Background
In a recent case owners of a closely held business got bad news. It is common to have a closely held business own life insurance on the owners (e.g., shareholders if it is a corporation). When an owner dies the business uses the life insurance proceeds on the owner’s life to buyout the equity interests the owner held at death. Since the corporation, not the other shareholders are purchasing the deceased shareholder’s stock it is called a “redemption.” If a surviving shareholder purchased the shares it is called a ”cross-purchase.” These present practical ways to keep the stock or other equity interests in a closely held business in the hands of the remaining active shareholders. It can be just good business planning. But good motives don’t assure good tax results (or perhaps more accurately, they don’t assure the tax result the taxpayer might have intended or hoped for). Connelly v. IRS, No. 21-3683 (8th Cir. 2023).
The Connelly case also provided some lessons as to the valuation of a closely held business (the taxpayers in the case didn’t handle that well), and setting that value for buyout purposes using an agreement between the owners (often called a “Certificate of Stated Value”). We’ll discuss these points too.
Now let’s review the Connelly case.
The Connelly Buyout Agreement in More Detail
Here’s how the Court described the buyout. “The stock-purchase agreement provided two mechanisms for determining the price at which Crown would redeem the shares. The principal mechanism required the brothers to execute a new Certificate of Agreed Value at the end of every tax year, which set the price per share by “mutual agreement.” If they failed to do so, the brothers were supposed to obtain two or more appraisals of fair market value. The brothers never executed a Certificate of Agreed Value or obtained appraisals as required by the stock-purchase agreement. At any rate, to fund the redemption, Crown purchased $3.5 million of life insurance on each brother.”
As a side note if the surviving shareholder did not buyout the deceased shareholder’s shares, and then the corporation purchased those shares, might the IRS have argued that the corporation relieved the shareholder of his personal responsibility and therefore that was equivalent to a distribution from the corporation? Perhaps review all aspects of any plan you have with your tax advisers.
Tax Law Requirements for a Buyout to Be Respected
The tax laws have specific requirements that must be met for a buyout agreement to be respected for setting the value of the business for estate tax purposes. The arrangement in Connelly failed these tests. While there wasn’t a lot of discussion of this in the case, because the failure to comply with the tax rules was pretty obvious, being aware of these general requirements is important to planning.
Code Section 2703 provides that for estate tax purposes the value of any property shall be determined without regard to: (1)any option, agreement, or other right to acquire or use the property at a price less than the fair market value of the property (without regard to such option, agreement, or right), or (2)any restriction on the right to sell or use such property. There is an exception to the above, meaning that the parties buyout agreement will be respected for estate tax purposes, if (1) It is a bona fide business arrangement, (2) It is not a device to transfer such property to members of the decedent’s family for less than full and adequate consideration in money or money’s worth, and (3) Its terms are comparable to similar arrangements entered into by persons in an arms’ length transaction.
The objective of these rules is to prevent taxpayers from using a buyout agreement to set an artificially low price (less than fair market value) at which to transfer interests in a business to a family member to save estate taxes. Demonstrating that your agreement is comparable to arm’s length deals may not be easy and is a point to address with your advisers. Having a formal appraisal completed by an independent qualified appraiser with expertise in valuing business such as yours, and who is familiar with the tax laws as they pertain to valuation, may be a good step to include in your planning.
The Connelly Buy Out Didn’t Pass Muster
In Connelly the shareholders arrangement provided that they could just agree as to a value. Mere agreement does not meet the tests of Code Section 2703 above for a buy-sell arrangement to be respected for estate tax purposes. But the taxpayers in Connelly never agreed to a buyout figure and signed a certification of that agreed value as their own agreement required. The fallback position in the Connelly agreement if no value was formally agreed to was to get two appraisers to value the business. But the taxpayer’s didn’t do that either. Had they hired independent appraisers as their agreement required there may never have been a case.
