Company-Owned Buy/Sell Life Insurance Increases Redemption Value

Authored by Otto Shill

Company-Owned Buy/Sell Life Insurance Increases Redemption Value

The United States Supreme Court held last week that, in determining the value of an equity interest in a company for federal estate and gift tax purposes, a company’s obligation to redeem the equity interest from the estate of a deceased shareholder does not offset the value of proceeds of a company-owned buy/sell life insurance policy collected by the Company for use in the redemption transaction.

Business owners generally follow one of two models when implementing a buy/sell agreement for their business. The first is the “cross-purchase” model where each owner has a contractual obligation to purchase the equity interest of another owner when the other owner leaves the company. To provide funds to make the purchase upon an owner’s death, each owner typically purchases a policy of life insurance on the life of each other owner (a company-owned buy/sell life insurance policy). However, if there are more than two owners, the insurance purchases quickly become complex. So, to simplify the process, a second “redemption” model is often employed. Under the redemption model, the company, rather than other owners, has the obligation to purchase a departing owner’s equity interest, and the company purchases life insurance to cover the cost of the obligation in the event of an owner’s death. Valuation experts typically have considered a company’s obligation to purchase the equity interest of a deceased member as a liability that offsets the increase in value added by the life insurance proceeds collected by the company as a result of the death. This is no longer the case.

Last week, in Connelly v. U.S., 602 U.S. _______ (2024), the United States Supreme Court held that:

[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…We do not hold that a redemption obligation can never decrease a corporation’s value…We simply reject [the] position that all redemption obligations reduce a corporation’s net value.

In the Connelly case, the result was an increase in company value equal to the amount of life insurance proceeds collected. The court recognized that a company’s purchase obligation could, in some circumstances, still justify a discount of company value. It noted that such a discount might be appropriate where a company was required to sell its assets to acquire redemption funding. However, where cash was infused through the settlement of a life insurance policy, the court did not support the discount upon which taxpayers have traditionally relied.

The Connelly case disrupts a long-standing valuation assumption concerning the impact of buy/sell obligations funded by life insurance. The impact to the Connelly family was that the value of the deceased shareholder’s interest was significantly understated on his federal estate tax return. Though not addressed by the court, another possible result of such an imputed increase in value could be that the Internal Revenue Service could take the position that the pre-defined purchase price for a deceased shareholder’s stock might include a bargain element that could be characterized as a gift or other taxable transfer. This could result in the imposition of additional tax, penalties, and interest, or the unanticipated dissipation of a taxpayer’s unified credit. Taxpayers who have engaged in planning in anticipation of the possible decrease of the Unified Credit Against Gift and Estate Tax beginning January 1, 2026, may encounter unanticipated gift or estate tax liability as a result of the Connelly decision. In addition, any insurance-funded arrangement, such as split-dollar plans and agreements, also could be negatively affected.

Buy/sell agreements and other insurance-based business arrangements are an important part of succession and estate planning for many closely held businesses. Now, each business should review its agreements and consult with its tax and financial advisors about what changes are necessary in light of this important change in the law.

We encourage those who have specific questions about company-owned buy/sell life insurance policies and how it might impact your succession and estate planning, or about any tax law topics, to contact the author, Otto Shill.

About the Author

Recognized as a Certified Tax Specialist by the State Bar of Arizona's Board of Legal Specialization, Otto helps individuals, business owners, and employers comply with and plan for laws and regulations related to federal and state taxation, employee benefits, and executive compensation. He assists clients with audits, investigations, and regulatory disputes related to these areas. He also advises businesses and their owners regarding business transactions and long-term business succession and estate planning.

Otto earned his LL.M. in taxation from Boston University and his J.D. and B.S. in accounting from Brigham Young University. He is admitted to practice before all state and federal courts in Arizona, the U.S. Tax Court, the U.S. Court of Federal Claims, the U.S. Court of Appeals for the District of Columbia, and the U.S. Supreme Court.