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.
Involved in Real Estate or Passive Activities? Passive Activity Loss Rules to Know
Let’s say you’ve dipped your toe into the real estate game and flipped a house. Instead of making a killing on it, you took a big financial hit. When tax time comes around, can you take that loss against your regular income to reduce your taxes?
Generally, no. That’s because of passive activity loss rules.
In short, passive activity loss rules are anti-tax shelter rules. They prohibit taxpayers from using financial losses from passive activity to offset active income and thereby reduce their taxable income and pay less in taxes.
If you own rental property or are otherwise involved in any passive activity trade or business, you need to know about passive activity loss rules. We’ll look at these rules more closely along with the important definitions and exceptions you should know.
Passive Activity Loss Rules: Definitions and Overview
Below is a summary of some key points of the passive activity loss rules along with definition of terms (in bold). Note that this blog is not intended to be exhaustive, but just to familiarize you with the topic. We’ll be discussing rules from the IRS, specifically Topic No. 425 and Publication 925 (2021), which are derived from 26 U.S. Code § 469. The IRS rules are detailed and contain multiple exceptions, which we won’t go into here, as this is an overview. If you believe you’re subject to passive activity loss rules, speak with an accountant to help you with your taxes.
Passive activity loss rules prohibit a taxpayer from taking a deduction of losses incurred from passive activity to offset active (ordinary/earned) income.
While passive activity losses can’t be used to offset active income, they can be used to offset passive activity income. Losses that exceed passive activity gains in the same year can be carried over to the following tax year.
Passive activity rules apply to:
- Individuals
- Estates
- Trusts (other than grantor trusts)
- Personal service corporations, and
- Closely held corporations
The IRS notes that grantor trusts, partnerships, and S corporations are not directly subject to these rules, but the individuals who own them are.
Active income includes wages, salaries, commissions, and any other income “that comes from performing a service.” This is the money you make from your job or business, whether you’re a W2 employee, 1099 contractor, or business owner actively involved in your business.
In contrast, passive income is income from a passive activity in which you’re not “materially” involved. The IRS defines two kinds of passive activity: 1) rental activities, and 2) trade or business activities the taxpayer did not actively contribute to.
Material participation means being involved in the business activity on a “regular, continuous, and substantial basis.” The IRS lays out seven “material participation tests” to help determine whether involvement is passive or active. The taxpayer only needs to satisfy one of the seven for their participation to be considered material and thus not have the activity considered “passive.”
To see all seven tests, go to IRS Publication 925, linked above; here are three:
- Participation in the activity for more than 500 hours in the tax year
- Participation in the activity for more than 100 hours in the tax year, and at least as much as any other individual (including individuals who don’t own any interest in the activity)
- “Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the year”
These material participation tests do not apply to rental activity (discussed below) or to working interests in oil and gas property, which have separate rules.
Active participation is a lower standard to meet than “material” participation. For example, taking decisions with regard to management of the business activity would qualify as active participation.
Passive Activity and Rental Activities
If you earn income from a rental property, then you know that it only takes a few major repairs or renovations or a couple months without tenants to put you in the red for the year.
That’s where passive activity loss rule comes in. These rules apply to you because the income from your rental property is considered passive activity, even if you are “materially” involved in the activity, as described above – unless you are a real estate professional.
To be considered real estate professional by the IRS, you must meet both of the following requirements:
- “More than half of the personal services you performed in all trades or businesses during the tax year were performed in real property trades or businesses in which you materially participated.”
- “You performed more than 750 hours of services during the tax year in real property trades or businesses in which you materially participated.”
Under the IRS’s definition, you do not need to be a licensed real estate agent, contractor, or other certified real estate professional to meet these requirements. Conversely, the IRS definition means that some people who are licensed in the field, like a part-time real estate agent, would not be considered a real estate professional, and their rental activity would be considered passive.
Real property trades or businesses include not only renting out a real property, but development, construction, acquisition, management, and more.
Special $25,000 allowance
If you are not a real estate professional, then your income is considered passive. Any loss you derive from rental activities may be “trapped” (meaning, you can’t take the loss on your taxes) unless you can offset gains from other passive activities – most of the time.
