The U.S. Supreme Court’s recent decision in Connelly v. United States is placing another hurdle on small business owners when dealing with buy-back agreements upon the death of a shareholder. The question presented to the Supreme Court in Connelly was whether the proceeds of a life insurance policy taken out by a closely held corporation on a shareholder to facilitate the redemption of a shareholder’s stock should be considered a corporate asset in valuing the deceased shareholder’s shares for estate tax purposes.

Prior to Connelly, some courts held that a redemption agreement is an obligation of the corporation to buy the shares, and this obligation, for valuation purposes, offsets life insurance proceeds received by the corporation to redeem the deceased’s shares. However, the court in Connelly had a different view and, in a unanimous opinion, held that, for federal tax purposes, the corporation’s contractual obligation to purchase the deceased shareholder’s shares does not necessarily diminish the value of the shares. The requirement of a business to purchase under a redemption agreement is not necessarily a liability that reduces a corporation’s value for purposes of the federal estate tax.

The facts surrounding the court’s decision in Connelly involved two brothers, Michael and Thomas Connelly, both owners of a roofing and siding company (Crown). The brothers entered into a buy-back agreement, which provided that upon the death of one of the brothers, the surviving brother was allowed to purchase the shares of the deceased brother. However, in the event the surviving brother refuses to purchase the deceased brother’s shares, the corporation, as required under the buy-back agreement, must purchase the shares.

To ensure there was enough cash to fulfill this requirement in the buy-back agreement, Crown purchased a $3.5 million life insurance policy for each brother. In 2013, when Michael died, Thomas chose not to purchase Michael’s shares. As a result, Crown was obligated to redeem the shares and used the life insurance payout to cover the cost of the shares redeemed from Michael’s estate, which Thomas valued at $3 million. Michael’s estate then paid taxes on the $3 million.

The issue began when the IRS audited the estate and disputed the valuation of Michael’s shares. The IRS argued that the $3 million in life insurance proceeds used to redeem the shares should be included in the valuation to determine the fair market value of Michael’s shares. The court agreed with the IRS and reasoned that although a redemption agreement, which contractually requires a corporation to repurchase a deceased shareholder’s share, may delineate how to set a price for the shares, it is generally not dispositive for valuing the decedent’s shares for federal estate tax purposes. Furthermore, as a general rule, the fair market value of the corporation determines the value of the shares, and, therefore, one must consider the company’s net worth, prospective earning power, and dividend-paying capacity, among other relevant factors, such as proceeds of life insurance policies payable to the company.

In other words, the life insurance proceeds were added to Crown’s fair market value, resulting in a higher tax liability. This premise leads to the question of what other options are there to avoid running into a similar situation, and there are a few options to consider. First, instead of entering into a buy-back agreement, consider a cross-purchase agreement, where shareholders agree to purchase the shares upon the death of the other and purchase life insurance policies on each other to ensure the insurance proceeds go directly to purchasing shares without inflating the tax value of the estate.

Another option to consider is an irrevocable life insurance trust. This method keeps the life insurance policy out of the business. The proceeds from a life insurance policy outside of the business and the decedent’s estate may be used by the trustee or beneficiaries to make capital contributions or loan funds to the business to redeem the shares of the deceased shareholder.

Other considerations, which may offer a more tax-efficient outcome, include the use of an alternative funding mechanism, such as sinking funds, installment sales or third-party financing. Regardless of the alternative strategy used by shareholders, it is important to remember that a purchase price agreed to by shareholders, while legally binding on the parties, is not always binding on the tax authorities. This mismatch can lead to very bad outcomes.

The Supreme Court’s decision in Connelly v. United States brings additional guidance on the way life insurance proceeds are treated in closely held businesses for estate tax purposes. Therefore, it is of critical importance to seek the advice of a knowledgeable professional on how to structure buy-sell agreements, evaluate life insurance policies, and better understand the potential tax implications to minimize tax liabilities and ensure the success and long-term viability of the business.