by Richard M. Morgan and Loraine M. DiSalvo, Morgan & DiSalvo, P.C.

2024 has been an eventful year for closely held business owners. First, the Corporate Transparency Act’s filing requirements became effective beginning January 1, 2024, and with them the risk of massive financial penalties for any willful failure to timely comply. See our News Alert on the Corporate Transparency Act here. Now comes the U.S. Supreme Court with the case of Connelly v. US (6/6/2024), in which the Court affirmed a decision by the Eighth Circuit. The Connelly case represents a significant change to existing assumptions on how to value a deceased business owner’s interest in a company for estate tax purposes where that company owns life insurance on its owners and the proceeds of that insurance must be used to fund the redemption of a deceased owner’s interest under a buy-sell agreement. See the U.S. Supreme Court Opinion here. Connelly means that companies with existing buy-sell agreements must review and, possibly, restructure those agreements. It also means that structuring buy-sell agreements in the future may be even more tricky than it was in the past.

Executive Summary

Owners of closely held businesses will often want buy-sell agreements for non-tax related business purposes, including controlling of the ownership of those businesses upon an owner’s death. A key question that arises when structuring a buy-sell agreement is whether the values determined under the agreement for the company to which the agreement applies and a deceased owner’s interest in that company can also be used when determining the fair market value (“FMV”) of the company and the deceased owner’s interest in it for estate tax purposes. The answer is maybe and will depend on the application of Internal Revenue Code (“IRC”) Section 2703 and its exclusions, as well as the remaining common law restrictions not otherwise included in IRC Section 2703.

If the buy-sell agreement does determine the FMV of the deceased owner’s business interest for estate tax purposes, then the law remains unchanged, and the Connelly opinion is irrelevant. However, if the buy-sell agreement does not determine the FMV of the deceased owner’s business interest for estate tax purposes, then, for those purposes, the value of the company and the value of the deceased owner’s interest in the company must be determined separately from any values set by the buy-sell agreement, using standard valuation procedures. The effect of the Connelly case is to change the application of these valuation procedures to companies in cases where the company owns life insurance on the life of the deceased owner. This is common in situations where the buy-sell agreement is either a redemption buy-sell agreement, where the company agrees to purchase the interest held by a deceased owner, or a hybrid buy-sell agreement, where the other owners are typically given the option to purchase the company interest held by a deceased owner, but the company agrees to purchase any portion of the deceased owner’s interest that is not purchased by the other owners.

Prior to Connelly, a company that received life insurance proceeds at an owner’s death and that was subject to either a redemption or hybrid buy-sell agreement generally had the life insurance proceeds included in its assets when the company was valued for estate tax purposes, but the value of the proceeds was generally deemed to be partially or fully offset by the value of the company’s obligation to use those proceeds to purchase (redeem) the deceased owner’s interest. This position was based on a 2005 ruling by the Eleventh Circuit (the Blount case), in which the Eleventh Circuit reasoned that the company’s obligation to use the life insurance proceeds to redeem the deceased owner’s business interest was equivalent to a business debt.

Connelly confirms that, when the FMV of the company is determined for estate tax purposes, the value of the company must include the full amount of any life insurance proceeds the company received as the result of the deceased owner’s death, and that those life insurance proceeds must be treated as additional non-operating assets. However, Connelly also now tells us that the requirement that the company use the life insurance proceeds to redeem the deceased owner’s business interest is not a debt and should not be treated as an offsetting obligation. This means that, when a company owns life insurance designed to provide it with the cash needed to purchase a deceased owner’s interest under a redemption or hybrid buy-sell agreement, the life insurance proceeds will increase the estate tax value of the company without any corresponding reduction. The increase in the value of the company will also increase the value of the deceased owner’s interest in the company for estate tax purposes, although the price set by the buy-sell agreement price may or may not be increased accordingly, depending on the terms of the agreement. Connelly’s rule creates the significant risk of a serious disconnect between the buy-sell redemption price paid for a deceased owner’s interest in a company and the estate tax value of that same interest. Such a disconnect may result in serious consequences.

