Thomas Connelly v. United States was decided by the United States Court of Appeals in June 2023. The case involved a dispute over whether a company’s value should include the portion of life insurance proceeds used to buy back a deceased shareholder’s stock. The court must determine the value of the company without taking into account the share purchase agreement; And, since the proceeds at the time of Michael Connelly’s death were a significant asset of the corporation, the IRS did not err in including the insurance proceeds as part of the fair market value of the corporation.
The case has implications for the valuation of a company’s buy-sell and MA&A agreements, as it suggests that the value of a company should increase as the value of the death benefit of the company’s own life insurance policies increases when the proceeds are used. To buy the shares of the deceased shareholder. The case highlights the importance of setting a clear value for a deceased person’s interest in a business for estate tax purposes, as a buy-sell agreement can lead to disputes over the company’s value.
The Conley v. United States decision has tax implications for buy-sell agreements. Here are the main implications:
1. Tax Liability:- The decision imposed a high tax liability on the estate of the deceased shareholder. The IRS successfully argued that the company’s value for estate taxes was $3.5 million higher by including the life insurance proceeds used to purchase the shares.
2. Pricing Effect: The decision states that the price of a company’s buy-sell agreement must include the life insurance portion used to purchase shares for the deceased shareholder. The court did not affect the company’s valuation of the share purchase agreement.
3. Fixed and determinable price: The court found that the purchase contract in question did not set a fixed and determinable price for federal tax purposes. This is important because if the sales contract does not provide a clear value for the decedent’s business use, it can lead to disputes over the value of the company.
4. Certification of Agreed Value: In the Connelly case, the taxpayers did not agree on a specific purchase number and signed an affidavit stating that they did not have the agreed upon value. This highlights the importance of having a clear and agreed value in buy-sell agreements to avoid potential tax issues.
There are some strategies to keep life insurance income from being included in a company’s valuation, including:
1. Use a cross-purchase agreement: In a cross-purchase agreement, each shareholder agrees to buy the shares of the deceased shareholder. A life insurance policy is owned by each shareholder, and the proceeds are used to purchase shares from the deceased shareholder. In this way, life insurance income is not included in the company’s valuation.
2. Use an Irrevocable Life Insurance Trust (ILIT): An ILIT is a trust that owns a life insurance policy. A trust is irrevocable, which means the policyholder cannot change the trust agreement or cash out the policy. When the policy owner dies, the death benefit is paid to the trust, and the money is not included in the owner’s estate. The trustee can then use the proceeds to purchase the deceased shareholder’s stock.
3. Use a buy-sell agreement with a fixed price: A buy-sell agreement with a fixed price sets a clear price for one’s business needs. The agreement must state that the company’s value must not include the portion of the life insurance proceeds used to purchase shares for the deceased shareholder.
4. Use investor-owned life insurance: In this strategy, the foreign investor owns the life insurance policy as the stock buyer. The investor pays the premium and is the beneficiary of the policy. When the shareholder dies, the investor uses the death benefit to purchase the shares from the deceased shareholder. In this way, life insurance income is not included in the company’s valuation.
Overall, the Conley v. United States decision emphasizes the importance of carefully considering the tax implications when structuring buy-sell agreements. It is important to establish a clear evaluation method and ensure that the agreement complies with federal tax requirements to avoid unexpected tax liabilities. With this decision in mind, business owners should review their buy-sell agreements and work with tax professionals to ensure compliance and minimize potential tax risks.
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