But instead, the brother of the decedent, who was the surviving shareholder benefiting from the buyout, and who was also the deceased shareholder’s executor, agreed on a figure for the buyout. Perhaps he reached that agreement with the surviving heirs of his deceased brother, but whatever the specifics were, he was sitting on too many sides of the fence. Another lesson of the Connelly case is to use independent fiduciaries to avoid conflicts like those in the Connelly case. Courts are impressed by the use of independent and especially professional trustees. (See Levine Est. v. Comr., 158 T.C. No. 2 (February 28, 2022)).
Had the taxpayers in Connelly set an agreed value would that have sufficed? Probably not as the mere agreement as to a value would still have been arbitrary and not demonstrably comparable to what comparable parties would have done. However, had the taxpayers done so, the Court may have been a bit less harsh since that would have demonstrated that they at least respected their agreement. A better approach then just shareholders agreeing on a number is to instead have a qualified appraiser value the business. As part of the process of valuing the business, the appraiser may also create a formula that can be updated each year to provide a current value that is based on terms similar to what unrelated persons might do. All of this can be baked into the buyout agreement. While the ideal approach is to have the appraiser return each year and update the valuation, using the mechanism provided by the appraiser may be reasonable to implement automatically for some number of years until facts change making the continued application of that formula inadvisable. Perhaps the appraiser can provide some of the factors or guardrails as to when the valuation mechanism must be revised.
Respect Formalities
“…the brothers were supposed to obtain two or more appraisals of fair market value. The brothers never executed a Certificate of Agreed Value or obtained appraisals as required by the stock-purchase agreement.”
This is a common issue. Owners of many closely held businesses fail to follow the formalities of the entities that they create. The buyout agreement the brothers signed in Connelly was ignored by them. They were to have agreed as to the value of the company in a document, called a “Certificate of Agreed Value” each year. They didn’t. If they failed to do that then they agreed to have independent appraisals of the value obtained to determine the buyout price from the deceased brother. They did not do that either.
While beyond the Connelly case, there are vital lessons to learn from the taxpayers’ failures in the Connelly case. Respecting and following the formalities of entities that are created is not only essential to have those entities and their arrangements respected by the IRS, but by creditors as well. If you run a business, you likely should have that business owned by an entity and you want the entity respected so if someone sues the business, they hopefully will not be able to legally pierce through the entity and reach your home and other personal assets. Failing to follow up on the terms of a buy sell agreement terms alone may not suffice to undermine the income tax status or creditor protection of an entity. But there is no bright line test as to what number of infractions might tip the results to a negative result. The safer approach is to strive for complete adherence to entity formalities so that when some formalities are inevitably overlooked, most won’t have been and the entity will hopefully be respected. Entity formalities include such fundamentals as not commingling personal and entity funds, not paying personal expenses through the business that are not legitimate business expenses, signing all agreements in the name of the entity, etc. Having an annual review meeting for the entity, with your outside advisers (attorney and CPA) to address these and other formalities, is a practical step to endeavor to adhere to entity formalities. Had the brothers in the Connelly case done this, their oversights on the buy-sell agreement may have been addressed.
This is the same lesson as the Smaldino (Smaldino v. Comr., T.C. Memo. 2021-127 (November 10, 2021)) and Sorensen (Sorensen v. Commissioner, Tax Ct. Dkt. Nos. 24797-18, 24798-18, 20284-19, 20285-19 (decision entered Aug. 22, 2022)) cases. The bottom line in these two cases, and a key problem for the taxpayers in the Connelly case, was not adhering to the formalities of entities and agreements the taxpayers themselves created. Taxpayers must realize that they have to administer estate plans properly to have any likelihood of success if audited. And proper administration in most cases will require periodic involvement of the professional advisory team given the complexities typically involved.
How Much Buy Out Life Insurance Do you Have?
It was difficult to identify statistical data on insurance funded buy sell agreements to get a “feel” for how relevant the Connelly case estate inclusion issue might be. One major insurance carrier unofficially shared the following information: The average premium for a policy for buy/sell insurance for closely held businesses is $5,300 or as they note it: $10,600 “Per Plan” for two owners. The average Death Benefit is $1.8 million per policy or $3.6 million “per Plan”. If this is representative of buy sell life insurance across the industry, it would appear that a significant portion of buy sell plans are below the estate tax threshold. That doesn’t mean that the Connelly issue of insurance inclusion is not relevant, but it is not likely to be relevant from an estate tax perspective for most business owners.
