Life insurance proceeds are considered corporate assets, and need to be included when calculating the value of the company, potentially imposing additional estate tax liabilities. There are multiple ways to avoid this, including designating the individual owners as beneficiaries of the life insurance policy rather than the corporation.
Background
Brothers Michael and Thomas Connelly were the sole owners of a building supply company in St. Louis, Missouri. In 2001, the Connelly Brothers agreed that, to keep the company in the family, the company would repurchase the shares of the deceased brother. These relatively common arrangements are called “buy-sell agreements”. To fund this buy-sell agreement, the corporation took out a $3.5 million life insurance policies on each brother. In 2013, Michael Connelly died, the company received $3.5 million in life insurance proceeds, and Michael’s interest in the company was purchase from Michael’s estate.
After filing estate taxes, the IRS concluded that this $3.5 million of life insurance proceeds should have been included in the corporation’s assets when calculating the value of the shares. The IRS imposed additional estate tax liabilities to the tune of approximately $1 million, and Connelly sued seeking a refund of these additional taxes.
Key Issue
“Whether the proceeds of a life-insurance policy taken out by a closely held corporation on a shareholder in order to facilitate the redemption of the shareholder’s stock should be considered a corporate asset when calculating the value of the shareholder’s shares for purposes of the federal estate tax.”
Supreme Court Decision
The IRS properly included life insurance proceeds in corporate assets when calculating value of shareholder stock. More technically, they upheld the Eighth Circuit ruling that said “a corporation’s contractual obligation to redeem shares is not necessarily a liability that reduces a corporation’s value for purposes of the federal estate tax.”
Impact
The Connelly vs Internal Revenue Service decision makes it very important to carefully structure buy-sell agreements with the estate tax implications in mind. For example, if the proceeds had been received by the surviving brother instead of the corporation, the additional tax liability would have been avoided because life insurance proceeds are (generally) tax-free.
It is important to:
- Carefully document all agreement, transactions and valuations.
- Get regular valuations to understand the current market values of your company, and the tax implications thereto.
- Consult with legal and tax experts.