But there is one big exception to know about. The IRS allows up to $25,000 in passive losses to be used to offset ordinary income such as salary or wages as long as you are “actively participating.” In this specific context, active participation may include things like determining rental terms, approving new tenants, and making repairs or hiring someone to do them.
The full amount up to $25,000 is available for taxpayers whose modified adjusted gross income (MAGI) is $100,000 or less. It begins to phase out above a MAGI of $100,000 and is completely phased out at a MAGI of $150,000, meaning that you cannot offset any ordinary income from passive losses if your MAGI is over $150,000.
There are several facets to this special allowance that we won’t go into here, including different allowance amounts depending on filing status and exceptions to the phaseout rules; again, read more on IRS.gov for more detail.
Estate Planning and Trusts
Passive activity loss rules apply to trusts and estates, too. Remember to work with an accountant if you have questions about how passive activity loss rules affect your taxes. If you have questions about trusts and estate planning, or are the personal representative of someone who recently died and need advice, call estate planning attorney Gem McDowell.
Gem and his team at the Gem McDowell Law Group help individuals and families in South Carolina with trusts, wills, powers of attorney, and other estate planning documents to ensure they’re in control of their assets now and in the future. Call Gem and his team at his Mt. Pleasant office at 843-284-1021 today to schedule your free consultation.
Partnership Representatives: What Partners and LLC Members Need to Know Now
Are you a member of a partnership or a multi-member LLC that’s taxed like a partnership? If so, you need to know about partnership representatives.
A partnership representative is an individual or entity that represents a partnership in front of the IRS in all matters including audits.
The term and role are relatively new. Partnership representatives (PR) went into effect in 2018 after being created in the Bipartisan Budget Act of 2015 (BBA), which repealed and replaced the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA). It replaces the role of the “tax matters partner” in TEFRA, though the two are not exactly the same (more on that below).
Importantly, the BBA also changed the way that the IRS can assess and collect taxes from a partnership due after an audit. Previously, those taxes were collected from the individual partners; now, they are collected at the partnership level – unless the partnership has opted out (more on that below, too). This process is more streamlined for the benefit of the IRS and may benefit partnerships, too.
All partnerships that file US tax returns and multi-member LLCs that are taxed as partnerships are affected. (For the sake of expediency, we’ll just use the term “partnership” throughout the rest of this blog as a shorthand for “partnerships and multi-member LLCs that are taxed as partnerships.”)
If your business is affected, here’s what you need to know.
Partnership Representatives
What is the role of the partnership representative?
In the IRS’s own words: “The partnership representative has the sole authority to act on behalf of the partnership for purposes of Bipartisan Budget Act (BBA) partnership audit procedures. The partnership and the partners are bound by the actions of the partnership representative under the BBA.” (Emphasis added.)
The IRS lists the following actions as things that a PR can do, noting that this list is not exhaustive:
- Entering into a settlement agreement
- Agreeing to a notice of final partnership adjustment (FPA)
- Requesting modification of an imputed underpayment
- Extending the modification period by agreement
- Waiving the modification period
- Agreeing do adjustments and waiving the FPA
- Extending the statutory periods for making adjustments by agreement
- Making a push out election
Ideally, the PR will have nothing to do, because as a business owner you want to have as little to do with the IRS as possible. But if your partnership is audited by the IRS, you want to be sure your PR is competent, honest, and trustworthy, because they have a lot of power to make binding decisions for the partnership and its partners.
Who can be a partnership representative?
A PR can be any individual or entity (including the partnership itself) that has a “substantial presence” in the US. An entity that’s a PR must appoint a designated individual to act on the entity’s behalf.
A “substantial presence,” as defined by the IRS for these purposes, is an individual or entity that has a US taxpayer identification number, a US street address, and a phone number with a US area code, and who is able to meet with the IRS in person in the US “at a reasonable time and place as determined by the IRS.”
A partnership must designate a PR on its tax return (IRS Form 1065 or 1066) each taxable year, as the PR does not carry over year to year. The designated PR can be changed in between tax returns by filling out IRS Form 8979.
Alternatively, eligible partnerships may opt out; more on that below.
Is a Partnership Representative the Same as a Tax Matters Partner?
A partnership representative is similar to a tax matters partner (TMP), but the two are not exactly the same.