But even if your insurance coverage is off the estate tax radar map the other lessons of the Connelly case, to adhere carefully to the formalities of your plan, are still vital. Also, another message from the Connelly case is to be certain that you and your business partners understand the economic, income tax, and other implications of your buy sell agreement. It is not only about estate taxes.
Is Your Estate Taxable?
In the Connelly case, “In 2014, the estate filed a tax return reporting that Michael’s shares were worth $3 million. To value the shares, Thomas relied solely on the redemption payment, rather than treating the life insurance proceeds as an asset that increased the corporation’s value and hence the value of Michael’s shares. All told, this resulted in an estate tax of about $300,000, which was paid.”
The taxpayer’s estate in Connelly was a taxable estate. In 2014 the federal estate tax exemption was about $5.3 million. In 2023 the exemption amount is now $12,920,000. So, for most taxpayers, the results of the Connelly case won’t matter unless you live in a state that has an estate tax with an exemption amount much lower than the federal exemption. This might change for many in 2026 when the federal exemption is cut in half. But that may still leave an estate tax exemption of more than $6.5 million and for a married couple $13 million (guestimates of the inflation adjusted exemption). Thus, for a non-taxable estate none of this may be looked at, and it all may have no estate tax consequences. With the current high exemptions how many business owners will face an estate tax? By the way, even if you may never face an estate tax, the economic implications of a buy out agreement can be monumental to the estate of a business owner and for that reason alone every business owner should be certain to have a proper buy out agreement if that is the succession plan.
With the above review of the Connelly case, let’s take a broader and more basic look at some of the issues and considerations in buy sell agreements generally, and in the case to make some of these concepts clearer.
Connelly Court Held that Corporate Owned Redemption Insurance Was Included in Business Value
There are really three valuation questions in the Connelly case: (1) How should the business be valued; (2) Must the life insurance proceeds be included in the date of death value of the business; and (3) Is the value of the insurance proceeds offset in part by the obligation the corporation had under the buyout agreement.
How should a business be valued? The Court in Connelly did not spend must time on this point. There is substantial law and technical literature as to how a value should be determined. There is a sophisticated industry of professional appraisals with expertise to value a business. Merely using a redemption payment amount as a value, especially given the conflicts of interests the brother/executor/surviving shareholder had in that determination, was never going to be acceptable. The Connelly Court noted: “But the estate glosses over an important component missing from the stock-purchase agreement: some fixed or determinable price to which we can look when valuing Michael’s shares…we naturally would expect those agreements to say something about value in a definite or calculable way...an agreement must contain a fixed or determinable price if it is to be considered for valuation purposes.” Had the agreement of a value been based on an analysis of an independent appraisal formula prepared by a qualified appraiser, the Court likely would have been satisfied (and had that been done there may never have been a court case).
The taxpayers in Connelly may have well understood that as their own buyout agreement called for the use of two appraisers. That the IRS or Court would not accept such a figure as value is not surprising. But that was not the key issue in the Connelly case as to valuation. The notable issue was how to treat a non-operating assets, and specifically, life insurance owned by the corporation.
The second valuation issue in Connelly is how should a business owning a non-operating asset to be valued? The tax laws seem pretty clear that all assets of a business, even non-operating assets like an art collection or a life insurance policy, are part of the economic worth of a business. Thus, the life insurance according to the Connelly Court had to be included in the value of the business. The Court cited a Treasury Regulation on this point and stated: “But in valuing a closely held corporation, “consideration shall also be given to nonoperating assets, including proceeds of life insurance policies payable to or for the benefit of the company, to the extent such nonoperating assets have not been taken into account in the determination of net worth, prospective earning power and dividend-earning capacity.” 26 C.F.R. § 20.2031-2(f)(2).”
