In Connelly v. United States, No. 21-3683 (8th Cir. 2023), two brothers owned a company that had a stock redemption plan funded by life insurance policies on the brothers. The stock redemption agreement provided that the brothers would annually agree on a valuation of their company during their lifetime and provided for a method of valuing the company at death. During their lives, the brothers ignored the valuation provisions. Similarly, when the first brother passed, the valuation terms of the agreement were also ignored, and a price was agreed on between the company and the deceased’s estate.
The court found that the agreement didn’t set a fixed and determinable price for federal tax purposes pursuant to Internal Revenue Code Section 2703 and related case law, and as a result, the sale price didn’t control the value of the business for federal estate tax purposes. The court held that the value of the business included the proceeds from the policy insuring the life of the deceased owner. Significantly and unlike the court in Estate of Blount v. Commissioner, 428 F.3d 1338 (11th Cir. 2005), the Connelly court held that there was no offsetting liability for the purchase obligation under the stock redemption agreement. For further discussion of the case, see “Company Owned Life Insurance Included in Estate” by Louis Laski.
A Transcendent Case
At a minimum and, at the risk of “short-circuiting” a far more probing analysis of the case and its differences with the Blount case, the Connelly case underscores the importance of: (1) a comprehensive, technically sound buy-sell agreement; and (2) documented compliance with its terms on an ongoing basis.
While the focus of commentary on the case is on estate tax, the case has implications well beyond that. It’s a stark reminder that any buy-sell arrangement that isn’t technically sound and faithfully complied with could give rise to a serious and expensive contest between the buying company and the selling estate or shareholder. At the very least, advisors should apprise applicable clients of the need to review the arrangement and document compliance.
The case also underscores the need and opportunity for advisors to meet with their client companies to determine if an existing redemption arrangement, even if comprehensively structured and technically sound, is still preferable to an alternative approach such as a cross-purchase. Such a determination would involve the traditional legal, economic and tax implications associated with the respective approaches. It would also include an assessment of the adequacy of funding in light of current valuation and anticipated growth.
Advisor/Agent Collaboration
An estate planning attorney sent an alert to her closely-held corporate clients. The alert explained the holding of the Connelly case and, at a high level, its implications on buy-sell planning. She followed up with individual messages to those clients whom she knew could have special interest in this development. One such client is a company that’s owned by three unrelated shareholders and has an insurance-funded redemption agreement. The company’s chief financial officer (CFO) responded with a request for the attorney, the company’s tax advisor and the company’s life insurance agent ( “the presenters”) to meet with the owners to explain the significance of the development and outline their options in response to the case, if any appeared necessary or advisable.
The presenters open with a discussion of the Connelly case and its potential implications on the company’s arrangement. They continue with a high level review of the respective legal, economic, tax and life insurance features of redemption versus cross-purchase arrangements. Once they have their bearings, the owners direct the three presenters to focus on the cross-purchase or maybe one of those variations on that theme that the attorney foreshadowed in her opening remarks. It just makes sense to them to exit their potentially volatile arrangement and move to higher ground. They also think that the tax implications of the cross-purchase, especially for surviving owners, made more sense for them now than the redemption. They do, however, submit one proviso. They’d prefer not to have re-qualify for new insurance. The presenters acknowledge the proviso, but respond with one of their own, namely that in light of anticipated growth of the company, the owners may have to increase their coverage to keep their arrangement fully funded. The agent goes through a couple of scenarios in which that underfunding could be problematic for both the surviving owners and the deceased’s estate. With that, the owners turn to CFO and said, “Put that on the agenda.”
How do they get there from here?
Being linear thinkers, the presenters suggest that a reasonable place to start a discussion about migrating from a redemption to a cross-purchase is at the beginning, which means with a comprehensive, technically sound agreement that meets the requirements of IRC Section 2703. The agreement would identify each owner as a buyer of a co-owner’s shares on the occurrence of a triggering event. As with their current agreement, the triggering events would include an owner’s death, disability, retirement, divorce or bankruptcy. The agreement would call for each owner to maintain life insurance on the other two owners. The agreement would also make provision for how policies owned by a deceased (or departing) owner would be transferred to the remaining owners to keep the arrangement fully funded.
