The Connelly Case: How Life Insurance Policies Impact Your Estate’s Value

 

Written by: Matt Roetcisoender, CPA, CVA

When it comes to estate planning, many business owners carefully set up strategies to protect their wealth and minimize taxes. Recently, however, the Connelly v. United States case brought a new consideration to light: A corporation that owns a life insurance policy on a shareholder may significantly increase the shareholder’s gross estate. This decision emphasizes the importance of reviewing and potentially restructuring life insurance policies to avoid unexpected estate tax implications. 

The Supreme Court Case Connelly vs. United States at a Glance 

Michael Connelly and his brother co-owned Crown Building Supply. Upon Michael’s passing, his life insurance policy, owned by the corporation, paid out $3 million, an increased value of the business which Michael’s estate originally excluded from the gross estate value. However, the IRS argued that this policy boosted the company’s value, treating it as a corporate asset, adding value to the business and consequently value to the estate, and triggering an additional $889,914 in estate taxes. The court ultimately sided with the IRS, clarifying that a corporation-owned life insurance policy indeed counts toward the corporation’s value, impacting the taxable estate. 

What This Means for Business Owners and Estate Planning 

The Connelly case demonstrates that owning a business that holds a life insurance policy on the life of the shareholder can add considerable taxable value to the estate of the shareholder since the life insurance proceeds increase the net worth of the company. For instance, if your corporation owns a $5 million life insurance policy on a shareholder, that value of the company increases by the $5 million in proceeds, potentially creating an estate tax liability, especially for state purposes.   The federal estate tax exemption for 2024 is $13.61 million, yet states have a much lower state estate tax exemption. 

The key term is “fair market value”—the price an outside buyer would pay for the business, including all assets like life insurance proceeds. The court’s decision effectively reaffirms that life insurance owned by a corporation raises the company’s value, even if it’s intended solely for redeeming shares after a shareholder’s death. 

Avoiding an Unexpected Tax Burden 

Consider a cross-purchase agreement to lower the value of an estate while still maintaining a life insurance policy. In a cross-purchase agreement, the shareholders individually own life insurance policies on each other rather than the corporation. This way, when a shareholder passes, the remaining shareholders can use the life insurance payout to purchase the deceased shareholder’s shares without impacting the corporation’s value. 

Planning Tips for Business Owners 

If you currently have life insurance policies owned by your corporation, now is the time to review and restructure your approach: 

• Consider Restructuring Life Insurance: Work with an estate planning advisor to assess the best way to transfer ownership of life insurance policies from the corporation to individual shareholders if the corporation owns a life insurance policy on the shareholders. 

• Establish a Cross-Purchase Agreement: This agreement between shareholders can secure the funds needed to buy shares upon a shareholder’s passing without increasing the company’s taxable value. 

• Review Stock Purchase Agreements: Existing corporation stock purchase agreements in which the corporation agrees to purchase shares upon the death of a shareholder might inadvertently expose the company to increased valuation for estate tax purposes. Updating these to align with a cross-purchase strategy can help prevent this. 

Takeaway 

The Connelly decision is a powerful reminder of how life insurance policy ownership is structured and can have major tax implications. By keeping life insurance policy ownership outside the corporation through cross-purchase agreements, you can protect your estate from unexpected increases in gross estate value. More than ever, proper planning is crucial to ensure that your estate passes as efficiently as possible to your heirs. Contact our team for help reviewing and updating your succession plan so you can be prepared for any tax changes.  A small shift in how life insurance proceeds are structured can make a large difference in the legacy that you leave behind. 

If you would like to read more information about this case, more details can be found here.