You might think Supreme Court cases don't affect your daily life as a business owner, but think again. The recent decision in a case called Connelly v. United States handed down on June 6, 2024, has far-reaching implications that could hit you right in the wallet. This case fundamentally changes how the IRS values businesses, potentially leading to higher estate taxes for you and your family.
I’ll break the case down for you in easy-to-digest bites in this article. I’ll also discuss the implications for you and your business and finally guide you to get the support you need so you’re not negatively impacted.
The case is somewhat technical, so stick with me because understanding this case could save your family hundreds of thousands of dollars or more.
The Facts
Two brothers, Michael and Thomas Connelly, owned a company called Crown C Supply (“Crown C”). Michael owned 77.16% of the shares, and Thomas owned the remaining shares, or 22.82% of the company. Like many business owners, they wanted to keep the company in the family after either died. So, they created an agreement to ensure this happened. The agreement gave the surviving brother the right to decide whether he wanted to buy back the deceased brother’s shares. If he chose not to, Crown C was obligated to purchase the shares.
Rather than paying out of pocket to purchase the other brother’s shares, the Connelly brothers did what many smart business owners do: they agreed that Crown C would purchase life insurance for each brother. This way, if one died, the company could use the life insurance payout to buy back the shares from the surviving brother, rather than the surviving brother having to come up with the funds to buy the shares from the estate of the deceased brother.
So far, so good. Their plan seems reasonable and is exactly what many business owners do. But then, Michael died, and his death triggered the circumstances that set this whole case in motion.
Following the terms of the agreement, Thomas had the first opportunity (in legal jargon, this is called the “right of first refusal”) to buy Michael’s shares. He declined. His refusal then prompted the backup plan the brothers agreed to: Crown C’s obligation to purchase Michael’s shares. Note that Thomas’s right to buy the shares was optional, whereas Crown C’s obligation was mandatory. This fact was crucial to the court's decision.
The reason the court highlighted Crown C’s obligation had to do with whether the obligation to purchase the shares created a liability for the company rather than an asset. This is an important distinction. A liability - or debt - decreases the company's overall value, whereas an asset increases its value. You don’t have to pay taxes on debts, but you do have to pay taxes on assets.
Having said that, let’s get back to the facts of the case.
Crown C had to be appraised to determine the value of Michael's 77.18% ownership. The appraisal put Crown C’s value at $3.86 million, making Michael’s share worth $3 million. Crown C then used the life insurance proceeds to purchase Michael’s shares for $3 million and paid that amount to his estate. The executor of Michael's estate filed the required estate tax return, which included the $3 million worth of Michael’s shares in the company.
I want to pause here to make an essential point about estates and taxes. When you own a business, and the business has value, your ownership stake counts as part of your personal estate when you die. Estates that are valued at a certain amount are subject to estate tax. Like any other person or entity, estates are also subject to a possible IRS audit. Michael’s estate got audited - and that’s when things got interesting.
The Plot Twist
The IRS looked at Crown C's finances and saw things differently than the estate did. The IRS valued the company at $3.8 million plus the value of Michael's shares, bringing the total to $6.86 million. This new calculation meant Michael's shares were actually worth $5.3 million - substantially higher than the original $3 million valuation. That meant an additional $2.3 million was to be added to the value of Michael’s estate, increasing the estate tax bill by almost $900,000. Ouch.
What does this mean for you? It changes how the IRS calculates the value of your business. Before this case, life insurance policies weren't typically included in a company's valuation. The reasoning was that they represented a future liability that would offset any payout. The Connelly decision flips this on its head. Rather than subtracting from a company's value, a life insurance policy purchase to buy out the shares of a deceased shareholder adds to the value of the company. This shift can significantly increase your company's value on paper, and potentially your tax bill, as the Connelly family learned.
But don’t fear. Instead, let your knowledge of this case empower you to adjust your company’s practices and update (or create) your personal estate plan.
The Steps You Can Take Now to Protect Yourself
If you're a business owner and want to avoid the same outcome as the Connellys, now is the time to take action. However, you may think you’re too busy to worry about your death. But here’s the thing about death: it can happen to any of us at any time. Death doesn’t care how busy you are. If you wait to plan for it, it could be too late.
Here are a few steps you can take now:
Create a business succession plan if you don't have one. A succession plan is simply a roadmap for what happens to your business if you aren’t a part of it anymore, either due to your death or exit. So if you've been putting off planning for the future of your business without you, use this as your wake-up call. A solid succession plan can help you avoid overpaying on taxes. The Connellys’ loss is your gain, if you take action.
Review your business succession plan if you have one. If your succession plan resembles Crown C's, it's time to make adjustments. Adjustments may include new or revised contracts, setting up a new entity to purchase and benefit from a life insurance policy, setting up a trust, or finding a different and creative solution. I can help you choose the best option for you and your business. All you need to do is set up a call with me using the link below.
Create or update your estate plan. As mentioned above, your business is an asset and its value will be included in your estate when you die, unless you create a plan to exclude the value of your company from your estate. So, to avoid any negative consequences, tax or otherwise, your personal estate and business plans should fit together. If you have an estate plan, the Connelly decision may mean it’s time to update it. If you don’t have an estate plan, time is of the essence. You need one, and you need one in place as soon as possible. I can help you with this, too.
These tasks may sound like a lot of work and may feel overwhelming. You’re running a business, after all. But don’t worry! I can take this off your plate and ensure you and your company have a plan that saves you unnecessary taxes. All you need to do is reach out and ask for my help.
We Do the Heavy LIFTing So You Don’t Have To
As your trusted advisor, I understand the damaging impact taxes can have on you and your business. That’s why I offer a comprehensive LIFT Business Breakthrough Session where we’ll analyze your current Legal, Insurance, Financial, and Tax (“LIFT”) systems and then develop a plan that fills in any gaps that could expose you and your company to loss. And we don’t stop there. We will continue to inform you whenever your plan is affected by changes in the law or anything else that could happen, like the death of a business partner. So, if you’re reading this and we’ve worked together before, be on the lookout for communications from my office about next steps.
Don’t worry about the heavy LIFTing. That’s what we’re here for. Book a call here to learn more and get started today.
This article is a service of a Personal Family Lawyer®. We offer a complete spectrum of legal services for businesses and can help you make the wisest choices with your business throughout life and in the event of your death. We also offer a LIFT Business Breakthrough Session™, which includes a review of all the legal, financial, and tax systems you need for your business. Call us today to schedule.
The content is sourced from Personal Family Lawyer® for use by Personal Family Lawyer® firms, a source believed to be providing accurate information. This material was created for educational and informational purposes only and is not intended as ERISA, tax, legal, or investment advice. If you are seeking legal advice specific to your needs, such advice services must be obtained on your own separate from this educational material.
We offer a complete spectrum of legal services for business owners and can help you make the wisest choices on how to deal with your business throughout life and in the event of your death. We also offer you a LIFT Your Life And Business Planning Session, which includes a review of all the legal, insurance, financial, and tax systems you need for your business. Schedule online today.