The Supreme Court recently made a ruling in Connelly v. United States that has drastically changed the tax treatment of death benefit proceeds for buy-sell life insurance owned by a business entity. The case focused on how to value a company for estate tax purposes when the company uses life insurance proceeds to buy a deceased owner’s shares.
The new ruling states that life insurance proceeds used by the business to redeem or “buy-out” a deceased owner’s shares are now factored into the business valuation and included in the decedent’s estate in proportion to their ownership percentage. It also ignores the repurchase obligation as an offset to the market value of the business- which will cause the business valuation to be “inflated” by the death benefit proceeds since those will now fully count as a business asset.
This change will increase the taxable estate of business owners, and when coupled with the upcoming estate tax sunset in 2025, has the potential to subject business owners to much higher estate taxes.
This only applies to policies that are entity owned (owned by the business). Cross-purchase policies (ones owned by the individual owners on each other) are not subject to this ruling. Because cross-purchase policies are exempt, it’s strongly recommended that partnerships with two owners now utilize cross-purchase life agreements to satisfy any buy-sell needs.
For businesses with more than 2 owners, cross purchasing can become a burden as each owner needs to own a policy on each other owner, so a business with 4 owners would need to have a total of 12 policies. There are some work-arounds for companies with more than 2 owners, where companies can set up an Insurance LLC or a trust.
This is also an important time to review existing buy-sells. All business-owner clients should review their current policies to make sure they won’t be subject to additional tax. Give Wholehan a call for more details and assistance on your buy-sell cases.