These consequences could be either positive or negative.  From a tax perspective, the ruling will often result in a business having a much higher value for estate tax purposes after an insured owner’s death than it would have had immediately before the insured owner’s death. This increased value can cause significant additional estate taxes, which may or may not be partially offset with a capital loss for income tax purposes. However, if the increased business value does not create additional estate taxes, it may result in creating a beneficial capital loss for income tax purposes. From a non-tax perspective, depending on the redemption purchase price formula used in a company’s buy-sell agreement, the effect of the Connolly ruling could mean that the purchase price for a deceased owner’s interest could be significantly higher than may have been originally anticipated when the buy-sell agreement was prepared and signed.

As a result of the Connelly ruling, those who own an interest in a closely held business with at least two (2) owners should immediately seek professional guidance. The business owners need to seriously consider the possible need to create a buy-sell agreement or modify an existing buy-sell agreement. They should also seriously consider the possible need to purchase new life insurance or restructure existing life insurance in order to fund any such buy-sell agreement obligations while minimizing any potentially negative consequences that could result from the treatment of the life insurance proceeds under Connelly.

The remainder of this News Alert discusses these topics in more detail.

Table of Contents

Background

When a closely held company has multiple owners, those owners often want to ensure that everyone understands what happens to any interest in the company that is held by an owner who dies. Most business owners would prefer that the surviving owner or owners end up with full ownership of the entity and that a deceased owner’s loved ones will only end up with the value of the deceased owner’s interest. As a result, the surviving owner or owners can continue to control the company without having to deal with the deceased owner’s family members, and those family members can enjoy the fruits of the deceased owner’s labor. In order to accomplish this objective, many owners of closely held companies use agreements under which the company interest held by a deceased owner must be purchased from the deceased owner’s estate or trust, either for cash, for an interest-bearing promissory note, or in some combination of cash and promissory note. These agreements are commonly known as “buy-sell agreements.” A buy-sell agreement can effectively be created as a standalone document, as is often the case with closely held corporations, or as part of a larger document, such as an operating agreement for a partnership or limited liability company (“LLC”) that includes buy-sell-agreement-style provisions in it along with other provisions regarding the operation of the entity.

In structuring a buy-sell agreement, many questions arise, including for example:

