Buy-sell agreements are common in multi-owner business entities. In fact, if you don’t have one, you crate one now. These agreements are typically funded by life insurance, which provides the liquidity necessary to purchase the departing owner’s share. However, recent legal developments, such as the Connelly v. United States decision, have highlighted potential tax pitfalls that business owners must address to protect their estate and business interests.
Taxation of Buy-Sell Agreements
Buy-sell agreements are typically structured as either cross-purchase agreements or entity-purchase (stock redemption) agreements. Each structure carries unique tax implications:
Cross-Purchase Agreements:
In a cross-purchase setup, each business owner takes out a life insurance policy on the others.
The surviving owners use the death benefit proceeds to purchase the deceased owner’s share.
Tax Implications:
Life insurance proceeds received by the beneficiaries are generally income tax-free.
The purchasing owners receive a step-up in basis for the acquired shares, reducing future capital gains tax liability.
Entity-Purchase (Stock Redemption) Agreements:
Typically the business entity owns the life insurance policies and uses the proceeds to redeem the deceased owner’s share.
Tax Implications:
While life insurance proceeds are income tax-free to the business, they may increase the value of the decedent’s estate for estate tax purposes.
The corporation’s obligation to redeem shares is typically not treated as a liability that reduces estate value, as clarified in the Connelly decision.
Connelly v. United States
In Connelly, the Supreme Court ruled that life insurance proceeds payable to a corporation under a stock redemption agreement increase the corporation’s value for estate tax purposes. This decision effectively means that using entity-purchase agreements funded by life insurance could lead to substantial estate tax liabilities.
THIS IS NOT THE RESULT YOU WANT
For example:
If a corporation receives $5 million in life insurance proceeds, this amount is added to the company’s fair market value.
The deceased owner’s estate must include their proportionate share of the business's value in their taxable estate, potentially inflating the estate’s value and resulting in significant estate tax exposure.
How ILITs Can Mitigate Tax Risks
An Irrevocable Life Insurance Trust (ILIT) can fix the Connelly issue:
What Is an ILIT?
An ILIT is a trust designed to own life insurance policies outside the insured’s taxable estate.
The trust holds the policy and receives the death benefit, ensuring the proceeds are not included in the estate for tax purposes.
Benefits of an ILIT in Buy-Sell Agreements:
Exclusion from Estate: By holding the life insurance policy in an ILIT, the proceeds are excluded from the estate’s valuation, avoiding the increased estate taxes highlighted in Connelly.
Liquidity for Succession Planning: The ILIT can distribute the death benefit proceeds directly to beneficiaries or to fund a buy-sell agreement, ensuring a smooth transition of ownership without triggering estate tax issues.
Asset Protection: Assets in the ILIT are protected from creditors of the insured or the business.
Implementing an ILIT for Buy-Sell Agreements:
The ILIT must be properly drafted and administered to avoid inclusion in the taxable estate.
Ownership and beneficiary designations of the policy must align with the trust’s terms.
Business owners should coordinate with tax and legal professionals to ensure compliance and maximize the tax benefits.
Premiums for policies owned by the ILIT should be funded via annual gifts to the trust, leveraging the gift tax annual exclusion or lifetime exemption.
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