What are the differences between a partnership representative and a tax matters partner?
Both a TMP and a PR represent a partnership in audits and other matters with the IRS. However, there are some important differences.
A TMP was required to be a partner of the partnership (or member of the LLC), while a PR can be any individual or entity that meets the requirements listed above. This is the most obvious difference between the two. This change allows partnerships to choose a different party, like a tax attorney or accountant, as their PR.
Also, a TMP represented the partnership to the IRS, but they did not have exclusive authority to do so; other partners could take part, too. A PR, on the other hand, has the sole and exclusive authority to do so.
Finally, the partnership and the partners are bound by the actions and decisions of the PR, as mentioned above. Previously, a TMP could bind the partnership but not the individual partners.
What this means for you, as a partner or member in LLC
If you’re a partner in a partnership or a member in a multi-member LLC that’s taxed as a partnership, here are some things to know and to consider.
You (may) have the option to elect out
Some partnerships are eligible to “elect out of the centralized partnership audit regime for a tax year,” to use the IRS’s words. By making the election to opt out, it means that any adjustments found during an audit will be processed at the partner level. By not electing to opt out, these adjustments will happen at the partnership level, which is now the default state.
To be eligible, a partnership cannot have more than 100 partners, each of which must be an individual, C corporation, foreign entity that would be treated as a C corporation if it were domestic, S corporation, or estate of a deceased partner.
A partnership that has opted out and then is notified of an audit may revoke their decision with the approval of the IRS.
Some advantages and disadvantages of opting out
The advantage of taking part in the BBA centralized partnership audit regime, i.e., not opting out, is that the situation is more streamlined for both the IRS and the partnership. Because an audit (or other matter) happens at the partnership level, individual partners do not have to (and cannot) deal with the IRS directly and do not have to amend their individual tax returns.
One disadvantage is that, depending on the nature of your partnership and your partners’ individual financial situations, it’s possible that assessing additional taxes at the partnership level could cost more than if it were done at the partner level.
Another disadvantage was mentioned before: the PR has a lot of power. In their role, they are authorized to make binding decisions unilaterally, which could lead to a situation that’s unfavorable to the partnership or some or all of the partners. The PR’s decision is binding, and individual partners do not have a right to appeal the PR’s decision(s) to the IRS.
Furthermore, under the BBA, the IRS only has to notify the partnership and partnership representative when initiating an administrative proceeding and thereafter only notify the PR. So it’s possible for an audit to occur without individual partners being aware it happened, even if in the past under TEFRA they would have known. (You can read more about the IRS’s BBA partnership audit process here.)
Discuss with the other partners/members and ensure your partnership agreement/operating agreement is updated
Some of the issues mentioned above can easily be handled by updating the partnership’s governance documents. This would allow your partnership to take part in the centralized partnership audit regime and designate a PR while providing more protections to the individual partners via your partnership agreement/operating agreement. For example, you could include a provision that the PR must notify all individual partners of audit proceedings, even if the IRS doesn’t require it.
Some issues to discuss:
- Whether the partnership (if eligible) will opt out or how that will be decided each year
- How the partnership will choose a PR each tax year
- Whether the PR must inform individual partners of audit proceedings, findings, decisions, etc., and how
- Whether and how partners have any say on decisions relating to an audit or other matter
- What to do if disputes between partners arise during or after an audit or other matter
Discuss these issues with your business attorney and make changes, as needed, to your partnership agreement or operating agreement.
Choose your partnership representative wisely
If your partnership accepts the default and does not opt out (or is not eligible to), then be very judicious about whom you designate as your PR. Hopefully, you will never need one, but if that day comes, you’ll want someone you can trust with the future of your business.
Call Business Attorney Gem McDowell for Help and Legal Advice
Gem has over 30 years of legal experience in South Carolina and he is ready to help you and your business. He can advise you on how to handle the issue of partnership representatives in your partnership or LLC and help you think through potential difficult situations that you may not have thought of.
Gem and his team not only help business owners with corporate governance documents like partnership agreements and operating agreements, they can help your business grow and thrive, all while keeping your assets protected. Call Gem and his team at the Mt. Pleasant office at 843-284-1021 today to schedule a free consultation.
