Connelly: How to Pull the Wrench from the Works

In last week’s post, we talked about the Connelly case before the U.S. Supreme Court, which involved a fight between an estate and the IRS about whether money from a Key Person Insurance policy (that a company takes out on the lives of its shareholders) should count toward the company’s fair-market valuation for the purposes of estate taxes for the shareholder’s estate. The link for last week’s post can be found here.

With the context and case last week, what is a business owner to do with Connelly? First, let’s qualify with some perspective. As mentioned in the last post, the estate tax in 2024 does not kick in unless an estate is valued at over $13.61 million. This $13.61 million figure is an inflation-adjusted benchmark set by the 2017 Tax Cut and Jobs Act, and it could revert back to $5.6 million if Congress does not vote to extend the 2017 Act by the end of 2025. Estates valued above $5 million made up 3% of estates in 2022, so at either level, we are talking about a very small subset of estates. With that in mind, if redemptions of you or the shareholders of your company are not rising to that $3 million level, this decision should not impact you.

Assuming you are nonetheless impacted, federal estate taxes are 40% on the assets above the threshold, so it can be helpful to think of solutions that will avoid the tax hit. The workarounds essentially work two ways: find other ways to redeem shareholders or take the insurance policies outside of the company.

In the first scenario, the company can find the money elsewhere (take out a loan or pay the shareholder back on a promissory note) to pay the redemption price. It adds liability to the company, but it does avoid estate tax concerns to the shareholders. In the other general approach, a life insurance policy is still taken on the life of the shareholder, but the policyholder is someone other than the company.

For example, the individual shareholders can take out life insurance policies on the other shareholders, and then use the proceeds to individually buy out the shareholder (rather than the company paying). There is added complexity in this approach (depending on the number of shareholders, there can be many duplicate insurance policies on each shareholder, rather than the company holding one policy for each shareholder), but the approach does help to avoid estate taxes.

Above all, it is important to involve your attorney, accountant, and other professionals as you plan for how your company will continue after the death of a shareholder.

Thanks for reading!

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