Changing the Rules Mid-Game: What the Connelly v U.S. Decision Means for Closely Held Corporations
If you are a shareholder in a closely held corporation, you need to know about the June 2024 decision from the U.S. Supreme Court case Connelly v. United States (2024). This decision (find it here) could have dramatic consequences for your business and for you, personally, as a shareholder.
Here’s the central issue:
Should life insurance proceeds paid to a closely held corporation to buy out a deceased shareholder’s portion of the business be counted as a non-offsettable asset for the purposes of calculating the decedent’s federal estate taxes?
The U.S. Supreme Court says YES.
The issue is somewhat convoluted. The upshot is that this decision allows the IRS, in some circumstances, to essentially “tax” a portion of previously untaxable life insurance proceeds without directly taxing them. Instead, it’s done by counting the life insurance proceeds as a business asset that cannot be offset, thus increasing the deceased shareholder’s share of the company at time of death and increasing their taxable estate – and possibly creating a federal estate tax liability.
This is a drastic change from what has previously been done. It’s like changing the rules while you’re in the middle of the game; you were expecting to pass Go and collect $200, but now you owe $300.
Below, we’ll look at the background of Connelly and the court’s reasoning, then discuss what it could mean for you and the other shareholders in your closely held corporation.
Note that today’s blog is just an introduction to the topic. Since this decision is so new, it’s not clear how things will shake out; it will take some time for business owners and their attorneys to determine the best course of action moving forward. But for now, we wanted to put this on your radar. We recommend speaking with your own business attorney and/or estate planning attorney about the potential consequences for you if you are an owner in a closely held corporation. (And if you do not yet have a business attorney or estate planning attorney in South Carolina, call us at the Gem McDowell Law Group at 843-284-1021 to talk.)
Connelly vs United States (2024) Summary
Briefly: Michael and Thomas Connelly were brothers and together owned a building supply company, Crown C Supply (Crown). They had an agreement to ensure the business would stay in the family if either brother died. The surviving brother would have the option to purchase the shares first, and if not, then Crown would be required to purchase the deceased brother’s shares. The corporation purchased life insurance policies of $3.5 million on each brother to this end.
Michael died in 2013 owning 77.18% of the business (385.9 of 500 shares) at death, with his brother Thomas owning the remaining 22.82%. Thomas declined to buy the shares, so Crown redeemed them for $3 million, an amount agreed upon by Michael’s son and Thomas.
Michael’s federal tax return for the year of his death was audited by the IRS. As part of the audit, an accounting firm valued the business at Michael’s death at $3.86 million, with his 77.18% share amounting to approximately $3 million. The analyst followed the holding of Estate of Blount v Commissioner of Internal Revenue (2005) that stated life insurance proceeds should be deducted from the value of a corporation when the proceeds are “offset by an obligation to pay those proceeds to the estate in a stock buyout.”
But the IRS argued that Crown’s obligation to buy back the stock did not offset the life insurance proceeds. The $3 million in life insurance proceeds should be added to the assets of the business, the IRS argued, making the total value of Crown at Michael’s death $3.86 million + $3 million = $6.86 million. Michael’s 77.18% share of this larger amount would be approximately $5.3 million, and based on this, the IRS said Michael’s estate owed an additional $889,914 in taxes.
Michael’s estate paid these taxes, and Thomas, as Michael’s executor, later sued the United States for a refund. The case went before the Supreme Court in March 2024.
The Supreme Court’s Reasoning
In its decision, the court states two points that “all agree” on:
- The value of a decedent’s shares in a closely held corporation must reflect the corporation’s fair market value for the purposes of calculating federal estate tax; and
- Life insurance proceeds payable to a corporation are an asset that increase the corporation’s fair market value.
The question, then, is whether the obligation to pay out those life insurance proceeds offset the asset, effectively canceling itself out.
The Supreme Court’s answer: No.