The above conclusion is one that professional appraisers support, as the insurance proceeds are, post-death, an asset of the entity. Prior to death appraisers might also attribute a value to insurance, especially if it is a permanent policy with value, or if the insured was of advanced age or seriously ill.
The third valuation question that perhaps was the key issue addressed by the Connelly Court is whether a requirement to buy out a shareholder is equivalent to a liability that would offset the insurance proceeds to the extent those proceeds are applied to fund the required buyout? That is precisely what the taxpayers argued: “Crown’s fair market value should not include the life insurance proceeds used to redeem Michael’s shares because, although the proceeds were an asset, they were immediately offset by a liability-the redemption obligation.” The court said no. The position advanced by the taxpayer in Connelly was similar to that in a prior case that had agreed that the buyout obligation should offset the insurance proceeds: “Like the estate in Blount, Thomas argues that life insurance proceeds do not augment a company’s value where they are offset by a redemption liability. In his view, the money is just passing through and a willing buyer and seller would not account for it.” (See, Est. of Blount v. Comm’r, 87 T.C.M. (CCH) 1303, 1319 (2004), aff’d in part and rev’d in part, 428 F.3d at 1338.)
The Connelly Court found that the prior Court holding in the Blount case was just wrong. The Connelly Court reasoned: “An obligation to redeem shares is not a liability in the ordinary business sense.”
The rationale for the above, according to the Connelly Court, was that: “…a hypothetical willing seller of Crown holding all 500 shares would not accept only $3.86 million knowing that the company was about to receive $3 million in life insurance proceeds, even if those proceeds were intended to redeem a portion of the seller’s own shares.” While commentators might disagree with this rationale, and likely many business owners would never contemplate this when they had their corporations purchase buyout insurance, this is now an estate tax reality that must be addressed in planning.
Example: John and Dave are shareholders in a closely held business, each owning 100 shares or 50% of the stock. The business, based on an appraisal report, is worth $4 million so the corporation buys a $2 million life insurance policy on each of John and Dave. If John were to die, the corporation would collect the $2 million death benefit on the insurance policy it owned on his life then use those proceeds to buy the 100 shares John has. If John’s 100 shares are purchased by the corporation then Dave as the surviving shareholder will still own 100 shares but those will be all the issued and outstanding shares, so Dave as the surviving active shareholder will own all the stock. In many cases that is a really practical business result. When John’s heirs file his estate tax return they would report the shares John’s estate sold at the $2 million John’s estate received for those shares. But not so fast. Although the business is worth $4 million, the business also received $2 million of insurance proceeds, which makes the value of the business plus the life insurance worth $6 million. If John owned one-half of the stock at death, then 50% of $6 million means he’d have to report $3 million as the value of the stock on his estate tax return.
Because of the view of the Connelly Court some tax commentators have suggested that the redemption approach to an insurance funded buyout arrangement should not be used. Others disagree. But whatever view your advisers take, consideration should be given to the risk of a Connelly-type view of this.
If you Respect Your Buyout Agreement Will You Get A Better Tax Result?
Maybe. One of the questions that may affect the analysis of a buyout obligation is if the agreement itself was invalid. The Court in the Connelly case did not appear to conclude that the agreement was invalid, but the Court was certainly dismayed by the degree to which the parties ignored their agreement. If the buyout obligation were not signed, not respected, ignored, perhaps the obligation under the agreement should be ignored in the valuation for that reason. But the Connelly case seemed to conclude that regardless of the status of the buyout agreement, the obligation to buyout shares would not be considered a liability that would reduce the value of the enterprise involved. That is important because some might conclude that if you merely respect the agreements, unlike the taxpayers in Connelly, you might achieve a better result. That is not clear from the reasoning in the case.
What Should Business Owners Do After Connelly?
