Strategies for Estate Planners in Light of Connelly v. United States: Addressing Life Insurance and Stock Redemptions in Estate Tax Planning

Case Background and Supreme Court’s Decision

Connelly v. United States arose from a dispute over the federal estate tax treatment of life insurance proceeds utilized by closely held corporations to fulfill contractual redemption obligations between a corporation and a deceased shareholder. The executor of the estate, Thomas Connelly, argued based on the “willing-buyer/willing-seller” standard as outlined in United States v. Cartwright, 411 U.S. 546 (1973), that such insurance proceeds paid to the corporation upon the death of the shareholder should not inflate the corporation’s estate tax valuation. He argued that no reasonable buyer would consider life insurance proceeds received by the corporation that were then used to buy out the deceased shareholder’s share to be part of the company’s value because of their designated use for stock redemption.

Contrarily, the Supreme Court held that life insurance proceeds payable to a corporation, even if designated for stock redemption, are part of the corporation’s value for estate tax purposes, and therefore increase the value of the corporation’s shares. The proceeds, as assets of the corporation, cannot be disregarded merely because they are earmarked for stock redemption.

Legal Analysis

Judicial Reasoning and Implications

The stock of a closely held corporation is included in the gross estate of a deceased shareholder at its fair market value at the date of the decedent’s death, in accordance with IRC 26 U.S.C. §§ 2031(a) and 2033. The fair market value is determined by the net amount a willing purchaser—individual or corporation—would offer, assuming both parties have reasonable knowledge of relevant facts.

This interpretation poses a significant challenge as the ruling indicates that life insurance proceeds designated for stock redemption are classified as corporate assets, thereby increasing the corporation’s value for estate tax purposes. The decision introduces inconsistencies in estate tax valuations across various stock redemption scenarios, thereby complicating the estate planning process.

Strategic Recommendations for Estate Planners

Cross-Purchase Agreements: In a Cross-Purchase Agreement, each shareholder purchases a life insurance policy on the other. Upon the death of one shareholder, the surviving shareholder(s) use the insurance proceeds to buy the deceased shareholder’s interest directly from their estate. This structure ensures that the proceeds bypass the corporation’s assets and are instead used for the inter-shareholder transfer of ownership, minimizing the estate’s exposure to tax liability. However, this approach may be less practical in businesses with multiple shareholders due to the complexity and administrative burden of maintaining multiple policies. In such cases, an Entity-Purchase Agreement (or stock redemption agreement) might be preferable.

Stock Redemption Agreements: Under this structure, the corporation itself purchases life insurance policies on each shareholder and uses the proceeds to redeem the shares when a shareholder dies. While this arrangement simplifies the buyout process for businesses with multiple shareholders, it comes with a significant caveat in light of the Connelly decision: the life insurance proceeds now used in these agreements may be included in the corporation’s value for estate tax purposes. Estate planners must carefully weigh the administrative simplicity of Entity-Purchase Agreements against the potential for increased estate tax exposure. This strategy requires careful planning, particularly for estates nearing or exceeding the estate tax threshold, which is expected to decrease substantially in the coming years.

Trust-Owned Life Insurance (TOLI): A strategic estate planning vehicle often employed is the establishment of an Irrevocable Life Insurance Trust (ILIT). Under this arrangement, the life insurance policy is held and owned by the trust rather than by the shareholder or the corporation. Upon the insured’s death, the insurance proceeds are paid directly to the trust, effectively separating the funds from the corporation’s assets. By ensuring that the proceeds do not flow through the corporation’s balance sheets, this method prevents any inflation of the corporation’s fair market value for estate tax purposes. The ILIT further ensures that the life insurance proceeds are excluded from the decedent’s gross estate under I.R.C. § 2042, provided that the decedent did not retain incidents of ownership in the policy. This structure thereby minimizes estate tax exposure while simultaneously preserving liquidity to satisfy the estate’s obligations or to benefit heirs.

Lifetime Gifting and Bequeathments: Transferring shares during the shareholder’s lifetime can be an effective tool for reducing the value of the decedent’s taxable estate. This method removes appreciating assets from the estate, thereby lowering the potential estate tax burden. However, such transfers trigger potential gift tax implications under I.R.C. §§ 2501 and 2503, as substantial lifetime transfers may count against the unified credit and require the filing of a federal gift tax return. A key consideration is the strategic timing of these transfers. Executing them too early may reduce the shareholder’s control and influence over the business, while waiting too long could forfeit the opportunity to optimize tax savings. Additionally, the application of I.R.C. § 2035 requires caution, as any transfers made within three years of death may be pulled back into the gross estate for tax purposes. This emphasizes the need for aligning lifetime gifts with broader business and succession planning goals, ensuring the transfers support long-term objectives while complying with applicable tax laws.

