Buy-sell agreements are a key part of owning a small business with others. Most businesses use buy-sells to keep a closely-held company in the hands of the owners or their families.
There are two typical ways to set up a buy-sell:
- Cross-Purchase Agreement: The other owners agree to buy out the departing owner’s shares, typically using life insurance policies to cover the cost.
- Redemption Agreement: The business itself buys back the shares from the departing owner’s estate, usually with life insurance.
Recently, thought, in Connelly v. United States, the Supreme Court ruled using life insurance in a buy-sell agreement can have unexpected and expensive tax issues.
Connelly and Its Impact on Your Business
Connelly v. United States dealt with how life insurance affects the value of a business when an owner dies. The two Connelly brothers owned a company with a buy-sell agreement in place. When one of the brothers, Michael, died, $3 million in life insurance money bought by the company was used to buy Michael’s shares. The surviving brother, Thomas, reported the value of Michael’s shares as $3 million for tax purposes.
However, the IRS contended that the company was worth more because of the insurance proceeds. They said the life insurance increased the company’s value, and, as a result, the estate owed more taxes. The Supreme Court agreed, ruling that the insurance money is part of the company’s total value.
This means that if you use life insurance in a buy-sell agreement, it could increase the company’s value and lead to more taxes for the estate of the late owner.
What This Means for Small Business Owners
If your company has a buy-sell agreement using life insurance to buy out an owner, this here’s what you need to know:
- Your Company Could Be Worth More Than You Think: The life insurance money is now part the company’s value for estate tax purposes.
- Review Your Buy-Sell: If your buy-sell is a redemption agreement where the company buys back the shares using life insurance, look for other options. One is a cross-purchase agreement as the insurance proceeds go directly to the remaining owners. This keeps the insurance out of the company’s value and can avoid more taxes.
- Clear Valuation: Your buy-sell should explain how the value of the business and its shares are calculated to avoid any surprises.
- Work with Experts: Taxes are tricky. Talk to your accountant and your lawyer about your buy-sell agreement and if it needs changing.
Conclusion
Because of the Connelly case, buy-sells can have a big impact on taxes. If you use life insurance, review your agreement now and consider changes to protect your business and retain a smooth transition in the future without facing a bigger tax bill than necessary.
