A recent Supreme Court ruling is prompting business owners and their agents to revise their old buy-sell agreements and accompanying life insurance. This is a good time to review your DI buy-sell agreements and disability insurance policies, too.
The Supreme Court Ruling
A recent Supreme Court Ruling has challenged the way life insurance proceeds are commonly used to buy shares in a buy-sell agreement. Hold on because it gets complicated.
On June 6, 2024, the U.S. Supreme Court issued a unanimous ruling in Connelly vs. United States. The case involved two brothers, Michael Connelly and Thomas Connelly, who jointly owned a small building supply corporation. They had a buy-sell agreement to ensure the business would stay in the family if either brother died. Under the agreement, the surviving brother would have the option to purchase the deceased brother’s shares, and if the brother declined, the company would redeem the shares. As is common with these agreements, the brothers purchased a $3.5 million life insurance policy on each brother to fund the deal. When Michael died, Thomas decided not to purchase the shares, so the company become obligated to do so. The company paid $3 million to Michael’s estate for the shares, and a tax return was filed for the estate.
The IRS audited the tax return. At this time, Thomas secured a valuation determined that the fair market value for the shares was actually $3.86 million, and this amount excluded the $3 million in insurance proceeds that had been used to purchase the shares under the theory that their value was offset by the redemption obligation. The IRS disagreed with the valuation and argued that the redemption obligation did not offset the life insurance proceeds, and the correct value of the shares was therefore $6.86 million. Based on this, the IRS said the estate owed an additional $889,914 in taxes.
The estate paid the additional taxes but then sued for a refund. The Supreme Court ruled in favor of the IRS.
Do Your Buy-Sell Agreements Consider Taxes?
An unexpected tax bill can be highly disruptive. In the Connelly case, the estate ended up owing close to a million dollars in additional taxes.
In light of this ruling, many business owners and their advisors will want to review their buy-sell agreements and corresponding life insurance policies to make sure they’re structured to minimize the tax burden. There are different types of buy-sell agreements, and the one used could have major implications for taxes. According to Forbes, a cross-purchase agreement could be an effective way to prevent the life insurance proceeds from increasing the taxes owed on an estate.
Check Your Disability Insurance Buy-Sell Agreements, Too
The Supreme Court case involved a life insurance policy, so that’s probably what a lot of people will focus on when they consider the implications of the ruling. However, it also makes sense to review your disability insurance buy-sell agreements – and if there is no DI buy-sell agreement in place, this is a good time to create one.
For working-aged individuals, the odds of becoming disabled are greater than the odds of dying. According to the Social Security Administration, one in eight 20-year-olds will die before reaching retirement age, and one in four will become disabled.
Given the odds, it makes absolutely no sense to insure against the risk of death while ignoring the risk of disability. This is especially true when you consider the fact that a disability can be just as disruptive for a business as a death – both can force someone out of work.
Let’s say two sisters open a restaurant together. The restaurant is successful, and they expand to a second location. When one of the sister’s has a stroke, she can no longer work. She also wants to sell her portion of the business because she has medical expenses. Without a disability buy-sell agreement, this situation could get complicated. For example, what if the sister who had the stroke wants to sell her share to a third party to maximize her profits, but the other sister doesn’t want to accept a stranger as a business partner? A buy-sell agreement works this out in advance so there are no disputes.
Funding is also critical. One business partner may want to buy out the exiting partner’s shares, but unless the funds exist, this won’t be possible. A buy-sell disability insurance policy takes care of this issue.
Do You Need Help Securing a Buy-Sell Disability Insurance Policy?
If your clients are looking for buy-sell disability insurance, DIS can help. Read more about disability buy-sell insurance.