Stock Redemption Funded by Non-Insurance Assets: In some cases, instead of relying on life insurance policies to fund stock redemptions, shareholders and corporations may opt to use non-insurance assets, such as cash reserves or other liquid assets, to ensure sufficient liquidity for a buyout. This approach can avoid the potential estate tax implications that arise when life insurance proceeds are included in the corporation’s value for tax purposes.

Review of Existing Agreements: When reviewing buy-sell agreements, estate planners must ensure that these contracts comply with I.R.C. § 2703(b) and the accompanying Treasury Regulation § 20.2031-2(h). These provisions are particularly significant in estate planning for closely held corporations, as they directly affect how buy-sell agreements are structured to avoid unjustly increasing estate tax liabilities.

I.R.C. § 2703(b) Overview

I.R.C. § 2703(a) provides that the value of property is generally determined without regard to any option, agreement, or restriction that limits the use or transfer of the property at less than its fair market value. However, subsection (b) provides exceptions to this rule. To qualify for the exception, an option, agreement, right, or restriction must meet the following three requirements:

Be a Bona Fide Business Arrangement: The agreement must represent a legitimate business arrangement. This means that the agreement is operationally necessary and reflects a genuine business purpose rather than serving as a mere device to avoid estate taxes.

No Transfer for Less Than Full Consideration: The agreement must not serve as a mechanism to transfer the property to family members for less than full and adequate consideration. This ensures that the agreement isn’t used to undervalue the decedent’s interests for the benefit of heirs.

Arm’s Length Comparability: The terms of the agreement must be comparable to those negotiated in arm’s length transactions between unrelated parties. This ensures that the agreement reflects fair market conditions and is not designed to artificially lower the property’s value for estate tax purposes.

Treasury Regulation § 20.2031-2(h)

Treasury Regulation § 20.2031-2(h) further addresses the valuation of closely held corporate stock for estate tax purposes in the context of buy-sell agreements. According to the regulation, the price stipulated by a buy-sell agreement is a strong indicator of the stock’s value if the following conditions are met: the agreement is binding both during life and after death; it is not a device to transfer property for less than full and adequate consideration; and it requires that shares be sold at fair market value, determined by reasonable methods at the time of the agreement’s execution.

Application in Estate Planning

To ensure compliance with I.R.C. § 2703(b) and Treasury Regulation § 20.2031-2(h), estate planners must thoroughly review and potentially restructure existing buy-sell agreements. This review involves evaluating whether the agreement serves legitimate business purposes without facilitating undervalued transfers, especially in family-owned businesses where IRS scrutiny is heightened.

First, planners should assess whether the terms of the agreement reflect genuine economic and business motivations consistent with industry standards. This demonstrates that the agreement is driven by legitimate business needs, not merely by tax avoidance strategies. Second, planners must examine the execution of the agreement to confirm that it operates as intended, rather than serving as a facade for transferring wealth under the guise of a business transaction. Ensuring that the agreement is consistently followed and not merely a nominal document will help withstand IRS challenges. While not a deciding factor, it is important to note that the parties in Connelly did not abide by the agreement which required an outside appraiser. Respect and follow your own agreements.

Finally, estate planners must meticulously document the business rationale behind any restrictions on share sales or redemptions. This documentation should clearly establish that such restrictions are designed to preserve business continuity and are not solely intended to reduce the estate’s tax liability. Proper documentation is crucial to demonstrating that the agreement meets the statutory and regulatory requirements.

Conclusion

The recent decision in Connelly v. United States reshapes the landscape for estate planning involving closely held corporations and life insurance-funded buyouts. In light of this ruling, estate planners must take a meticulous approach to structuring buy-sell agreements and managing life insurance proceeds to minimize potential estate tax liabilities. By ensuring compliance with I.R.C. § 2703(b) and Treasury Regulation § 20.2031-2(h), planners can help safeguard these agreements against IRS challenges while preserving the continuity and financial stability of closely held corporations.

By Nancy Burner, Esq.

Nancy Burner is the Founding Partner of Burner Prudenti Law.