High Court Estate Tax Ruling Forces Succession Planning Revamps

Estate lawyers will have to reevaluate their options for reducing taxes for family businesses creating succession plans after the US Supreme Court’s decision against an estate in its stock valuation dispute with the IRS.

The high court unanimously ruled Thursday that the value of a family company, Crown C Supply Co., must include the life insurance payout made to the company after co-owner Michael Connelly died. Thomas Connelly, the executor of his brother’s estate, argued that the payout shouldn’t be included in the value because the company was using it to redeem Michael’s shares.

Estate lawyers said the straightforward opinion will narrowly affect family businesses in a similar situation as the Connellys. Otherwise, as the opinion written by Justice Clarence Thomas states, there are other options the Connellys could have considered to avoid additional estate taxes.

“If you’re going to use life insurance proceeds to support your buyout of your shareholders, then you either have to figure out how to count that in the value of the enterprise or take a different approach,” said Ernest & Young LLP Tax Principal David Herzig.

Looking at Other Options

Owners of closely held businesses have other options when using life insurance as part of succession planning.

One of those is a cross-purchase agreement, where, in this case, Thomas Connelly—rather than the company—could have taken out an insurance policy on his brother’s life. Had Thomas received the life insurance payout, the company shares wouldn’t have gone up in value, said James I. Dougherty, partner at Dungey Dougherty PLLC.

Another option would be putting the life insurance in a trust, Herzig said.

“You’re just going to have to plan more,” he said.

That additional planning could put business owners who can’t afford legal expertise at risk of paying more estate taxes, Herzig said. It’s particularly meaningful for those whose estates may fall on the cusp of the exemption amount, or $13.6 million in 2024, Herzig said. For those business owners, an increase in the value of their shares could cause their estate to go above the exemption threshold and incur a 40% tax.

“Many that are affected by this decision are small businesses,” said Richard Mills, a senior counsel specializing in estate planning at Smith Haughey Rice & Roegge. “There’s a lot of folks who will need to be told of the decision and have their buy-sell agreements reviewed.”

The decision is unlikely to create a tidal wave of family business owners altering their succession plans because cross-purchase agreements already tend to be more common than these specific buy-sell agreements that use life insurance proceeds, Dougherty said. And it’s common for family businesses to have no succession plan at all, he added.

Known Risks

Many estate planners previously suspected the potential tax risks associated with buy-sell agreements, but the Connelly decision confirms those concerns, said Carlyn S. McCaffrey, a partner with McDermott Will & Emery.

McCaffrey, who called the court’s decision “obvious,” said it is difficult to have a tax-efficient buy-sell agreement such as that in the Connelly case. Other planners agreed that the brothers would have been better served with a different arrangement.

“We have 10 or so partners in our private wealth group, we have different opinions about things from a risk assessment standpoint,” said Frank Paolini, a Neal, Gerber Eisenberg partner. “But for many of us out there, we more or less anticipated this issue and would have planned around it.”

Despite the clarified tax risk, not all closely held businesses will opt to move away from the buy-sell agreement used by the Connellys, McCaffrey said. In some cases, such as when the business’s owners are arm’s-length partners, the buyout price of a buy-sell agreement might not be based on the company’s value, she said.

Still, reevaluation may be needed for redemption plans where other business factors were put ahead of any estate tax implications, Paolini said.

“People who were already kind of pushing the envelope a little bit, this will be good medicine for them,” he said.

Paul, Weiss, Rifkind, Wharton & Garrison LLP and Aegis Law represented Thomas Connelly.

The case is Connelly v. United States, U.S., No. 23-146, 6/6/24.