How Do You Solve a Problem Like Connelly? A Few of a Practitioner’s Favorite Things
A buy-sell agreement has been a fundamental part of thoughtful business planning for decades, but it received renewed attention following the 2024 United States Supreme Court decision in Connelly v. United States, 602 U.S. 257. In Connelly, the Court held that for purposes of valuing the company shares for federal estate tax purposes, a company’s contractual obligation to redeem shares would not necessarily be deemed a liability of the company that reduces the company’s value in a decedent owner’s gross estate. Resolving a split between decisions in the Eighth and Eleventh (and Ninth) Circuits, the Court provided a rare glimpse into its review of business owners’ obligations to purchase shares upon a triggering event pursuant to a set price or method for determining the price of such shares, as well as Internal Revenue Code (“IRC”) Section 2703 and Treasury Regulations Section 20.2031. This article reviews some of the key takeaways from Connelly, contemplates some practical application and considerations for advisors implementing these takeaways for business owners going forward, and concludes with an opportunity for collaboration across disciplines.
Overview of Connelly, or a Very Good Place to Start
In Connelly, brothers Thomas and Michael owned all the shares in a C corporation. Like many good business owners, they were concerned about each of their mortality risks, so they entered into a buy-sell agreement that set the value of the company shares and required the company to buy or redeem a deceased owner’s shares (a “stock redemption” or “entity redemption”). The buyout was to be funded with the proceeds from separate life insurance policies on each brother-owner’s life, owned by and payable to the company. Unfortunately, this is where the prudence stopped and the Connelly problem began.
A buy-sell agreement can control the value of shares in a closelyheld company for federal estate tax purposes if several requirements are met under IRC Section 2703:
Generally, the value of such shares will be determined without regard to (1) any option, agreement or other right to acquire or use the shares at a price less than their fair market value, or (2) any restriction on the right to sell or use such property.[1]
However, this general rule will not apply if: (1) the agreement is a bona fide business arrangement; (2) it is not a device to transfer the shares to members of the decedent’s family for less than full and adequate consideration; and (3) the terms of such agreement are comparable to similar arms-length transactions.[2]
The buy-sell agreement between the Connelly brothers provided two mechanisms for valuing the company shares: (1) the brothers were to execute a “Certificate of Agreed Value” at the end of every tax year, setting the price per share by “mutual agreement;” and (2) in the absence of such mutual agreement, the brothers were directed to obtain two or more appraisals of the then fair market value of the shares. Notably, the brothers failed to follow their own agreement. When Michael died, Michael’s estate and Michael’s son agreed to the purchase price of $3 million for Michael’s shares, which was subsequently reported to the Internal Revenue Service (the “IRS”) on Michael’s Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return. This was part one of the Connelly problem that we will return to analyzing in the later part of this article.
Upon audit, the IRS argued that the company should be valued at approximately $6.86 million and therefore Michael’s shares were worth $5.3 million, resulting in a deficiency in the federal estate tax paid. The company held $3.5 million life insurance policies on both Michael and Thomas, providing the liquidity for it to redeem Michael’s shares upon his death. It is worth noting that the life insurance proceeds did not match the value agreed to between the estate and the beneficiary, and entirely disregarded the terms of the buy-sell agreement. The estate argued before the District Court that the company’s obligation to purchase the shares should offset the life insurance proceeds because the purchase was an enforceable obligation, and, therefore, a company liability. The District Court disagreed, applying Treasury Regulations Section 20.2031-2(f)(2) as to the value of the closely held company as including the life insurance proceeds payable to or for the benefit of the company. The Eighth Circuit further affirmed, dismissing the buy-sell agreement because the brothers failed to follow its provisions for determining the shares’ value. It further held that the redemption provisions did not offset the life insurance proceeds because such provisions did not rise to the level of a company liability, stating that a buyer could purchase all the company shares, extinguish the buy-sell agreement and control the life insurance proceeds (and the willing buyer would likely consider this scenario when deciding whether to purchase the company shares).
The Eighth Circuit decision in Connelly differed from the Eleventh Circuit’s and Ninth Circuit’s decisions in Estate of Blount v. Commissioner and Cartwright v. Commissioner, respectively, in its inclusion of the life insurance proceeds. On June 6, 2024, the Supreme Court unanimously decided Connelly in favor of the IRS, affirming the Eighth Circuit ruling, on the discrete question of “whether the proceeds of a life insurance policy taken out by a closely held corporation on a shareholder in order to facilitate the redemption of the shareholder’s stock should be considered a net corporate asset when calculating the value of the shareholder’s shares for purposes of the federal estate tax.”
