D—Section 303 Stock Redemption Buy-Sell and Life Insurance

For C corporations, savvy advisors typically utilize cross purchase buy-sell arrangements. Cross purchase arrangements in C corporations allow the remaining owners to receive a basis step-up equal to the price paid for the shares. Given the importance of capital gains planning, this has become the typical way of planning for C corporations. To avoid the problems caused by traditional cross-purchase arrangements, such as the transfer of life insurance between owners upon retirement or sale of the business, the cross endorsement buy-sell has become a popular planning strategy. This allows for the insured to own his or her own life policy while still funding a buy-sell arrangement. But, despite the relative simplicity of strategies such as the cross endorsement buy-sell and the trusteed cross purchase. Many advisors still utilize entity buy-sell arrangements when the business is not a C corporation. The thought is that a basis step-up can be achieved with pass-through entities when a short-year partnership tax election is made. Therefore, using an entity arrangement to own the life insurance at the business level is the simplest alternative. Although some tax professionals previously hypothesized about possible estate tax inclu sion of life insurance when using an entity buy-sell, the concern was generally disregarded by most professionals. The conclusion that the life insurance death benefit was not included in the business valuation is supported by Blount v. Commissioner, 428 F.3d 1338 (11th Cir. 2005). However, the recent case of Connelly v. United States, 4:19-cv-01410-SRC (E.D. Mo. Sep. 21, 2021) weakens the support offered by the Blount case and opens up the possibility that other courts (outside of the Eleventh Circuit) could include life insurance death benefits in the valuation of business interests for purposes of not only estate tax but for the buy-sell agreement as well. Because of Connelly, many advisors are now cautious about recommending entity buysell arrangements that will be funded with life insurance. Instead, various forms of cross purchase, including the Cross Endorsement Buy-Sell, are typically being recommended regardless of the business structure. Although some tax professionals consider Connelly a case of bad facts making for bad law, it may be prudent to avoid entity buy-sell arrangements funded with life insurance at least until other courts look at this issue. Connelly was upheld by the Eighth Circuit Court of Appeals in June of 2023 (Connelly v. United States, No. 21-3683 (8th Cir. 2023)) and ultimately by the U.S. Supreme Court on June 6, 2024 (Connelly v. Unites States, 144 S. Ct. 1406 (2024)) casting further doubt on the viability of life insurance funded entity buy-sell arrangements. Some commentators continue to point to the facts of Connelly and view the case as an aberration – but despite that, care should be taken and consideration should be given to using or converting to a cross-purchase arrangement. For advisors who continue to use an entity arrangement (or wait and see) funded with life insurance, it is important to consider the warnings from Connelly. These include following the valuation methodology provided by the buy-sell (not done in Connelly) and taking care to fairly set value (such as a qualified appraisal or a shareholder agreement setting a binding mutual price). Not surprisingly, Connelly was a family-owned business where the IRS is more likely to look for (and find) an opportunity to question the fairness of the purchase price. Moreover, because of Connelly, most advisors are now cautious about recommending entity buy-sell arrangements that will be funded with life insurance.