Lessons from Connelly v. United States
Business succession planning for closely held companies often includes life insurance-funded buy-sell agreements, an approach typically viewed as a practical way to provide liquidity and ensure a smooth ownership transition upon a shareholder’s death. However, the Supreme Court’s decision in Connelly v. United States, 602 U.S. 257 (2024), underscores the need to evaluate how these plans are structured, particularly when the corporation itself is the owner and beneficiary of the life insurance policy.

While the Connelly decision is now well-settled law, it continues to raise important questions for business owners, advisors and estate planners about how shareholders’ agreements with insurance-funded redemption obligations may unintentionally increase a decedent’s estate tax liability.

Life Insurance, Redemptions and Estate Tax: What Connelly Teaches
In Connelly, two brothers owned a closely held business and entered into a redemption agreement under which the company would buy out the shares of the first to die. The company took out a $3.5 million policy on one brother’s life and used the proceeds to redeem his stock when he passed away. The deceased brother’s estate claimed that the life insurance proceeds should not increase the value of the company, and therefore, should not increase the value of his taxable estate because the funds were earmarked for the redemption.

The IRS disagreed, and the Supreme Court sided with the government. The Court held that life insurance proceeds paid to a corporation, even if used to redeem shares under a binding agreement, must still be treated as increasing the company’s fair market value. Because the company simply exchanged cash for shares, its overall value remained the same, meaning the value of the deceased shareholder’s interest was not diminished by the redemption. In other words, for estate tax purposes, a decedent’s shares are valued at the company’s fair market value at death, including life insurance proceeds payable to the corporation, regardless of whether those proceeds are later used to redeem shares.

Why Structure Matters
The Connelly decision highlights that the ownership and beneficiary structure of life insurance policies can have a profound impact on the estate tax implications of a buy-sell agreement. When a corporation owns the policy and redeems a deceased shareholder’s stock, the value of the insurance proceeds is generally considered included in the company’s valuation for estate tax purposes – potentially inflating the taxable estate of the decedent or even creating a liquidity shortfall for the estate.

There are exceptions that permit the IRS to respect valuations excluding insurance proceeds, but those exceptions are narrow, and valuation provisions in a shareholders’ agreement must be carefully crafted to limit risk.

By contrast, in a cross-purchase arrangement, where individual shareholders own life insurance on each other, the insurance proceeds never enter the company’s balance sheet. This structure can mitigate estate tax exposure, though it introduces practical challenges when there are multiple shareholders with varying ownership percentages.

Planning Considerations
For clients with existing succession plans in place, especially those relying on redemption agreements funded by corporate-owned life insurance, now is the time to reassess:

• Review ownership of life insurance policies: Who owns the policy, who is the beneficiary, and how are proceeds used?
• Evaluate the structure of the buy-sell agreement: Is it a redemption or a cross-purchase? Is the valuation method clearly defined and defensible?
• Coordinate with estate planning documents: Ensure that business succession provisions align with the broader estate plan and that liquidity needs are addressed given potential estate tax exposure.
• Consider updating valuations: A regular appraisal schedule or a defined valuation formula may help avoid future disputes with the IRS.

How We Can Help
Our firm’s Business and Trusts & Estates practice groups work together to help business owners structure tax-efficient succession strategies that reflect both operational goals and long-term wealth preservation. Whether you are drafting a new buy-sell agreement or reviewing an existing one, we can advise on how to structure life insurance policies, corporate governance documents, and estate plans to avoid unintended tax consequences and ensure a smooth transition of ownership.

If your business succession plan involves life insurance or if it’s been more than a few years since your agreement was reviewed, we invite you to contact us to evaluate your situation and plan.

To learn more, please contact attorneys Eric Ondo, Dan Desmond or John Reed in Barley Snyder’s Business Practice Group or Randy Moyer in our Trusts & Estates Practice Group.