The Supreme Court stated that a fair market value redemption has no effect on any shareholder’s economic interest and, therefore, no willing buyer would have treated the company’s redemption obligation as a factor that would (or could) reduce the value of such shares. The Supreme Court also focused on the timing of the valuation, namely, before the redemption. As of the decedent’s date of death, the buyer of the decedent’s shares would not ignore the insurance proceeds payable to the company as an infusion of cash affecting the company’s underlying valuation. For these reasons, the economics of the Supreme Court’s decision and rationale made sense but seemed like a harsh reality for the decedent’s estate when it only received $3 million for Michael’s shares but owed federal estate taxes on the inclusion of shares valued at over $5 million. What could have led to a better result for the Connelly brothers and how do advisors solve the Connelly problem for owners with existing buy-sell agreements and insurance policies?
Intermission
As a brief aside, it bears asking whether, in our current era of historically high federal estate tax exemptions, business owners should care about this Connelly problem and the inclusion of the life insurance proceeds in the valuation of the company. In Connelly, the value of the company prior to Michael’s death was deemed to be approximately $3.89 million; many other closely held businesses may be worth many multiples of this value. In addition, while the IRS and the Connelly estate were litigating federal estate tax valuation methodologies, these principles would typically apply in large part at the state level for any state death taxes owed, such as Pennsylvania inheritance taxes. Therefore, any significant increases in value of estate assets upon audit could have dramatic impact on the taxes owed by the estate.
Before returning to our main event, it is also worth noting that, for the Connelly brothers, the life insurance proceeds adequately covered the redemption purchase price agreed to between the parties after Michael’s death, with even a $500,000 remainder for continuing business operations. As discussed in more detail below, this outcome is not always the case as life insurance policies may be written years before a triggering event, in the early stages of a business’s lifecycle. In addition, the Supreme Court left some latitude to consider the possibility of another redemption obligation that could decrease a company’s value; in a footnote, the Court contemplates that a redemption obligation could require a company to liquidate its operating assets to pay for the decedent’s shares (and thereby decrease the company’s future earning capacity), but that the Court did not need to consider this issue in Connelly. The magnitude of the company’s value at some triggering event against the amount of the death benefit could contribute to the economics of whether other company assets will need to be sold for the company to satisfy its redemption obligation. The application of this financial management and its impact on the company’s valuation and estate tax would need to be considered for another day. Regardless, without further review and stress-testing, the economics of the stock purchase agreement structure might not be the “sound of music” that we were hoping.
“Sixteen Going On Seventeen” Cross Purchase Agreements
The Supreme Court in Connelly reiterated a practically impractical solution for some business owners: the Connelly brothers could have entered into a “cross-purchase agreement” instead of a stock-purchase agreement/buy-sell agreement. In this scenario, the surviving brother Thomas could have purchased deceased brother Michael’s shares upon Michael’s death with the death benefit payable to Thomas, and therefore avoided the issue of including the life insurance proceeds in the value of the company (and, thereby, in the value of Michael’s shares for estate tax purposes). For two business owners, a traditional cross-purchase arrangement could make sense. Each owner is the owner and beneficiary of a life insurance policy on the other owner’s life. Upon the death of either owner, the surviving owner receives the death benefit, generally income tax-free, and may use it to purchase the deceased owner’s shares from his or her estate. The surviving owner’s basis in the company is increased when this buyout occurs. However, the mechanics of this arrangement may become unwieldly as additional owners become part of the equation. The number of policies needed for a traditional cross-purchase arrangement is x(x-1), where x equals the number of owners. For example, for five owners, 20 policies would be needed; if a sixth owner joins, an additional ten policies would need to be obtained.