The reasoning: “An obligation to redeem shares at fair market value does not offset the value of the life-insurance proceeds set aside for the redemption because a share redemption at fair market value does not affect any shareholder’s economic interest.” The court says that no willing buyer would treat the obligation as a factor that reduced the value of the shares.
Also, for the calculating estate taxes, the point is to assess how much an owner’s shares are worth at the time of death. In this case, it was before Crown paid out the $3 million to buy Michael’s shares. Therefore, that $3 million should be added to the value of the business’s assets and income generating potential, valued at $3.86 million.
This decision will likely affect millions of business owners and trillions of dollars. Depending on your personal and business circumstances, it could affect you, too.
What This Means for You: Federal Estate Taxes
The most important thing to know about federal estate taxes is that the laws affecting them can and do change regularly. (This is one big reason it’s important to have your estate plan reviewed regularly to ensure it’s up to date with current law. Read about the unintended consequences of an out-of-date estate plan here on our blog.)
The majority of individuals subject to U.S. taxes who die in 2024 will not be subject to federal estate taxes; only about 0.2% were expected to in 2023, according to a Tax Policy Center estimate. Currently, if an individual dies in 2024 with a taxable estate valued below $13,610,000, no federal estate tax needs to be paid. This amount doubles to $27,220,000 for married couples filing jointly.
But the “applicable exclusion amount” (also called the “unified tax credit” or “unified credit”) has not always been so high. For many years, it was just $600,000. The current unified tax credit amount is set to expire at the end of 2025, after which it will revert to a lower amount (expected to be around $7 million), unless Congress passes more legislation changing it first.
When Michael Connelly died in 2013, the unified tax credit amount according to the IRS was $5,250,000. Valuing his share of the business at death at $5.3 million rather than $3 million meant he had a larger taxable estate and owed additional federal taxes.
What does this mean for you? This makes estate planning tricky. You can’t know for sure when you’ll die or what the applicable exclusion amount will be that year. Depending on the value of your business and your personal assets, your estate may owe federal estate taxes you weren’t anticipating. The bottom line: If you have a buy-sell agreement and it is funded with life insurance, have it reviewed by an attorney ASAP.
What This Means for You: Succession Planning Going Forward
It’s common for shareholders in a family-owned closely held corporation to have buy-sell agreements that would keep the business in the family should a shareholder die. (Read more about buy-sell agreements on our blog here.) To that end, life insurance policies are often taken out on the shareholders to ensure funds are available to buy out the deceased shareholder’s shares at death.
For years, many business owners have had the corporation itself buy and maintain those life insurance policies on each shareholder. The proceeds went directly to the corporation and were not taxed. Additionally, they did not increase the value of the business, and thus the value of the deceased shareholder’s portion, at the time of the shareholder’s death.
Until now.
What does this mean for you? Now that this has changed after Connelly, shareholders in a closely held corporation may reconsider having the corporation purchase and maintain life insurance policies on its owners.
One option suggested in the Connelly opinion is for the shareholders to take out life insurance policies on each other in a “cross-purchase agreement.” The court acknowledges that this comes with its own set of problems, however, including different tax consequences and the necessity for each shareholder to maintain policies on the other shareholders.
Another potential option is to set up a separate LLC to maintain life insurance policies on the shareholders. In the event of a shareholder death, the LLC – not the corporation itself – would buy out the decedent’s share. This is one possible new solution to this new problem, but it is not yet tried and tested.
Finally, shareholders may continue to have the corporation purchase and maintain life insurance policies with the knowledge that each shareholder should create an estate plan for their personal assets that helps avoid federal estate taxes.
Watch This Space
As the dust settles from this decision, we’ll keep on top of it and come back with more information and advice.
Just remember – the law is not set in stone. Congress passes new legislation and courts render decisions regularly that can affect individuals and business owners. It can be hard to keep up with all the changes, which is why it’s important to have an attorney you can rely on to help keep your estate plan current and your business thriving.