The Connelly decision on the inclusion of redemption life insurance in the value of the company with no offset for the required buyout is pretty significant. Every business that has insurance funded redemption arrangements in place should reconsider its plan. Even if you think the Connelly case is wrong, and some advisers seem to think so (and the rationale for ignoring the buyout obligation may not be acceptable to some), is it worth the potential tax cost not to evaluate your plan and consider options? (And when did you last review all the economic and other aspects of your succession plan anyway?). You might consider other options for funding a buy sell arrangement: ESOP, outside financing, note paid overtime to the estate of the deceased owner, cross-purchase agreement, etc.
If you are going to unravel an existing redemption buy sell insurance structure do so with close involvement of your attorney, CPA and insurance consultant as you need to be quite careful not to trigger the transfer for value rules that could, if violated, result in the insurance proceeds being subjected to income tax.
As stated already several times, be certain you, your partners, and your advisers all understand the legal, income tax, estate tax, economics, and other implications of your buy sell agreement, how it will be funded, what the implications to the surviving co-owners will be etc. And keep in mind that a death buyout out is only one of many critical termination type provisions to consider. What of disability, termination for cause, retirement or even other events? A comprehensive plan should address all potential scenarios.
Further Discussion of Buy Sell Concepts
A few simplified examples (not the numbers in the case) will illustrate conceptually some of the points of what happened in the case.
Example: Say a business is worth $10 million and the business is obligated to buy out your 50% interests which is worth $5 million. The company uses $2 million of redemption life insurance to buy out your shares. The balance of $3 million might be paid by the business overtime, or paid for with outside financing, or some combination. The fact that insurance is added to the equation may make no difference in the “value” from your perspectives, but that is not what the Connelly Court has said from an estate tax perspective. In all events the valuation agreement must be clear that it is a price/value net of insurance if that is intended. That is an important lesson of the Connelly case regardless of your view of whether it is correct. Buyout agreements should precisely state what is to be done with the life insurance component of the plan from an economic perspective. So, if the company owned a $2 million life insurance policy on your life that would apply to cover $2 million of the $5 million purchase price. If $2 million is included in the value to be included in your estate, it would be $6 million not $5 million per Connelly. But is that $2 million included in the value of the business for purposes of determining the payment to the deceased shareholder’s estate? That depends on the agreement.
That economic determination, what the deceased shareholder’s estate gets paid, may be independent of the tax law determination of value. That is what the Connelly case demonstrated. If the buyout agreement said pay the deceased shareholders’ estate one-half the fair market value of the business on the date of death, that would mean after Connelly $6 million, not the $5 million half of the enterprise value. If you and your partners view the insurance as a funding mechanism and not a part of the enterprise value to be paid then be sure to state that.
Also, if this is the approach you and your partners desire perhaps you should evaluate a cross-purchase agreement. That might be particularly important based on the numbers in this hypothetical example because after 2026 when the estate tax exemption amount is reduced by half the estate of the deceased shareholder in this illustration is on the cusp of being taxable. Adding the extra $1 million of insurance value based on Connelly might tip the scales to a taxable estate and perhaps using instead a cross-purchase agreement might avoid that.
Do you need to buy more life insurance to cover not only the value of the business but the estimated estate tax cost resulting from the inclusion of a pro-rata portion of the life insurance proceeds in your estate? Maybe, and that may be why a life insurance funded redemption agreement is less desirable in the wake of Connelly.
Example: Say the business was worth $4 million. The corporation purchased a $2 million life insurance policy on each shareholder. If, as the Connelly Court suggests, the $2 million life insurance policy proceeds must be included in the value of the business, then the value of the business was increased from $4 million to $6 million. Does that mean that $3 million, not $2 million of life insurance should be purchased on each shareholder’s life? But it becomes an iterative calculation because if $3 million of life insurance is purchased then the value of the business would be $7 million, not $6 million, and so on.
Background on Redemptions and Cross-Purchase Buyouts
The following discussion will provide a simplified discussion to illustrate as background some of the concepts involved in buyout arrangements generally, including a few of the points raised in the Connelly case. Hopefully, this background will provide a broader and simpler context for holistic planning for succession.