Many practitioners consider only the sheer number of policies as a deterrent for the owners to adopt this arrangement, but ignore other impracticalities that might arise. For example, the owners might vary in age and insurability, with the costs of such policies being borne by the individual owners, creating more of a burden on younger owners relative to their older business partners (and ignoring the issues when one owner might be more or less insurable). In addition, to the extent that ownership percentages in the company change in the future, each of the policies may need to be reviewed for sufficient liquidity coverage. As alluded to above, the admission of a new owner also might create additional barriers to entry based on the logistics of underwriting exponentially more policies. The potential ongoing costs of keeping the policies in force may also impact their viability, depending on each owner’s available annual cash flow. As discussed further below, there may be opportunities to creatively structure these cross-purchase agreements for increased viability. In general, however, while the Supreme Court may have been correct in noting this potential solution for the Connelly brothers, this arrangement is far from a drop of golden sun.
The Insurance LLC, or The Lonely Goatherd
Following Connelly, many practitioners debated options other than the stock purchase agreement for their business owner clients, often each option with their own advantages and disadvantages:
Traditional Cross-Purchase Arrangement: This is a popular alternative, which avoids the harsh realities of the Connelly problem but may introduce additional complexity and administrative burdens.
Joint Ownership of Insurance Policies: This arrangement reduces the number of policies, but creates administrative complexity when a policy must be revised or adjusted, (with some carriers not even offering such a plan), and ownership concerns upon an owner’s death, divorce or exit.
Hybrid Agreement: This solution combines a cross-purchase arrangement for majority owners (particularly those who might have estate tax issues) and a stock redemption agreement for minority owners (who may be less likely to have estate tax issues), but may deceptively oversimplify the issues (a minority owner may have an estate tax liability), impeding business succession planning in the future, or complicating the strategic review of the plan with a dual system.
Cross Endorsement on Policies Owned by Each Owner: Similar to a split-dollar policy, each owner has his or her own policy and endorses a portion of the death benefits to each other business owner based on the buyout responsibility. This creative solution, however, shifts and may minimize the estate tax issue from the Connelly problem to the decedent’s estate with potential deductions (to the extent the death benefit is controlled by and owed to the other surviving owners), but could create substantiation and funding issues for keeping the endorsements in line with the buyout responsibilities of the respective other owners.
Trusteed or Escrowed Cross-Purchase Arrangement: A trustee or escrow agent manages the policies but, depending on the circumstances, if the policies are already in existence, a change in ownership may create transfer-for-value issues under IRC Section 101(a)(2) (whereby the income-tax-free treatment of the death benefit may be lost if the policy is transferred for valuation consideration), and it adds administrative costs and complexity.
It also bears mentioning that the operations differ not only before the triggering event but also upon redemption of an owner’s shares. For example, under a stock redemption, if an owner dies with only one other owner surviving, as in Connelly, the company redeems the deceased-owner’s shares for the agreed-upon purchase price, with those shares becoming treasury stock, and the surviving owner owning 100% of the company, but without any adjustment to the surviving owner’s basis. In contrast, under a cross-purchase arrangement, assuming again only two owners for simplicity, the surviving owner purchases the deceased-owner’s shares directly from such owner’s estate with a basis adjustment to the fair market value as of the deceased-owner’s date of death (assuming that such shares are eligible under IRC Section 1014), which may minimize the capital gains taxes owed upon the surviving owner’s later sale.
An alternative with the most viability, but requiring the most initial coordination, is the life insurance, or business continuation, limited liability company (an “insurance LLC”). This insurance LLC functions as a conduit to facilitate a streamlined cross-purchase arrangement. The owners establish an LLC to hold one life insurance policy on each owner, dramatically reducing the administrative burden and complexity of a traditional cross-purchase arrangement. The LLC elect to be treated as a partnership that is to own and administer the life insurance policies on the owners that fund the buy-sell agreement. Each of the owners is a member of the insurance LLC in approximately the same proportion as his or her ownership in the company. When an owner dies, the LLC collects the death benefit proceeds on the single LLC-owned life insurance policy on that owner’s life and allocates the proceeds among the surviving members according to their proportionate ownership interests. These owners would then use the cash to buy the deceased-owner’s shares in the company under the buy-sell agreement. Importantly, the surviving owners’ purchased shares may benefit from a basis adjustment and the life insurance policies (and therefore the proceeds) are never an asset on the company’s books, avoiding a major part of the Connelly problem.