1. 1. Should the buyout at an owner’s death be mandatory or only an option?
   2. Should the obligation to buy a deceased owner’s interest be imposed on the entity itself (a redemption buy-sell agreement) or on the individual owners of the entity (a cross-purchase buy-sell agreement)? Or should the agreement give the individual owners the option to purchase the deceased owner’s interest but then obligate the entity to purchase the remaining interest if the surviving owners do not elect to purchase the entire interest (a hybrid buy-sell agreement)?
   3. How are the owners to create the cash or other liquid assets necessary to purchase the deceased owner’s interest in the business? In some cases, the buy-sell agreement simply provides that a deceased owner’s interest will be paid for in installments, usually in connection with an interest-bearing promissory note; the theory in this case is usually that the company will continue to generate the cash flow needed to make the payments. However, the better answer is often to use life insurance on the lives of the owners, so that, at an owner’s death, the life insurance proceeds will be available to fund part or all of the purchase price that must be paid for that owner’s interest. In many cases, the insurance will be term life insurance, which is generally relatively inexpensive, and the insurance will be purchased and owned by the party or parties on whom the obligation to purchase the deceased owner’s interest is imposed by the agreement. If the buy-sell agreement is to be funded with life insurance, it often also provides that, if there is a difference between the insurance proceeds available and the purchase price to be paid for a deceased owner’s interest, that difference must be paid in installments associated with a promissory note, with as much as possible being paid up front using the insurance proceeds.
   4. How should the purchase price for the deceased owner’s interest in the business be determined? In many cases, the buy-sell agreement simply requires that the surviving owners have the business appraised after an owner’s death, with at least one valuation required and, usually, with provisions requiring more than one valuation to be obtained if there is a dispute over the correct valuation. In a lot of other cases, the buy-sell agreement will provide for a stated initial value, which the parties then agree to update periodically (often annually). Agreements that contain an agreed-upon initial value also often require that business appraisals must be obtained and used to determine the value of the interest to be purchased if the parties have failed to update the agreed-upon value for longer than a certain period, such as two (2) years. Yet another common option is for the buy-sell agreement to provide a formula that must be used to determine the value of the company, often based on financial statement calculations. These formula provisions are generally intended to allow the valuation of the company to change as the business’s economics (which could be its profits, its Earnings Before Interest, Taxes, and Amortization (EBITA), or otherwise) change over time without requiring the owners to periodically agree on an updated value. Finally, some buy-sell agreements simply use a set figure without providing for the use of any appraisals or other method designed to allow the value to be changed (this kind of provision is not recommended).
   5. Do the owners want the purchase price of the deceased owner’s business interest under the terms of the buy-sell agreement to set the value of that interest for estate tax purposes? The price to be paid under a buy-sell agreement for a deceased owner’s interest in a company does not necessarily determine the value of that interest in the owner’s estate for estate tax purposes. If the owners of a company want to ensure that the value determined under their buy-sell agreement will effectively set the value of a deceased owner’s interest in the company for tax purposes, then they must be very careful in setting up the agreement, as it must comply with a strict set of rules. If the price set by a buy-sell agreement does not effectively set the value of the purchased interest for tax purposes, those values could be quite different. If the purchase price for a deceased owner’s interest is significantly different from the value that interest is deemed to have for estate tax purposes, then one or more of the following situations could result: (i) the higher estate tax value could result in unexpected estate taxes becoming due and payable if the estate is either a taxable estate or becomes a taxable estate as the result of the increased estate tax value of the business interest; (ii) the deceased owner’s estate or trust may realize a capital loss on the sale for income tax purposes if the estate tax value of the purchased interest is determined to be higher than the purchase price paid under the buy-sell agreement (any such capital loss may or may not be deductible); or (iii) where the buy-sell agreement adjusts the purchase price to be at least equal to the finally determined estate tax value through some method, the purchase price itself could be much higher than expected, and there may not be enough in cash or other liquid assets available to carry out the intended purchase. If no additional estate taxes are generated by the higher-than-expected estate tax valuation, then situation (ii) may produce a welcome income tax benefit for the deceased owner’s estate if a deductible capital loss is generated, although the deceased owner’s family may still not be happy that they are not getting the full estate tax value for the interest. The income tax benefit potentially produced by situation (ii) may also help offset the cost of increased estate taxes if the estate is taxable for estate tax purposes. However, unexpected estate taxes generated by a higher-than-expected estate tax valuation will likely not be welcomed by the deceased owner’s loved ones, even if there is some offset from a deductible capital loss. Similarly, an unexpectedly expensive purchase obligation for which insufficient liquidity exists likely will not be welcomed by the company or its surviving owners.

The Supreme Court’s Ruling in Connelly v. U.S. and its impact on buy-sell agreement planning.

The Connelly ruling does not change the need for owners of closely held businesses to consider the factors discussed above in paragraphs 1 through 5. These factors are still of critical importance. However, the Connelly ruling may make determining whether a buy-sell agreement sets or should set the estate tax value of the deceased owner’s interest in the business even more important than it was before, as it appears to significantly increase the chance that the estate tax value of a purchased interest will be higher than the purchase price set by a buy-sell agreement in certain situations. In particular, a multiple owner, closely held business entity that wishes to use a redemption or hybrid buy-sell agreement and wishes to fund that agreement with life insurance will need to be very careful in designing and implementing their buy-sell agreement, as unintended consequences could result. If that buy-sell agreement does not effectively determine the value of the business for estate tax purposes at a deceased owner’s death, then the value of the business could be significantly greater than anticipated for estate tax purposes, and the results of that increased value may negatively impact the deceased owner’s loved ones, the surviving business owners, and/or the business.

Before the recent Connelly case, it was understood (and confirmed by the legal reasoning of the 2005 Eleventh Circuit Court in the Estate of Blount, https://caselaw.findlaw.com/court/us-11th-circuit/1372756.html) that life insurance purchased by an entity to fund its obligation to purchase a deceased owner’s interest under a redemption style buy-sell agreement would not end up affecting the value of the entity for estate tax purposes. While the life insurance proceeds would be included as additional non-operating assets when the business was valued for estate tax purposes pursuant to Treas. Reg. 20.2031-2(f)(2), the business was also deemed to effectively have an offsetting debt obligation to the extent the life insurance proceeds were required to be used to redeem the deceased owner’s interest in the business.

