.

Jack Elder is senior vice president of advanced markets at CBS Brokerage.