Like the trusteed or escrowed arrangement discussed above, to qualify for an exception to the transfer-for-value rules, the LLC must be taxed as a partnership and operate with a real business purpose. While Private Letter Ruling 200747002 issued on November 23, 2007 approved this structure and provided guidance for other advisors and their clients pursuing this approach, it is my understanding that these structures have since been on the IRS’s no-ruling list. The initial administrative complexity, along with the risks of inadvertently triggering the transfer-for-value rules, means that owners should consult with a trusted advisor, especially in learning the proper mechanics and operation approved under prior Private Letter Rulings, including, but not limited to, the need for independent management, strict voting restrictions on the members, mandatory distributions of the proceeds to satisfy the buy-sell agreement, and separate capital accounts for each member.
Similarly, converting from one approach to another requires careful consideration and due diligence. For example, some advisors have been advocating to abandon stock redemption arrangements by transferring the policies from the company to its owners. This should not trigger the transfer-for-value rules, but, depending on how the company is structured, it could trigger a taxable event for the owners and the company, particularly if the policies have substantial cash value. While some advisors might consider selling the policies to the company’s owners instead, this approach may cause adverse tax consequences to the extent the sales price exceeds the basis in the policy, and it requires owners to have available cash. Neither of these approaches avoids triggering the transfer-for-value rules. However, the transfer of the policies from the owners to the insurance LLC can fall under one of the limited transfer-for-value exceptions. In addition, the buy-sell agreement will likely need to be revised significantly to go from a stock redemption to a cross-purchase arrangement, with the worst outcome resulting from the transfer of policies to new owners while the buy-sell agreement continues to require the company to purchase an owner’s shares (but now without the necessary liquidity to do so!).
Often, the revision of these arrangements requires clear communication and coordination among a team of experts with various expertise. An insurance specialist might quickly identify that issuing new policies on more seasoned owners is impractical, at best, and unattainable, at worst. A financial advisor might determine the best method for transferring the policies from the company to the owners, while the accountant and estate and business planning attorney can opine on the nuanced tax rules, the potential structure and ramifications for these transactions.
A Few of My Favorite Things Post-Connelly
Following the June 2024 Connelly decision, many commentators issued a call to action for business owners and their advisors, including, but not limited to, the following:
Review the structure and terms of a buy-sell agreement;
Compare and contrast the viability of a stock purchase redemption and a cross-purchase arrangement;
Ensure sufficient liquidity afforded by the current life insurance policies and death benefits;
Evaluate the formula and terminology used in the buy-sell agreement;
Emphasize the important practicalities of adhering to the buy-sell agreement before a triggering event;
Monitor the buy-sell agreement in the event of future tax law changes, business valuation changes, changes in the owners, and other changes in circumstances or assumptions; and
Brainstorm hybrid solutions to address the advantages and disadvantages of cross-purchase arrangements and stock purchase redemptions.
Many of these actions were not likely taken, or the attention to them has waned since the summer and fall of 2024, without the proper mechanisms for monitoring and reviewing.
One issue is receiving adequate attention from business owners. Depending on the terms of the buy-sell agreement, the compliance hurdles of satisfying the valuation provisions might require repeatedly climbing a mountain, such as with the Connelly brothers who prescribed annual agreement between them. Completing this “Certificate of Agreed Value” among two brothers might be easier than among five unrelated business partners, particularly if not all of them are involved in all parts of the business and might disagree on the company’s valuation, or a change in the valuation. The option to retain qualified appraisers is often desirable but the cost and time might be prohibitive, especially when the valuation is not necessary until a triggering event. The Eighth Circuit in Connelly also critiqued the “Certificate of Agreed Value” mechanism and a lack of methodology for a qualified appraiser to use, such as the preferred formula for valuing the company.
This creates an important opportunity for collaboration among advisors. Because the formula or methodology for appraising the value of a company may be foreign to some drafting attorneys, and ultimately, it may bind the qualified appraiser using the buy-sell agreement’s provisions in its appraisal process, these attorneys might benefit from early consultation and collaboration with a qualified appraiser in the drafting (or review) process of these agreements. In addition, definitions and other terminology used in the buy-sell agreement should be reviewed and coordinated, as these terms might impact the appraisal process and future disagreements regarding the mechanics of the stock purchase redemption or cross-purchase arrangement. The drafting semantics, along with the requirements for these arrangements, may create additional and potentially unnecessary burdens on the owners, further isolating them when important and relevant changes need to be considered and made to the buy-sell agreements.
