Buy-Sell Agreements and Tax Traps

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The recent U.S. Supreme Court decision, Connelly v. U.S., has created a tax trap for certain buy–sell arrangements between business owners. The case provides that the value of life insurance owned by a business on its owners could be included in the estate of the business owner at death.

Specifically, all owners with buy–sell arrangements in the form of a stock redemption/entity purchase agreement should immediately review this arrangement in light of Connelly to avoid potential estate taxation on the value of life insurance proceeds. The Connelly decision alone could cause an estate that is not taxable today to be subject to estate taxes, which are assessed at 40% of the value subject to estate tax.

As a simple example, ABC Inc. is owned equally by Joe and Kim. ABC Inc. owned $4 million of life insurance on Joe. Based on a recent appraisal, the value of the business is $8 million. At and after Joe’s death, ABC Inc. would use the $4 million life insurance proceeds to redeem Joe’s shares, and ABC Inc. would be valued at $12 million ($8 million value + $4 million life insurance). On Joe’s estate tax return, his family would report a $6 million value for ABC Inc. The inclusion of the life insurance policy in the value of the business could increase Joe’s estate tax liability by $800,000.^*

Action plan

• Review your existing buy–sell agreement immediately with your financial, legal and/or tax advisors to determine whetherConnellyapplies
• If Connelly causes estate tax inclusion, explore alternative buy-sell arrangements, including, but not limited to, cross-purchase agreements and trust planning.
• Work carefully with your qualified professional team if unraveling any existing life insurance policies to ensure no transfer for value issues are created.
• Review your personal balance sheet and wealth strategy to determine estate tax impact of Connelly, if any.
• Conduct annual review meetings with trusted advisors to review formalities of buy–sell structure (including the need for independent valuation) and other governing documents.

Your Fifth Third team is prepared to conduct a complimentary review of your buy–sell agreement and provide you with actionable feedback on its structure. Please reach out to your local Fifth Third advisor to initiate this review process.