In the recent case of Connelly v. United States (No. 21-3683), the Eighth Circuit Court of Appeals issued a decision that has significant implications for business owners who utilize buy-sell arrangements in their private companies. This decision underscores the importance of carefully structuring buy-sell agreements to avoid potential pitfalls and legal challenges. At Cedar Point Financial Services LLC, we are discussing with clients and their advisors the key takeaways from the Connelly case, the precautions business owners should take regarding their own buy-sell agreements, and how cash value life insurance can be integrated into compliant buy-sell arrangements.
In Connelly, two brothers owned a company that had a stock redemption plan funded with life insurance policies insuring both brothers. The stock redemption agreement provided that, during their lifetimes, the brothers would annually agree on a valuation using a pre-determined method of valuing the company at death. During their lives, the brothers ignored the valuation provisions. Similarly, when the first brother passed away, the valuation terms of the agreement were also ignored, and instead, a purchase price was agreed upon between the company and the deceased’s estate at that time.
The Court found that the agreement did not set a fixed and determinable price for federal tax purposes pursuant to Internal Revenue Code Section 2703 and related case law. As a result, the sale price didn’t control the value of the business for federal estate tax purposes. The court also held that the value of the business included the proceeds from the life insurance policy insuring the deceased owner. As a result, the IRS sent a notice of deficiency to the estate for $1 million in additional tax liability.
This was certainly not the outcome intended when the brothers set out to structure (as any business should!) their buy-sell agreement. However, because of their lack of adherence to their own plan’s valuation terms, poor documentation, and failure to regularly review and update their plan, that outcome is not that surprising. The planning specialists at Cedar Point Financial Services LLC remind their clients to annually review transition plans for their companies to ensure an orderly transition.
Implications of Connelly
The Connelly case revolved around the validity of a buy-sell arrangement in a private company. The court's decision highlighted the following crucial points:
- Arm's Length Transaction: The court emphasized the need for a buy-sell arrangement to be structured as an arm's length transaction. In the Connelly case, the business was found to have been undervalued and not reflective of fair market value, raising concerns about potential gift tax implications.
- Fair Market Value: The court stressed that buy-sell agreements must establish a clear methodology for determining the fair market value of the business interest being transferred. A lack of proper valuation methods can lead to disputes and legal challenges.
- Independent Expertise: The court highlighted the importance of involving independent experts in determining the value of the business interest. Relying solely on internal valuations or biased opinions can undermine the credibility of an arrangement.
Precautions for Business Owners
To ensure that business owners do not encounter similar difficulties as those in the Connelly case, Cedar Point Financial Services LLC recommends the following precautions be taken when setting up, and managing, buy-sell arrangements:
- Professional Advisors: Engage experienced legal, financial, insurance and valuation professionals who can provide unbiased guidance and expertise throughout the process.
- Clear Valuation Methods: Clearly outline the valuation methods used to determine the value of the business interest. These methods should be based on industry standards and reflect fair market value.
- Regular Updates: Periodically review and update the buy-sell agreement to account for changes in the business, market conditions, and regulatory environment.
- Independent Appraisals: Obtain independent appraisals from qualified valuation experts to establish credibility and fairness in valuation.
- Adequate Funding: Evaluate the life insurance purchased to fund the buy-sell arrangement to ensure it is properly owned, has the correct beneficiary(ies) listed and has adequate death benefit to provide the required liquidity.
Cash Value Life Insurance in Buy-Sell Arrangements
As was the intended purpose in Connelly, cash value life insurance plays a pivotal role in compliant buy-sell arrangements. It offers a means to fund the buyout of a retiring business owner (via its cash surrender value) or the purchase of deceased owner's share of the business (via its death benefit), ensuring a smooth transition and financial stability. It is critical that life insurance be incorporated correctly into any of these customary buy-sell arrangements:
- Entity Purchase Plan: This was the structure in Connelly. Here, the business entity purchases and owns life insurance policies on each owner's life. In the event of an owner's death, the business receives the insurance proceeds, which are then used to buy out the deceased owner's share.
- Cross-Purchase Plan: Each owner purchases life insurance on the lives of the other owners. Upon an owner's death, the surviving owners use the insurance proceeds to buy the deceased owner's share.
- Hybrid Plan: Combines elements of the entity purchase and cross-purchase plans, allowing some owners to buy out the deceased owner's share while the business entity buys out the remaining portion.
- Insurance LLC: Involves setting up a limited liability company that purchases life insurance policies on the lives of business owners. In the event of an owner's death, the insurance proceeds are utilized by the LLC to fund the buyout of the deceased owner's share, facilitating a seamless transfer of ownership while providing necessary financial resources.
More detail about buy-sell arrangements can be found in the Cedar Point Financial Services LLC thought leadership piece, “Be In Control of Your Business Succession.”
What Would Happen to Your Business, Your Family, and Your Estate if You or your Business Partner(s) Died Today?
Connelly underscores the importance of structuring buy-sell arrangements meticulously to avoid legal challenges and tax implications. Surviving business partners and family members do not need any emotional and financial surprises that can arise from the failure of a buy-sell arrangement.
Business owners should work closely with their advisors to establish fair valuations and clear processes. Cedar Point Financial Services LLC can assist in integrating cash value life insurance to further enhance the feasibility and effectiveness of these arrangements, providing financial security during ownership transitions. Our team looks forward to helping plan for a smooth transition that secures a company’s continuity.