Call Gem at the Gem McDowell Law Group in Myrtle Beach and Mt. Pleasant, SC. He and his team help South Carolina individuals and families create and review estate plans to protect assets and avoid family disputes. He also helps with the creation, purchase, sale, protection, and growth of South Carolina businesses through the creation of corporate governance documents, contracts, problem solving, and more. Call 843-284-1021 today to schedule a free consultation or fill out this form. We look forward to hearing from you.
The Unintended Consequences of Bad Estate Planning
We always advise people to get estate planning done. If you don’t decide what will happen to your assets upon your death, the state will decide for you.
But sometimes, despite best intentions, an estate plan turns out to cause unforeseen problems. That can happen with bad planning, which is sometimes worse than no planning at all. To illustrate this point, let me tell you a story.
What John & Nancy Planned For
Imagine a man named John in the following situation. John’s wife of 50 years, Nancy, recently died. John and Nancy thought they were being smart when they got estate planning done many years ago – and they were. But it turned out to be bad planning, because it didn’t take into account the fact that laws, people, and family dynamics change over time.
When Nancy and John sat down and talked about what they wanted to happen to her estate when she died, they agreed that she would split the estate up: part of her assets would go to their children, and part would go to her husband.
First you need to know that the government allows an unlimited amount of assets to be left to a spouse tax-free upon death. But the government doesn’t allow you to leave an unlimited amount tax-free to heirs or anybody else. The amount it allows you to leave tax-free is called the “applicable exclusion amount” (formerly called the “unified credit”).
So together Nancy and John decided that they would create a trust, and into that trust would go the full amount of money up to the amount of the applicable exclusion amount, so that her children could get that money and not have to pay taxes on it. The key is that here, she didn’t specify the exact dollar amount to go into the trust, she only said that the trust was to be filled to the point of whatever the current exclusion amount was. Her husband was named as trustee to control the trust during his lifetime, and the full value of the trust would go to the children upon his death.
What was left over from her estate after the trust was “filled up” would go to John. No matter what amount that was, it would be tax-free, because they were married.
So far so good. This kind of estate planning is pretty common, and it’s a smart way to maximize the amount of money you pass on to future generations while reducing the amount of taxes paid to the government. It works out well – but not all time.
When John and Nancy made this plan, it seemed great. The applicable exclusion amount at that time was $600,000, which was the limit for many years. Her estate was worth a total of $2 million, so during the planning phase, they expected that upon her death, $600,000 would go into the trust for the children, of which John would be the trustee. The other $1.4 million would go straight to John, including her half of the house they owned together.
Had she died soon after completing the plan, it would have worked out just the way they intended. But that didn’t happen.
What John & Nancy Got Instead
By the time Nancy died in early 2015, the applicable exclusion amount was not $600,000, but $5.43 million – a much larger amount. The full value of her estate went into the trust for the children, and her husband got nothing free and clear. Not even the house.
This was not what Nancy intended. Because of bad planning, everyone is in a difficult situation. Not only are they dealing with the grief of having lost their mother and wife, the family members now have to deal with the consequences of the faulty estate planning.
As the trustee of a trust that will go to the kids upon his death, the wishes of the father are now at direct odds with the wishes of the children. John, who had no substantial assets of his own and was counting on having some of his wife’s estate when she died (which is exactly what they thought was going to happen), wants money from the trust to live on. The kids want the trust to stay as it is, so they get the full value amount upon John’s death.
John has some limited access to the assets of the trust during his lifetime. That is, he can get his hands on some of the money, but not all of it. He’s entitled to the income from that trust during his lifetime; plus a total of 5% of the value of the trust, or $5,000, whichever is greater; plus expenses related to his health, education, maintenance and support (sometimes abbreviated “HEMS”). He would ask the trustee – in this case, himself – for the money to spend on those things. If they were considered legitimate expenses, he could spend it.
But here’s the rub: whether something counts as a legitimate or not varies from person to person. The IRS determines this, and they base that on someone’s standard of living. Donald Trump’s expenses considered “legitimate” would be substantially different from those of someone who makes $30,000 per year and lives very modestly. And if the trustee (John) disagrees with the future beneficiaries (the kids) over what’s legitimate, then they have to go to court.
