Funding Buy-Sell with Insurance May Affect Business Value
The Supreme Court's Connelly v. United States decision requires company-owned life insurance death benefits to be included in business valuations without offsetting the redemption obligation. This ruling can significantly increase estate tax liabilities and create funding shortfalls in buy-sell agreements, requiring immediate review of existing succession plans.
Business owners face a critical challenge in succession planning. Most have their wealth tied up in their businesses, making buy-sell agreements essential when a partner dies. Life insurance has long been the go-to solution for creating the liquidity needed to fund these buyouts. However, the June 2024 Supreme Court decision in Connelly v. United States has fundamentally changed the landscape for company-owned life insurance in buy-sell agreements.
Understanding the Connelly Decision
The Connelly case involved two brothers who owned a family business with a redemption buy-sell agreement funded by company-owned life insurance. When Michael Connelly died, the business used $3 million of the $3.5 million life insurance proceeds to redeem his shares. The estate valued Michael's shares based on the business value after netting out the $3 million redemption obligation.
The IRS argued that the entire $3.5 million death benefit should be included in the company's valuation without any offset for the redemption obligation. The Supreme Court agreed, creating a shortfall and increasing the estate tax by almost $1 million. This ruling establishes that company-owned life insurance increases business value for estate tax purposes, but the corresponding obligation to purchase shares does not reduce that value.
The Valuation Impact
Consider this example: Two equal business partners own a company worth $1 million and maintain a company-owned $500,000 life insurance policy. Under the Connelly ruling, when one partner dies, the company value increases to $1.5 million. The deceased partner's share is now worth $750,000, creating a $250,000 shortfall beyond the insurance proceeds.
This creates several problems. Large death benefits may increase share values by millions, potentially triggering estate tax where none existed before or significantly increasing existing obligations. For families hoping to keep businesses intact across generations, these increased tax liabilities could force sales to outside parties. Most critically, life insurance originally intended to provide adequate liquidity may now prove insufficient.
Implications for Business Succession Planning
The Connelly decision requires business owners to fundamentally rethink their succession strategies. Redemption buy-sell agreements funded with company-owned life insurance, once standard, now carry significant risks that must be evaluated and potentially restructured.
Life insurance remains valuable for creating liquidity. The key is understanding how to structure ownership and agreements to minimize unintended valuation consequences. This might involve exploring alternative ownership structures, reconsidering the type of buy-sell agreement, or adjusting policy amounts to account for the valuation impact.
Business partners should engage their legal, wealth management, and insurance advisers to review existing arrangements. This review becomes particularly urgent for businesses with substantial company-owned life insurance or those approaching succession events. The goal is to understand how the Connelly decision affects current valuations and tax situations, then establish the best course for business continuity.
Moving Forward
The Connelly decision underscores that strategies working yesterday may create problems tomorrow. Regular reviews of buy-sell agreements and estate plans are essential to protecting family wealth and ensuring smooth business transitions.
We recommend taking action now rather than waiting. Meet with your advisers to assess your situation, model the potential impact on your specific circumstances, and implement appropriate restructuring where needed. The complexity means there is no one-size-fits-all solution, but with proper planning, you can minimize risks while maintaining the benefits of life insurance funding.
Key Takeaways
• The Supreme Court's Connelly decision requires company-owned life insurance death benefits to be included in business valuations without offsetting the redemption obligation, potentially increasing estate values by millions.
• This ruling can create significant estate tax liabilities and funding shortfalls, where life insurance proceeds become insufficient to cover the inflated share values they helped create.
• Redemption buy-sell agreements funded with company-owned life insurance require immediate review to assess potential tax exposure and restructuring needs.
• Business owners should work with legal, wealth management, and insurance advisers to evaluate alternative ownership structures and agreement types that minimize unintended valuation consequences while maintaining business continuity.
Conclusion
The Connelly decision represents a significant shift in business succession planning. While it creates new challenges, it also provides an opportunity to strengthen your succession strategy through informed, proactive planning. By understanding the implications and working with qualified advisers, you can navigate these changes and ensure your business transitions smoothly when the time comes.
Source: Smart Business, May 2025