In the Connelly case a common approach or sequence to a buyout arrangement was used. The two shareholders and the Corporation negotiated an agreement, a stock-purchase or buyout agreement. The surviving shareholder was first given the right to purchase the deceased shareholder’s stock. That could be advantageous because the surviving shareholder would gain tax basis for the price paid.
Example: John died and Dave had the right to buy John’s stock from John’s estate for $2 million. If Dave paid John’s estate $2 million then Dave would have a $2 million income tax basis in the shares purchased from John’s estate. But in the Connelly case, Dave did not pursue his right to buy John’s shares. Therefore, per the buyout agreement, the corporation bought John’s shares. Dave does not get any income tax basis from the transaction.
What does the corporation’s purchase of shares mean economically to the surviving shareholder?
Example: The corporation was worth $4 million and received $2 million of life insurance proceeds on John’s death. The corporation then paid $2 million to John’s estate for his 50% of the shares. Dave owns the same 50% of the shares but since those are the only shares outstanding after the corporation repurchase of John’s shares he now owns all of the corporation and his ownership interest is worth $4 million.
Under Connelly it appears that no matter what the shareholders might do the value to be included in John’s estate is not the $2 million received but rather $3 million which consists of the one-half the value of the business ($4 million plus $2 million insurance). So, John’s heirs will receive $2 million cash but have $3 million to include in John’s estate. If John’s estate is taxable, say both for state and federal purposes, and faces a 50% estate tax, there would be $1.5 million in estate tax due (50% x $3 million includible value) which will decimate the $2 million cash received on the buyout.
But is that always the case? Perhaps not. If John and Dave were not related then their agreement to pay the deceased shareholder’s estate may be binding as the determination of value. But if they are related such that the restrictions of Code Section 2703 apply then the Connelly decision will result in $3 million being included in John’s estate. The difference between the two situations is that Code Section 2703 may apply to ignore the agreement because it restricts the value. For unrelated parties that should not be the case.
Assume that the two shareholders had formed the corporation years earlier with nominal capital and built the value of the business to its current $4 million value. What are the consequences if the corporation was sold under various assumptions to the shareholders?
Example: If the corporation had been sold by John and Dave before John’s death each shareholder would have received $2 million in proceeds, had no income tax basis, and would have realized a $2 million capital gain. What if Dave sold the corporation following John’s death and the corporation repurchased the shares under a stock redemption arrangement? Dave would receive a full $4 million for the sale of the company. That is double what John’s estate received on the insurance buyout. Dave would have had no income tax basis and would realize a capital gains of $4 million.
Is the above a windfall to Dave since he received double what John received? Perhaps not. The partners, John and Dave, had made a decision to finance a future death of whichever one of them died first with life insurance. Since that was done, each partner (really shareholder) realized lower income in every year as the corporation was paying for the life insurance. Dave may have died first and then the economic results may have inured to John instead. Also, consider that the deceased shareholder’s estate got assured cash from the insurance funded buyout. The surviving partner has no assured cash and the value of the business may not be secure following the death of a key owner. It is all very fact dependent and there could be a myriad of different reasons for the approach that the co-owners agreed to.
Let’s say the partners did not have the corporation purchase life insurance and instead just opted to finance the buyout of the first to die shareholder’s shares. Then they would have each earned more money in all prior years (since no insurance premiums would have been paid) and on John’s death Dave would have used corporate assets and perhaps borrowing by the corporation to pay out John’s estate. What is the risk to the deceased shareholder’s estate in collecting in that case? What about the increased financial risk to the surviving shareholder because of the possible impact of debt on the entity? Again, there are a myriad of different considerations and every business buyout may be different.
What if instead of a redemption (the corporation or entity buying the deceased shareholder’s shares) a cross purchase arrangement was used? With a cross-purchase arrangement each shareholder commits to buy-out the shares of a deceased shareholder. A cross-purchase arrangement can be funded with life insurance or just be a contractual arrangement. If it is funded with life insurance each shareholder purchases life insurance on the life of the other shareholder.