However, in Connelly, the U.S. Supreme Court held that a company’s obligation to use life insurance proceeds to purchase a deceased owner’s interest in the company generally should not be considered as a debt of the business. Instead, life insurance proceeds received by the company will be included as additional non-operating assets when the value of the company is determined for estate tax purposes, but the value of those proceeds normally would not be offset by the value of redemption obligations imposed on the company by any buy-sell agreement.

If the buy-sell agreement is determined not to set the value of a deceased owner’s interest in a business entity, then a disconnect can exist between the redemption (non-tax) value of the business interest and the estate tax value of the business interest. After Connelly, this valuation disconnect will likely be significantly larger where the business uses a redemption or hybrid buy-sell agreement and it is funded with business owned life insurance on the lives of its owner.

This valuation disconnect is important, and it needs to be considered. From a tax perspective, the ruling will often result in a business having a much higher value for estate tax purposes after an insured owner’s death than it would have had immediately before the insured owner’s death. This increased value can cause significant additional estate taxes, which may or may not be partially offset with a capital loss for income tax purposes. However, if the increased business value does not create additional estate taxes, it may result in creating a beneficial capital loss for income tax purposes. From a non-tax perspective, depending on the redemption purchase price formula used in a company’s buy-sell agreement, the effect of the Connolly ruling could mean that the purchase price for a deceased owner’s interest could be significantly higher than may have been originally anticipated when the buy-sell agreement was prepared and signed.

A critical question: Does a Buy-Sell Agreement set the value of a business for estate tax purposes?

The potential disconnect between the estate tax valuation of a company and the value placed on a deceased owner’s interest in that company for purposes of the company’s buy-sell agreement has been an issue for decades. Under common law, there were several rules that were intended to prevent perceived tax valuation abuse. These rules determined the extent to which the provisions of a buy-sell agreement would be allowed to control the value of a company for tax purposes. The 1987 Tax Act created IRC Section 2036(c), which was intended to address this issue. However, IRC Section 2036(c) was so broadly worded that it adversely affected normal business transactions, and it was quickly eliminated. In 1990, a new series of tax valuation provisions was enacted as a substitute for the ill-fated IRC Section 2036(c): IRC Sections 2701 – 2704, also known as “Chapter 14.” Two (2) of the existing common law rules were codified by the first two requirements of IRC Section 2703(b), as part of that Section’s safe harbor rules (discussed below). The additional common law requirements, which were not codified under the IRC Section 2703(b) safe harbor, but which still continue to apply, include: (i) the price must be fixed or determinable from the agreement; and (ii) the terms of the agreement must be binding throughout both life and death.

As a result, in order for the value set by a buy-sell agreement to set the value of an owner’s interest in a company for tax purposes, the agreement must deal with the applicable provisions of Chapter 14 and the two (2) remaining common law rules. The applicable Chapter 14 rules that potentially apply to buy-sell agreements include IRC Sections 2701, 2703 and 2704. Of these, the most on point is IRC Section 2703.

IRC Section 2703(a) states the general rule that the value of any property shall be determined without regard to any option, agreement, or other right to acquire or use the property at a price less than the fair market value (FMV) of the property (without regard to such option, agreement, or right), or any restriction on the right to sell or use such property. In other words, buy-sell agreements will generally not set the value of an owner’s interest in a business for estate tax purposes. This means that buy-sell agreement provisions which could depress the FMV of a business will generally be ignored and the business value must be determined without considering such buy-sell agreement provisions.

It should be noted that while we refer only to buy-sell agreements, the application of IRC Section 2703 is much broader, and it applies to provisions contained in a partnership agreement, articles of incorporation, corporate bylaws, shareholder agreements, or any other agreement, and it may likewise be implicit in the capital structure of an entity. Treas. Reg. Section 25.2703-1(a).

While the general rule of IRC Section 2703(a) theoretically applies to all buy-sell agreements, IRC Section 2703(b) provides a safe-harbor rule. IRC Section 2703(b) provides that the general rule of IRC Section 2703(a) (that agreement-imposed restrictions on an interest will be ignored for tax valuation purposes) will not apply if all three (3) of the following requirements are independently satisfied: (1) the agreement is a bona fide business arrangement; (2) the agreement is not a device to transfer the property to members of the decedent’s family (or “natural objects of decedent’s bounty,” per Treasury Regulations (“Treas. Reg.”) Section 25.2703-1) for less than full and adequate consideration in money or money’s worth (this test is known as the “device test”); and (3) the terms of the agreement are comparable to similar arrangements entered into by persons in arms’ length transactions.

