Tax Implications for Life Insurance in Business Succession Planning
Co-Author: Blake S. Gabriel
The recent Supreme Court decision in Connelly v. United States, has introduced significant legal and tax considerations for business owners involved in succession and estate planning using life insurance policies. The Court’s ruling determined that a company-held life insurance policy on a deceased owner cannot be leveraged to reduce the value of shares repurchased from the deceased’s estate. As a result, the value of the life insurance proceeds used as part of succession planning, if not structured properly, most likely will be treated as additional value for the business for estate tax purposes. With the estate tax exemption set to sunset to reduced amounts at the end of the 2025 tax year, business owners must review and reassess their succession and estate planning goals.
This decision underscores the crucial role of life insurance in succession planning, particularly for small, closely held businesses and their owners. Life insurance policies are typically used to ensure liquidity, providing funds to facilitate the purchase of a deceased owner’s shares and allowing for a smooth transition of ownership. By providing this financial support, life insurance helps maintain business continuity and alleviates potential financial burdens on the company or remaining owners.
Though the Court’s focus in Connelly was narrow, the ruling has broad implications for commonly used stock and equity purchase arrangements in closely held companies. These companies often prioritize ownership continuity by permitting or mandating the redemption of equity via life insurance policy proceeds held by the company, thereby reducing the complications and risks of individual owners holding life insurance policies on one another.
Entity Purchase Agreeements and Cross-Purchase Agreements
Understanding these dynamics is vital as businesses reassess their post-Connelly strategies. Below are two common ownership transition methods affected by this ruling:
- Entity Purchase Agreements: In an entity purchase agreement, the business normally holds the life insurance policy on the life of the owner and itself repurchases the shares from the deceased owner, simplifying the process by making the company the sole buyer. However, this approach can impact the company’s cash flow and overall profitability. The Connelly decision highlights the importance of valuing life insurance policies accurately, as these policies cannot be offset by obligations to repurchase shares, and the policy proceeds most likely will be treated as additional value for the business for estate tax purposes.
- Cross-Purchase Agreements: In this arrangement, the remaining owners individually purchase the departing owner’s shares, thereby increasing their respective stakes. This method often involves more complex transactions and valuation challenges, with life insurance policies typically used to ensure sufficient funds for these purchases.
These considerations are essential for business owners aiming to align their succession and estate planning goals with the latest legal and tax standards while optimizing both tax efficiency and succession and estate planning benefits. If you have a current purchase agreement in place for your business which is funded by life insurance or if you are considering implementing an agreement, consulting with an expert to review things can help adapt succession and estate planning strategies in light of these legal and tax developments, as well as explore new opportunities to ensure business continuity.
The information provided herein is not intended to provide legal advice to the reader. If you should have any questions or need assistance, please contact Jeffrey D. Cohen and Blake S. Gabriel for more information. We are here to help provide legal and tax counsel.