Transferring the Policies
Once the agreement is in place, the owners have to address the funding, which means it’s time for the agent to introduce the latest statements from the carriers. It’s also time for the agent to start diagramming on the whiteboard how the three policies could be transferred from the company to the owners in cross-owned fashion. That transfer presents its own set of logistical challenges and tax complexities, including:
- Administratively, the company will execute the appropriate forms to assign the policies to the respective owners in cross-owned fashion and enable them to designate the beneficiary accordingly.
- Ah, but here’s the rub. Actually, it’s the first of several rubs. The company can transfer the policies by way of a dividend under IRC Section 302, a transfer under IRC Section 83 or a sale. The tax advisor now describes the tax implications to both the company and the owners of the respective modes of transfer. Key components of the discussion are the value of the respective policies when transferred or sold and whether they’re in a gain position at that time. The agent will also be helpful later on with another key piece of inside baseball on this score, namely an adjustment of the new owners’ basis in the policies after the transfer so as to reflect the amount included in their income or the price they paid for the policies.
- Another rub. While the redemption involved only one policy on each owner, the cross-purchase agreement typically involves higher math. That’s because each owner, again typically, has to own a policy on each of the other owners. Does that mean that they have go out and buy a new set of policies? Not necessarily. There are ways to structure things to accommodate a simpler approach that would satisfactorily address the owners’ proviso about new underwriting. Stay tuned.
- And another rub, which is the transfer for value rule of IRC Section 101(a)(2). To make a long story short, the generally tax-free proceeds of a life insurance policy become taxable if the policy is transferred for a valuable consideration. In this setting, the transfer by any of the modes described above would involve valuable consideration. Fortunately, there are exceptions to this rule. The proceeds will be tax-free if the transferee is a partner of the insured or a partnership in which the insured is a partner. Therefore, unless the owners are already partners for tax purposes in some venture, they’ll have to create a partnership or other entity that causes them to be treated as partners for tax purposes before the company transfers the policies. The good news, if you can call it that, is that once they’re partners, a transfer to the surviving owners after the death (or other triggering event) of a deceased (or departing) owner to maintain full funding of the arrangement won’t violate the transfer for value rule.
Paying the Premiums
And now, the unkindest rub of all, which is how the owners will pay the premiums, which to this point have always been paid by the company, with no direct tax implications to the owners. Here are the choices:
- The owners can pay the premiums with their own cash. “Keep going”, they say.
- The company can pay the premiums on their behalf and include those payments in their compensation. Some might call that a “bonus plan.”
- The company can lend the premiums to the owners in a split-dollar plan. While that involves the company’s cash, the owners became concerned when the agent used the word “assuming” one too many times in his explanation of the plan and the diagram of the plan suggested that split-dollar would add even more complexity to an already complex transition. So, they improvised an exit strategy from that alternative and asked the advisors to press on with the discussion. All agreed that they’d revisit this point when the time comes.
A Simpler Approach?
The presenters now return to that somewhat simpler approach, which could theoretically obviate the need to add or restructure insurance coverage. Briefly, meaning there’ll be much more detail to follow in future meetings, here’s an overview of several alternatives:
- The first is a so-called “trusteed” or “escrowed” buy-sell. Here, the policies are transferred to and then owned by and payable to a trustee or escrow agent who also holds the respect owners’ shares. When an owner dies, the trustee or escrow agent receives the proceeds and applies them to the purchase of the stock. While that arrangement can make things simpler from an administrative standpoint, it doesn’t solve the cash flow or transfer for value issues, with a partnership required to address the latter.
- The second involves the use of a special purpose insurance limited liability company (LLC) that’s owned by the insureds. This entity is taxed as a partnership for federal tax purposes, which addresses the transfer for value issue. It will take ownership of the policies and designate itself as beneficiary. The LLC will obtain the funds to pay premiums by way of the owners’ capital contributions and, perhaps, rental payments from the company for equipment or other items that the LLC will lease to the company. Of course, the owners will have to get the funds for those contributions from the company, In any event, when an owner dies, the LLC collects the proceeds and makes a distribution to the remaining owners to finance their purchase obligation under the cross-purchase agreement.
We haven’t written this article to praise or bury the Connelly decision. it’s now the law in the Eighth Circuit and has created uncertainty in all but the Eleventh Circuit, where Blount was decided. There will certainly be advisors who counsel their clients that the case will have no bearing on their well-structured, well-followed redemption arrangements. However, when fully apprised clients express enough discomfort with their redemption arrangements to make some adjustments, either because of Connelly or because of changed circumstances, the steps outlined here should be helpful.