Treas. Reg. Section 25.2703-1(b)(3) provides the most significant exclusion from the restrictions of IRC Section 2703(a). Essentially, satisfaction of the ownership percentage test of Treas. Reg. Section 25.2703-1(b)(3) means that all three requirements of the IRC Section 2703(b) exclusion are automatically satisfied.

Specifically, Treas. Reg. Section 25.2703-1(b)(3) states that the three (3) safe harbor requirements of IRC Section 2703(b) are automatically satisfied if less than 50% by value of the property subject to the right or restriction is owned directly or indirectly (within the meaning of Treas. Reg. Section 25.2701-6) by individuals who include the transferor (here, the deceased business owner) and other members of the transferor’s family. The property owned by the other owners must be subject to the same rights and restrictions as the transferor and the transferor’s family members.

Members of the transferor’s family include the persons described in Treas. Reg. Section 25.2701-2(b)(5) and any other individual who is a natural object of the transferor’s bounty. Any property held by a member of the transferor’s family under the rules of Treas. Reg. Section 25.2701-6 (without regard to Section 25.2701-6(a)(5)) is treated as held only by a member of the transferor’s family. Members of the transferor’s family likely includes: (i) the transferor; (ii) the transferor’s spouse; (iii) the ancestors of the transferor and the ancestors of the transferor’s spouse; (iv) the lineal descendants of the parents of the transferor and the lineal descendants of the parents of the transferor’s spouse; and (v) any other individual who is a natural object of the transferor’s bounty. Also note: while one would think that two unrelated 50% owners would not be subject to rules intended to prevent valuation manipulation among related parties, that is not the case. Two unrelated 50% owners fail the Treas. Reg. Section 25.2703-1(b)(3) exclusion requirements.

If the Treas. Reg. Section 25.2703-1(b)(3) exclusion does not apply, it is often difficult to comply with all three (3) IRC Section 2703(b) requirements as they have been interpreted by the IRS and the courts. Even if the deceased owner can qualify for the 2703(b) or Treas. Reg. Section 25.2703-1(b)(3) exclusions, the buy-sell agreement must still satisfy the two remaining common law requirements, including: (i) the price must be fixed or determinable from the agreement; and (ii) the terms of the agreement must be binding throughout both life and death.

In Connelly, the parties essentially ignored the terms of the buy-sell agreement. As a result, the buy-sell agreement’s terms were ignored by the courts, and its redemption price was ignored for estate tax purposes.

Where does that put us today in having a Buy-Sell Agreement able to set the value of a deceased owner’s business interest at death?

1. If the business owner passes the ownership relationship test under Treas. Reg. Section 25.2703-1(b)(3) and is deemed to own less than 50% of the company, then that owner can qualify for the IRC Section 2703(b) exclusion from IRC Section 2703(a). In that case, the value set by the buy-sell agreement should determine the estate tax value of the owner’s business interest at the owner’s death if the agreement sets a fixed and determinable price and is binding throughout both life and death.
2. If the business owner cannot satisfy the ownership relationship test under Treas. Reg. Section 25.2703-1(b)(3), then the three (3) requirements of IRC Section 2703(b) must be independently satisfied to qualify for the exclusion from IRC Section 2703(a) and thereby have the buy-sell agreement set the estate tax value of a deceased owner’s business interest.                                After Connelly, it will likely be more difficult to satisfy the “device test” (second requirement under 2703(b)) unless the business includes any business owned life insurance proceeds in its redemption price calculations.
3. If the buy-sell agreement is not excluded from restrictions of IRC Section 2703(a), then the buy-sell agreement does not set the estate tax value of the deceased owner’s business interest, and the FMV of the deceased owner’s business interest must be determined without considering the provisions of the buy-sell agreement, at least in general.

If a redemption buy-sell agreement exists and that agreement is funded with life insurance payable to the company at the owner’s death, then Treas. Reg. Section 20.2031-2(f)(2) provides that the life insurance proceeds received by the entity need to be considered as part of the business’s non-operating assets. Connelly states that, in general, the obligation for the company to use some or all of the life insurance proceeds to carry out the redemption of the deceased owner’s business interest must not be considered when the value of the company is determined for estate tax purposes.

