By Eric Reich
For about a century now, most life insurance laws have been generally stagnant and therefore (for lack of a better term) reliable. This changed last week in a potentially very impactful way when the Supreme Court ruled on an ongoing case known as Connelly vs. United States, involving a buy-sell agreement between two brothers.
First, what is a buy-sell agreement? A buy-sell agreement is where parties agree to how shares of a business interest are to be sold or transferred upon one of the party’s death, disability, or retirement. Having a buy-sell in place can help eliminate potential problems that can arise during these events by agreeing to everything in advance. The issues addressed in a buy-sell agreement can include the price of the shares, who is allowed to or is compelled to buy the shares, and the circumstances under which rights or obligations occur. In my opinion, having a buy-sell agreement is crucial for business owners who have partners and want the business to continue after they leave the business.
Buy-sell agreements can be funded or unfunded. A funded buy-sell typically has some mechanism to help the other party afford to buy the exiting partner’s shares. This could include a sinking fund where the partners deposit part of their distributions to an account to help fund the future buy-sell event. The most common way to fund a buy-sell, however, is to use life insurance. The way life insurance is used is for the partners to buy life (or disability) insurance policies on each other, and then use the proceeds to buy the other partners’ shares of the company out from their estate. This is known as a cross-purchase agreement.
While this is often the easier way to structure a buy-sell, in some instances, particularly when there is a larger number of partners, having everyone buy a policy on each partner can become overly complicated. In these cases, an entity purchase agreement is established instead of a cross-purchase. The company itself buys the policy on each partner, thereby reducing the number of policies to be purchased and managed.
These are the ways that the vast majority of funded buy-sell agreements work. The surprising decision started when in the Connelly case, the IRS argued that the entity purchase of the shares of one of the deceased party’s shares should add to the value of the company. The IRS claimed that since the deceased partner owns part of the company, the value of his estate should be increased by the amount of the life insurance proceeds. This is based on the idea that life insurance you personally own at your death is included in your gross estate. The unusual aspect is that it wasn’t owned by the decedent, but rather by the company that he was a part-owner of. The case was appealed in the 8th Circuit but was upheld. The case was later appealed to the Supreme Court, which upheld the decision 9-0. This ruling has major potential tax implications. In this case, the tax due was increased by almost $900,000.
So, what can we take away from the Connelly case? First, review your buy-sell agreements with your attorney to see if the Connelly decision affects you. If it does, you might want to explore a cross-purchase agreement. You’ll want to discuss this with your CPA. Next, you may want to review your life insurance policies themselves to make sure they are still structured the way you want them to be. Also, make sure that the valuation for the shares is updated and accurate. If not, seek an updated professional valuation. Lastly, make sure your documents are up to date, reflecting your intended structure and valuation.
By checking your current buy-sell agreement with the help of your CPA, attorney, and financial advisor, you could potentially save yourself a lot of headaches and potentially even more taxes.
Securities offered through Kestra Investment Services, LLC (Kestra IS), member FINRA/SIPC. Investment advisory services offered through Kestra Advisory Services, LLC (Kestra AS), an affiliate of Kestra IS. Reich Asset Management, LLC is not affiliated with Kestra IS or Kestra AS. The opinions expressed in this commentary are those of the author and may not necessarily reflect those held by Kestra Investment Services, LLC or Kestra Advisory Services, LLC. This is for general information only and is not intended to provide specific investment advice or recommendations for any individual. It is suggested that you consult your financial professional, attorney, or tax advisor with regard to your individual situation. To view form CRS visit https://bit.ly/KF-Disclosures.
Eric is President and founder of Reich Asset Management, LLC. He relies on his 25 years of experience to help clients have an enjoyable retirement. He is a
Certified Financial Planner™ and Certified Investment Management AnalystSM (CIMA®) and has earned his Chartered Life Underwriter® (CLU®) and Chartered Financial Consultant® (ChFC®) designations.
