Thomas Connolly v. United States was decided by the United States Court of Appeals in June 2023. The case involved a dispute over whether a company’s value should include the portion of life insurance proceeds used to purchase shares of a deceased shareholder. The court ruled that the value of the company should be determined without reference to the share purchase agreement; and that the IRS did not err in including the insurance proceeds as part of the corporation’s fair market value because the proceeds were a substantial asset of the corporation at the time of Michael Connolly’s death.
The case has implications for the valuation of a company for sale and purchase agreements and mergers and acquisitions, as it clarifies that the value of a company must be increased by the value of the death benefit of life insurance held by the company when using the proceeds of her to purchase shares of a deceased shareholder. The case also highlights the importance of setting a clear value for a decedent’s interest in a business for estate tax purposes, as a sale and purchase agreement that fails to do so can lead to disputes over the value of the company.
The Connolly v. United States decision has potential tax implications for buy-sell agreements. Here are the main implications:
1. Tax liability: The judgment imposes a significant tax liability on the deceased shareholder’s estate. The IRS successfully argued that the company’s value for estate tax purposes was $3.5 million higher due to the inclusion of the life insurance proceeds used to purchase the stock.
2. Valuation Impact: The ruling clarifies that a company’s value for buy-sell agreements must include the portion of life insurance proceeds used to purchase shares of a deceased shareholder. The court accepted that the sale agreement did not affect the valuation of the company.
3. Fixed and determinable price: The court found that the sale agreement at issue did not establish a fixed and determinable price for federal tax purposes. This is important because a sale and purchase agreement that fails to establish a clear value for the decedent’s interest in a business can lead to disputes over the value of the company.
4. Certification of Agreed Value: In the Connelly case, the taxpayers did not agree to a specific buyout amount and signed a certification stating that they had no agreed value. This highlights the importance of having a clear and agreed value in buy-sell agreements to avoid potential tax issues.
There are some strategies to avoid including life insurance proceeds in a company’s valuation, including:
1. Use a cross-purchase agreement: In a cross-purchase agreement, each shareholder agrees to purchase the shares of a deceased shareholder. The life insurance policy is owned by each shareholder and the proceeds are used to purchase shares from the deceased shareholder’s estate. Thus, life insurance income is not included in the company’s valuation.
2. Use an Irrevocable Life Insurance Trust (ILIT): An ILIT is a trust that owns a life insurance policy. The trust is irrevocable, meaning the policy owner cannot change the terms of the trust or access the cash value of the policy. When the policy owner dies, the death benefit is paid to the trust and the proceeds are not included in the owner’s estate. The trustee can then use the proceeds to purchase the deceased shareholder’s shares.
3. Use a Fixed Price Purchase Agreement: A fixed price purchase agreement establishes a clear value for the decedent’s interest in a business. The agreement must specify that the value of the company must not include the portion of the life insurance proceeds used to purchase shares of a deceased shareholder.
4. Use investor-owned life insurance: In this strategy, the outside investor, as the buyer of the stock, owns the life insurance policy. The investor pays the premiums and is the beneficiary of the policy. When the shareholder dies, the investor uses the death benefit to purchase the shares from the deceased shareholder’s estate. Thus, life insurance income is not included in the company’s valuation.
Overall, Connelly v. United States underscores the need to carefully consider the tax implications when structuring buy-sell agreements. It is critical to establish a clear valuation method and ensure that the arrangement meets federal tax requirements to avoid unintended tax liabilities. Business owners should review their sale and purchase agreements with this ruling in mind and consult with tax professionals to ensure compliance and reduce potential tax risks.
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