Please note that, while not discussed above, the U.S. Supreme Court did provide a possible exception in footnote 2 of the Connelly opinion by saying that the buy-sell agreement terms may be considered as a sort of debt obligation or otherwise reduce the value of the business to the extent that complying with the buy-sell agreement’s payment terms might actually harm the business, as in a case where the business ends up having to liquidate important operating assets to pay for the redeemed interest. However, this exception seems unlikely to apply in many cases where the buy-sell agreement is funded with life insurance.

Let us review an example.

A closely held business is owned by two owners, each of whom owns 50% of the company. The company is valued at $20 million. The parties create a redemption style buy-sell agreement. To fund the future redemption obligation upon an owner’s death, the business entity purchases two $10 million term life insurance policies, one on each of the two (2) owners. The value of the insurance purchased on each owner’s life assumes that each owner’s interest will be worth 50% of the company’s $20 million total value.

In this example, let us assume that the buy-sell agreement does not effectively determine the value of the business for estate tax purposes. The buy-sell agreement states that the value of a deceased owner’s interest for purposes of the buy-sell agreement will be determined using the appraised FMV of the entire company as of date of that owner’s death, and that none of the life insurance proceeds that are paid to the company at one owner’s death are to be considered in determining the FMV of the business.

Let us also assume that the appraised FMV of the company, without considering the life insurance proceeds, is still $20 million on the date of death of the first owner to die. Under the buy-sell agreement’s provisions, this means that the deceased owner’s interest (assuming no valuation discounts) is worth $10 million, and the agreement requires the company to purchase the deceased owner’s interest for $10 million. After Connelly for estate tax purposes, however, the value of the entire business may be as high as $30 million ($20 million + $10 million of life insurance proceeds). The buy-sell agreement requires the business to purchase the deceased owner’s 50% interest in the business for $10 million (50% x $20 million), but the deceased owner’s potential estate tax liability is based on a value of $15 million (50% x $30 million) for the same interest.

What are the effects of the difference between the estate tax value and the buy-sell agreement purchase price? The decedent’s estate could have to pay as much as $2 million in additional estate taxes over the amount that would have been payable if the estate tax value was the same as the buy-sell agreement value, and assuming that the extra $5 million in estate tax value is fully subject to estate tax at the current essentially flat 40% rate ($5 million x 40%). However, this additional tax estate tax cost may be somewhat offset because the decedent’s estate (and eventually the decedent’s beneficiaries) may realize a capital loss of $5 million on the redemption of the decedent’s interest in the company under the buy-sell agreement. The estate’s step-up in income tax basis is determined by the higher $15 million estate tax value but the purchase is carried out at the lower $10 million value set by the buy-sell agreement. Depending on various factors, including tax technicalities, such as the IRC Section 267 limitations on capital losses for transactions between related parties and whether the IRS decides to take the position that the purchase should be recharacterized as a part-sale/part-gift transaction, the redemption purchase price at less than the estate tax value may or may not produce a deductible capital loss for  income tax purposes, and it may or may not produce a taxable gift for gift and estate tax purposes.

If we change our scenario above to include a buy-sell agreement that uses a redemption price that is effectively set to be equal to the estate tax value, such as one based on using appraisals done as of the date of death, so that the life insurance proceeds are included in determining the purchase price value of the deceased owner’s interest, the results change. Under Connelly, the value of the deceased owner’s interest in the business will now be $15 million under the same facts assumed above, instead of the anticipated $10 million, because the value of the life insurance proceeds paid on the deceased owner’s life will be included in the company’s non-operating assets when the company itself is appraised. This means that the company will receive $10 million in life insurance proceeds but will be obligated to pay the deceased owner’s estate $15 million for the redeemed company interest. Depending on how the agreement addresses a shortfall like this, the company may need to find or generate additional liquid assets to pay the difference, or it may find itself with a continuing payment obligation that it was hoping to avoid.

If a business owner has an estimated estate tax value (generally net worth plus face amount of life insurance as of date of death) that is unlikely to generate an estate tax liability, and if that owner’s estate or its beneficiaries qualify to deduct a capital loss, then there may be a positive outcome from the ruling in the Connelly case for that owner and that owner’s loved ones. However, many other businesses and their owners will only face potentially negative results from the Connelly ruling.

