Estate Planning Lessons from the Connelly Case: Avoiding Costly Tax

Life insurance is commonly used to fund buy-sell agreements and provide liquidity when an owner passes away. Historically, many business owners assumed these arrangements had little impact on the overall value of the business. The Connelly case challenges that assumption and highlights a potential gap in many existing agreements. This case was decided in the Eighth Circuit Court of Appeals, which includes Nebraska, making its implications especially relevant for business owners in our region.

A Summary of the Connelly Case

At a high level, the Connelly case addressed how a business should be valued for estate tax purposes when it receives life insurance proceeds following the death of a shareholder. Historically, many believed that while life insurance proceeds increased the company's assets, there was an offsetting obligation to redeem the deceased owner's shares. As a result, many assumed the two effectively canceled each other out when determining value. The Supreme Court disagreed.

The Court held that life insurance proceeds received by the business increase the value of the company, even when those proceeds are intended to fund a shareholder redemption. As a result, the value of a deceased owner's interest may be higher than many business owners anticipated.

Why This Creates a Problem

The challenge is that many existing buy-sell agreements were drafted before the Connelly decision and may not account for this valuation treatment.

Consider a simplified example:

• A business is worth $3 million.
• Two shareholders each own 50%.
• The business owns a $1.5 million life insurance policy on one of the shareholders.
• When that shareholder passes away, the business receives the $1.5 million insurance payout.

Under older buy-sell arrangements, the deceased shareholder's estate might receive a $1.5 million buyout based on their 50% ownership interest in the $3 million company. However, the IRS may view the company as being worth $4.5 million after receiving the insurance proceeds. In that case, the deceased shareholder's interest could be valued at $2.25 million for estate tax purposes.

What This Means in Practice

The example above highlights several practical implications that business owners should not overlook:

A Higher Taxable Estate

In this example, the value included in the estate increases by 50%, from $1.5 million to $2.25 million. This increases the decedent’s taxable estate, which may not impact every business today but becomes more relevant for larger estates approaching the federal exemption, or where state-level estate or inheritance taxes apply. For those estates, a life insurance-funded redemption structure could lead to a meaningfully higher tax liability than expected.

A Circular Funding Problem

The life insurance was intended to fully fund the buyout. However, once the proceeds are received, they increase the value of the business, which in turn increases the price of the shares being redeemed. In effect, the funding target moves as soon as it is met. This creates a situation where the insurance proceeds alone may no longer be sufficient, requiring additional liquidity from the company at the time of redemption.

A Mismatch Between Cash Received and Taxes Owed

In scenarios where the buy-sell agreement still pays $1.5 million but the IRS values the interest at $2.25 million, the estate may owe taxes on value it never actually received. While the buyout proceeds will often be enough to cover the additional tax, the result is a larger estate tax bill than the funding was sized to anticipate, leaving less for the heirs.

What Business Owners Should Review Now

The Connelly decision does not mean every buy-sell agreement is flawed, but it does highlight the importance of reviewing existing arrangements. Business owners should consider:

1. How the Buy-Sell Agreement Determines Value

Many agreements contain valuation formulas that focus only on the operating value of the business. Those provisions may need to be revisited to ensure they reflect current estate planning considerations. Regular reviews are especially important if the agreement has not been updated in several years or if ownership structures have changed since it was drafted.

2. Who Owns the Life Insurance Policy

The ownership structure of life insurance policies can have a significant impact on both valuation and tax outcomes. When the business owns the policy, the proceeds generally become an asset of the company, which is the issue highlighted in Connelly. As a result, some business owners are exploring alternative structures that may better align with their succession planning goals.

Alternatives Worth Considering

1. Cross-Purchase Agreement

One option that has gained increased attention following Connelly is a cross-purchase arrangement. Under a cross-purchase structure, shareholders own life insurance policies on one another rather than having the business own the policies. Because the insurance proceeds are paid directly to the surviving owners rather than the company, this approach may help avoid some of the valuation concerns raised by the case. Cross-purchase arrangements can also provide additional tax benefits, including a higher cost basis in the acquired shares.

2. Insurance LLC or Similar Shared-Ownership Structure

For businesses with multiple owners, a traditional cross-purchase arrangement can become difficult to manage because each owner must hold a separate policy on every other owner, and the number of policies grows quickly as owners are added. As a result, some organizations use alternative structures such as a limited liability company, partnership, or trusteed arrangement to hold life insurance policies outside the operating business.

These structures can simplify administration while still addressing the valuation concerns highlighted in the Connelly case. The appropriate structure depends on the number of owners, the value of the business, and long-term succession objectives.

Plan for the Future With Lutz

The Connelly decision did not create a new estate planning issue so much as it exposed one that may already exist in many business succession plans. For companies with buy-sell agreements funded by company-owned life insurance, now is a good time to revisit those arrangements and confirm they still work as intended. A proactive review today can help prevent unexpected tax consequences and provide greater certainty for owners, their families, and the next generation of business leadership.

Because these issues often involve multiple moving pieces, business owners benefit from evaluating them through several lenses. The valuation methodology used in a buy-sell agreement can directly impact estate tax exposure. Ownership structures for life insurance policies can influence both tax outcomes and succession planning objectives. In some cases, these considerations may even affect future transaction or exit planning decisions.

At Lutz, our Business Valuation, Tax Planning, and M&A professionals regularly work together to help business owners navigate these complex decisions. By bringing multiple perspectives to the table, we help clients evaluate how ownership structures, valuation approaches, and long-term business goals align before a triggering event occurs.

Whether you're reviewing an existing buy-sell agreement, updating an estate plan, or preparing for a future ownership transition, a coordinated approach can help ensure your strategy achieves the outcome you intended. Contact us to learn more.