The recent Connelly decision has undoubtedly shifted the landscape for structuring buy-sell agreements, particularly for businesses with three or more partners. Traditionally, these agreements have often been set up as redemption agreements, where the corporation holds life insurance policies on each partner. However, the Connelly ruling has prompted a re-evaluation of this approach, especially in cases where life insurance is involved.
Are Redemption Agreements Obsolete?
While it might be an exaggeration to declare redemption agreements entirely obsolete, the Connelly decision certainly limits their applicability. Redemption agreements still have their place, particularly in scenarios where life insurance is not the chosen method for funding the buy-sell agreement. In such cases, use of a promissory note can avoid the complications brought to light by Connelly.
The Cross-Purchase Alternative
One viable alternative is to structure the agreement as a cross-purchase. Under this arrangement, each business owner directly owns life insurance policies on the other partners. For a business with three partners, this translates into a total of six separate policies—one for each possible combination. While this approach ensures the agreement is properly funded, it also introduces challenges. The potential burden and upkeep of a larger number of policies may not be attractive from an administrative perspective. As such, this option needs to be carefully weighed on a case-by-case basis.
Estate Tax Considerations
A key area of concern post-Connelly is for clients who either have, or are nearing, assets of value to trigger a taxable estate. If their buy-sell agreement includes a redemption requirement, the increased value of the company could inadvertently trigger estate taxes or exacerbate existing liabilities. This does not mean that clients without estate tax concerns can ignore these implications. However, those individuals with a taxable estate must pay especially close attention to the Connelly ruling.
Even for those without a taxable estate, redemption agreements can still pose problems. The use of life insurance to fund a redemption agreement may inflate the company's value due to the influx of cash from a life insurance death benefit. This inflated value can lead to an underfunded agreement and potential scrutiny from the IRS.
The Role of the CPA in Policy Transfers
When considering amending a buy-sell agreement and transferring a company-owned life insurance policy to individual partners or shareholders, it's crucial to consult with a CPA. The tax implications of such a transfer depend heavily on the entity's tax structure. For example, the transfer might be considered a distribution by the company, requiring the owner to recognize the policy's fair market value as taxable income. These factors must be carefully evaluated before any policies are removed from the business.
Conclusion
The Connelly decision has introduced new complexities into the planning and structuring of buy-sell agreements. While redemption agreements are not entirely off the table, the potential pitfalls imposed by this case make it imperative to consider alternatives like cross-purchase arrangements, especially in taxable estates. As always, these decisions should be made in close consultation with both legal and tax professionals to ensure that the chosen strategy aligns with the client's overall financial and estate planning goals.
If you have further questions or need clarification on any of these points, please watch our webinar on the topic, "Supreme Court Decision Impacts Buy-Sell Agreements" or contact us at 866-708-2335.