Example: John and Dave enter into a cross-purchase agreement so that if one dies the surviving shareholder buys out the shares of the deceased shareholder from that deceased shareholder’s estate. John dies, Dave collects $2 million of life insurance and buys John’s shares. Dave would then own the entire company and would have a $2 million income tax basis in the shares purchased from John’s estate. If Dave sold half the company to a new partner he would recognize no capital gains as he would have a $2 million tax basis in the shares purchased. If Dave sold the entire company he would have a $2 million gain on the half of the shares that he previously owned as there would be no change in the income tax basis on those shares as a result of John’s death and Dave’s purchase of those shares.
While a cross-purchase might sound like a better option that is not always certain. It may be more difficult for each shareholder to monitor whether the other shareholder is keeping the insurance in force, etc. Perhaps that can be addressed contractually with reporting requirements, representations and warranties that the insurance premiums will be paid and the policy not pledged, etc. Also, with a traditional cross-purchase you might need to purchase a large number of policies. If instead of two shareholders there were three shareholders a total of six policies might be necessary as each shareholder would have to purchase a life insurance policy on the lives of the two other shareholders. That can get costly and complicated really quickly.
As a result of the growing number of policies needed as the number of co-owners grows, some business owners use a trusteed cross-purchase or form an entity, like a limited liability company (“LLC”) to own the policies. But each of those options raises other issues as well. Will an LLC owning life insurance policies on each co-owner have a value equal to the insurance collected on the death of the first shareholder (plus the value of the other policies) and a pro-rata portion of that LLC have to be included in the estate of the first to die shareholder under a Connelly rationale?
Is There a Best Approach?
There is no “best” solution but you might find a “better” solution by planning in a holistic way considering not only the Connelly estate inclusion issue but all the various alternatives that might be used as part of your succession plan.
Might Connelly make having the corporation take on debt to finance the repurchase of a deceased shareholder’s interests a better deal than using insurance to finance the buyout? This is probably a fact sensitive determination. If even one shareholder is not insurable, or only insurable and very costly rates, the insurance funded buyout may not be viable.
There is another common issue, many insurance funded buyout arrangements are structured using term life insurance. That is common especially for startup companies because term insurance is so much less costly than permanent insurance coverage. But term insurance is often only a temporary solution since at some age the coverage may lapse or become unaffordable. So, even the ideally structured (if there were such a thing as an ideal plan) term funded insurance buyout may have to yield to another approach at some future date.
On the other side, if the plan is for the corporation to take on debt, what will the cost of that debt burden due to the viability of the company after a shareholder’s death? That could result in the deceased shareholder’s family getting the best deal as compared to the surviving shareholder. That is not a good result either. But an array of different options might be mixed and matched to arrive at a buyout arrangement that is viewed as the best for the company (what is best may never be known without hindsight).
Perhaps the buyout agreement requires some down payment and the balance of the buyout price has to be secured by a note from the company, perhaps guaranteed by the other shareholder. This type of arrangement could provide for a payout over time that is anticipated to be financially palatable to the business and the shareholders (as it cannot be known who will be a surviving shareholder). The note and buyout agreement might require a payment pegged to corporate earnings, or perhaps that some agreed percentage of principal be paid off to the deceased shareholder’s estate each year, e.g., 10% or 20% so that the entire note would be paid off in 10 or 5 years. That may provide the surviving shareholder some flexibility to pay some or much of the buyout price from earnings or to finance from a third-party lender as needed but not all at once.
There Are Lots More Issues
There is another issue that complicates all of this beyond the simple facts in the Connelly case. What if anything should be provided for if the surviving shareholder dies during the payout period or becomes disabled? What if the business is no longer viable? How many businesses have been obviated by change? Or disrupted or closed by Covid or some future event? If there are three or more owners, what if one retires, another dies, and one is incapacitated? Addressing multiple events is complicated and commonly overlooked. When multiple events occur in close succession in time the impact could be devastating and the last standing shareholder may realize the worst result of all co-owners.
Conclusion
Connelly may change the game for using life insurance to fund a corporate or entity redemption. But the case holds many more lessons that business owners should consider. Likely there will be more to be heard on the Connelly case and buyout planning.
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