On June 6, 2024, the U.S. Supreme Court decided a case that will affect all business owners who have life insurance-funded buy-sell agreements, specifically agreements commonly referred to as "entity purchases" or "stock redemptions." This decision has muddied the waters around buy-sell agreements by reversing generally accepted principles long held by the financial services community.
The question now is: When is it proper for an advisor to consider a life insurance-funded stock redemption (entity purchase) buy-sell agreement for their clients?
To review Connelly v. United States, the U.S. Supreme Court addressed the narrow question of whether a corporation's fair market value, where the corporation has an obligation to redeem a decedent owner's shares, is impacted by life insurance proceeds received by the corporation and committed to funding the redemption for estate tax purposes.
The Supreme Court unanimously held that the corporation's redemption obligation is not a liability that reduces the estate tax value of the decedent's shares and that the death benefits received by the corporation must be included as part of the estate tax valuation of the business.
Connecting With Business-Owner Clients
As a result, all buy-sell agreements or provisions in corporate shareholders agreements, LLC operating agreements, and partnership agreements should be reviewed for their appropriateness if the agreements call for the business to buy back the ownership interest of a deceased owner and the business purchases life insurance on the owner to do that.
Even if it does not specifically refer to a life insurance-funded buy-out, the Connelly decision still affects the purchase price of the business.
It is certain that life insurance-funded buy-sell agreements will produce HIGHER death-time business valuations versus unfunded arrangements, as the life insurance death proceeds payable to the business MUST be included in the business valuation.
Someday, this point might possibly be litigated as to why an agreement was not funded with life insurance, as a higher business valuation could have been achieved.
An Impact on All Business Value
Regardless of the nature of the agreement, because the insurance was held by the company, the value of the company was increased by the proportional amount of the death benefits paid.
The choice to fund with company-owned insurance is now a decision that directly affects the value of the business for all types of valuations.
So, for the advisor, when is it appropriate to consider a life insurance-funded stock redemption agreement?
Clearly, when a business is going to be sold after the death of a founder to unrelated parties, a higher value would be desirable.
Insurance-funded redemption buy-sell agreements have a huge benefit for surviving shareholders.
Consider the following hypothetical example:
◆ Imagine a company worth $1 million with two owners (father and son).
◆ The father owned the majority of the shares 80, and the son owned 20%.
◆ Their basis in the company is $100,000 for the father and $200,000 for the son.
Let's say that the business has a company-owned policy worth $800,000 on the father and one worth $200,000 on the son.
When the father dies, the death benefit would be paid to the company, and the company would now be worth $1.8 million, of which 80% is payable to the father's estate ($1.440 million).
If this was a lifetime sale transaction, the father would be looking at a capital gain of $1.34 million ($1.44 million-$100,000 cost basis).
But, when a person dies their basis is "stepped up" to the date of death value of the stock.
If the son is the sole beneficiary of the father's estate, when he inherits the shares, he is now the 100% owner of the company.
The company would have increased in value to $1.8 million (the value of the father's shares, $1.44 million plus $560,000, the value of the son's shares).
Let's further assume that the father had eight shares worth $1.44 million.
That is $180,000 per share.
The son's shares would remain at their cost basis, what he paid for them or the price they were given to him at.
If that was $200,000, the per-share value of two shares is now $360,000.
That is an increase of $160,000 for the son.
The Son Wants Out
The son, however, is not interested in running the business anymore.
Instead, he goes to a competitor company and offers to sell them the business.
They agree to the date of death value of $1.8 million.
The son sells the shares for $1.8 million.
He would only have to pay capital gains tax on his shares.
Thus, if he is in the 20% capital gain tax bracket, he would owe 20% of $160,000 or $32,000.
That is the power of "stepped-up cost basis" at death.
Once again, had the sale of the company occurred while the father was alive, the capital gain tax would have been $180,000 for the father ($1 million -$100,000 *20%).
The son saves over $150,000 because of the stepped-up cost basis. Further, the son had sufficient liquidity to complete the transaction.
The son receives $1.8 million for the 10 shares minus the tax owed, $32,000, for a net of $1.768 million.
If the father and son had structured the buy-sell agreement as a cross-purchase, the father's policy would not have been included in the business valuation as the son owned it and was the beneficiary.
The business would have been worth $1 million.
The son would have paid $800,000 of the death benefit to the father's estate in exchange for the shares.
The per-share value would have been $100,000 per share.
The stepped-up cost basis would still apply, but the son would only receive $800,000 in share value.
As his basis was $200,000, there would be no gains on his shares. He would also receive the $800,000 from the estate for a total of $1.6 million.
In conclusion, it's safe to say that when a deathtime sale is being contemplated by the parties to a buy/sell agreement, the higher valuation afforded by the life insurance-funded stock redemption agreement may be the superior way to pass the business.
Financial professionals need to communicate these changes to clients because of the Connelly decision and further discuss the appropriate use of life insurance in a buy-sell arrangement.
Marc Belletsky, ChFC, CLU, RICP, is a senior advanced sales counsel, advanced markets, at Securian Financial.
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