Bottom line take-aways.

1. 1. Need to consider whether an existing or proposed buy-sell agreement (or similar agreement) is intended to either set or strongly influence the value of the business for estate tax purposes at an owner’s death. Don’t fail to consider the purpose of price-setting provisions in a proposed buy-sell agreement or other agreement that is designed to control what happens to a deceased owner’s interest after that owner’s death. Whether or not a buy-sell or similar agreement can determine the value that a deceased owner’s interest in a company will have for estate tax purposes is determined by factors set out in existing, but often ignored, law. If the buy-sell agreement is able to effectively set the estate tax value of the business and a deceased owner’s interest in it at the owner’s death, then the Connelly case may have no significant impact. However, if a buy-sell agreement does not determine the value of the business to which it applies for estate tax purposes after an owner’s death, the Connelly case may create a significant disconnect between the value of the business as determined for buy-sell agreement purposes and for tax purposes.
   2. Buy-sell agreements are complicated, can have a huge impact, and should be created with the help of competent professionals. Owners of a closely held business who have not yet created a buy-sell agreement should seek guidance from their professional advisors (e.g., a business attorney, business advisor, CPA or other tax advisor, life insurance professional, and business appraiser) for help creating one. The advisors should assist with determinations including whether a buy-sell agreement is truly needed, how any such agreement is best structured, and the extent to which insurance, such as life insurance and disability insurance, should be used to provide funding for the obligations created by the agreement. The Connelly ruling just adds another factor to the list of items that should be considered as part of these discussions.
   3. You should review any existing buy-sell agreements periodically and make any necessary or desirable changes. Owners of closely held companies that have redemption or hybrid buy-sell agreements in place should review those agreements as soon as possible with the help of their professional advisors, to determine whether the agreement will still operate as desired after Connolly or whether changes to the agreement, any associated insurance, or both are desirable. These owners should be certain that the existing buy-sell agreement is structured and being administered correctly. They should also consider whether the structure of the buy-sell agreement should be retained or changed in light of Connelly, and should revisit the funding and ownership structuring of any life insurance that is associated with the agreement and decide whether changes are needed. Some of the wide variety of changes that should be considered include: Should the existing redemption or hybrid buy-sell agreement be retained or changed to a cross-purchase buy-sell agreement? If so, should another entity, such as a life-insurance-only LLC, be used to own the life insurance policies for this purpose? (For more information on insurance only LLC agreements, see “The Special Purpose Buy-Sell Insurance LLC” authored by The LISI Editorial Staff. https://leimbergservices.com/webinars/product.cfm?linkid=60.) Will additional life insurance policies on the lives of the owners be needed and do issues exist as to owner insurability and cost? Are there any negative income tax consequences resulting from any such buy-sell agreement and related life insurance policy changes, including for example, IRC Section 101(a)(2) transfer-for-value issues, gain on distribution of the life insurance policy issues, and IRC Section 2042 Incidents of Ownership issues? If the owners decide to retain or implement a life-insurance-funded redemption or hybrid buy-sell agreement, how possible is it that an additional estate tax may end up being owed at an owner’s death in light of the Connelly decision, and should the owners modify their personal estate planning documents and their tax apportionment clauses to help ensure that the intended beneficiaries of their interests in the business or the benefits therefrom also suffer the related extra estate tax liability?

Conclusion

Connelly represents a significant shift away from previous law. This shift means that existing buy-sell agreements should be revisited and, possibly, restructured as soon as possible to reduce the risk of unforeseen negative consequences to both closely held businesses and their owners. It also means that business owners who need to create or reconsider buy-sell agreements will need to go through an even more complex decision-making process than they might previously have had to. Critical factors that should be considered in creating or modifying a buy-sell agreement will include the style of agreement to use and how the parties expect to create the liquidity needed to pay any redemption or cross-purchase obligations at death. Business owners will want to ensure that they have experienced and knowledgeable professional advisors helping them with these considerations.

The attorneys at Morgan & DiSalvo are always pleased to share important and timely information pertaining to those who have interests in closely held businesses. Because of the complexity of these new requirements, we strongly recommend seeking the advice of your own independent legal counsel regarding your potential buy-sell agreements.

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