The issue of coordination returns when determining or considering which of the business owners’ advisors will be responsible for encouraging the review of the buy-sell agreement. Internal or external corporate counsel might be best positioned to review and revise these agreements, and opine on the various nuances or strategies to accommodate the owners’ unique circumstances, but they might:
Not be concerned with its ongoing practicality or utility until a triggering event draws their attention to it;
In the case of internal counsel, be in a conflicted position, depending on the goals and circumstances of the owners;
Be unaware that the circumstances warrant a review and change.
An owner’s financial or wealth advisor, however, might be best equipped to raise the issue to the owner, and gather the necessary parties and collaborators.
The financial advisors’ awareness of this need to collaborate and review means that they must understand and appreciate the issues if left unaddressed, including, but not limited to:
A stale valuation of the company without the proper mechanisms for an updated appraisal, or, worse, an impractical mechanism for valuing the company;
Unrealistic and impractical requirements to adhere to the valuation methodology under the current buy-sell agreement;
An outdated stock purchase arrangement with a Connelly problem, at the federal and/or state level;
Unknown or limited triggering events under the buy-sell agreement; and
A change in circumstances that would otherwise warrant a review of its impact on the economics and viability of the current buy-sell agreement.
It is typically easier to modify a buy-sell agreement prior to the triggering event because all parties would likely have an interest in amicably and efficiently resolving any ambiguities or issues, and all parties are still alive and aligned regarding the function of the buy-sell agreement. After a party dies, begins a divorce proceeding, becomes disabled or wants to retire (or leave or is forced out of the company) is often a long, long way to run.
How Can Buy-Sell Agreements Survive?
The Connelly problem draws attention to only one potential concern related to buy-sell agreements, but the visibility and awareness generated from this decision, as well as the guidance it provides, should compel advisors to raise similar issues to their business-owner clients. For example, while many buy-sell agreements are funded with life insurance, they need not be, with some redemptions self-financed, paid with a promissory note or through external financing. Like with a critical review of current life insurance coverage, the practicality of these funding mechanisms warrants regular and comprehensive review. For example, self-financing may have made sense when the company was flush with cash but purchases of illiquid assets might threaten this approach.
Similarly, the commercial reasonableness of a promissory note or external financing might need to be stress-tested against the company’s continued free cash flow, especially as the valuation might exceed the economics of this available cash because of intellectual property and other illiquid company assets. Input from qualified appraisers also has strengthened the valuation methodologies in buy-sell agreements over the years, which may leave older and unrevised agreements lacking the practical and defensible provisions and best practices of newer agreements. Similarly, older buy-sell agreements may be limited in the identification of the relevant triggering events. For example, while the Connelly problem raises awareness regarding an owner’s death, an owner’s divorce, disability or bankruptcy, or strategic or unplanned exit, might be a more immediate and potentially more adversarial triggering event for which a company’s (or its owners’) redemption of certain shares might be warranted and desired. In general, these buy-sell agreements work best when an advisor is intentionally and strategically reviewing them every three to five years with the relevant stakeholders and their advisors.
So Long, But Not Farewell to Buy-Sell Agreements
Some business owners may think that, like their operating agreements, buy-sell agreements are a one-time formality to check off the list of business planning tasks when forming a new enterprise. The lessons from the Connelly problem illustrate that this could not be further from the truth. Businesses evolve, owners enter and exit, strategic business and personal goals shift, tax and business laws change and valuations increase. To be faced with a triggering event, such as an owner’s death or divorce, and a buy-sell agreement that binds its owners like a package tied up with string to undesirable terms and conditions, might be worse than having no buy-sell agreement at all. Instead, when life circumstances affect the owners, a buy-sell agreement should address the current and evolving circumstances of the company and its owners, align with estate planning and other governing documents, support the viable application of IRC Section 2703 (if so desired) and facilitate the efficient and effective transfer of ownership, with fewer surprises. Overall, business owners may benefit from renewed attention with coordination among their team of advisors to address evolving needs related to buy-sell agreements and their functionality.
Brian M. Balduzzi, Esq., Tax LL.M., MBA, CFP ®, CEPA ®, AEP ®, IPA is a Partner at Holland & Knight, LLP in its Philadelphia and New York offices. Brian advises and counsels families on estate, tax, charitable and business planning, as well as on trust and estate administration and fiduciary litigation. Brian practices in PA, NY, NJ, MA, and FL.
[1] IRC Section 2703(a)
[2] IRC Section 2703(b)