So if, for example, John says he needs to use money from the trust to go to France for a year because that’s necessary for his maintenance, and the children disagree, they have to sue him.
And if the father wants to sell the house to move somewhere else, he can’t do it easily because it’s not his free and clear – half of the house is in the trust. If he goes ahead and sells the house anyway, it’s likely that his children will sue him.
As you can see, the situation is very complicated and it’s begging for lawsuits.
You don’t want to be in this situation. But how can you avoid it?
Avoid This Situation With Good Estate Planning
Remember that estate planning should be based on you, your unique situation and your family. It should not be based on whatever pre-made forms an attorney has ready. It must be about you.
1. Know that you have options.
Nancy and John could have decided to do something else instead. For example, Nancy could have left everything to John, and he could have used a “disclaimer” to disclaim anything he didn’t want, and that would go into the trust for the children. That’s just one option, but there are others. The point is, you don’t have to go with the first estate planning option presented to you if it’s not what’s best for you and your family.
2. Ask a lot of questions.
You should ask yourself what you want to happen with your estate when you die, and you may include your family in those discussions if you wish. You should ask questions before choosing an attorney to help you draw up these documents. Has he done these kinds of things before? What examples can she give you of the most complicated estate planning she has done?
Ask “what if” questions about the plans you’ve created.
• What if by the time I die, the applicable exclusion amount is $20 million? What if it’s $0? What will happen to my estate and my family then?
• What if my spouse remarries after my death? Will any of my money go to the new spouse’s children?
• What if one of my children does something I disapprove of after I die, do they still inherit a portion of my estate? Can I include something in my will to prevent that from happening?
An attorney experienced in complex estate planning will be able to answer these questions clearly and will be able to pose additional questions you hadn’t thought of.
3. Review your plan periodically with an attorney.
As you’ve seen, family dynamics can be complicated, especially when children from different marriages are in the picture, and things change. The amount excluded from estate tax is not set in stone, but is determined by Congress and therefore can change in any given year. That alone could have a huge impact on how your current estate plan will play out in the real world.
Again, ask questions.
• With the way things are now, will my original intention be honored?
• Has anything significant happened in my situation (births, deaths, estrangements with family members) to affect my original intentions?
• What changes must I make to ensure that my estate is distributed the way I want?
Learn More About Personalized Estate Planning
So what about your estate plan? Is it customized to you? Would it honor your intentions? If the answer is no, or you’re not sure, contact South Carolina attorney Gem McDowell and his associatess at 843-284-1021 to discuss your own estate planning needs.
What to Know About Estate Taxes for Estate Planning
An estate tax is levied on an estate of a certain value. Because the tax rate is so high – up to 40% – it’s smart to do what you can through estate planning to reduce or eliminate the likelihood that your estate will be taxed at your death.
If someone dies in the year 2015 and their estate is worth less than $5.34 million, it will not be subject to estate taxes. If they die and their estate is worth $5.34 or more, it may or may not be subject to estate tax.
Here are some other things to know about estate tax.
Spouses and estate tax
Estate tax usually doesn’t apply if you are passing on your estate to your spouse. This is “usually” because in some cases, if your spouse is not a U.S. citizen, different rules apply. If your spouse is not a U.S. citizen, you will want to speak to an experienced estate planning attorney like Gem McDowell.
You and your spouse can combine your separate amounts together so you can freely pass $10.68 million to your heirs. And spouses can “share” the amount so as long as the couple’s combined assets are $10.68 million or less, they will not be subject to estate tax.
Remember that this amount can change so always check for the most current value when making your estate planning documents.
An experienced tax and estate planning attorney in Mt. Pleasant
This is a very simplified overview of estate taxes. To discuss your own estate, and how to best handle it to reduce or avoid taxes, contact Gem McDowell at his Mount Pleasant, SC office at (843) 284-1021. Gem is an estate planning attorney with experience in tax law, and he can work with you to develop an estate plan to meet your goals. Call today.
