Supreme Court case highlights planning strategies for family businesses

A Supreme Court case about certain life insurance policies and estate valuations presents a fresh rationale for exploring planning strategy for business owner clients, two experts said.

Financial advisors, tax professionals and their clients are waiting on a ruling this summer in Connelly v. Internal Revenue Service, a case revolving around the estate tax impact on a closely held family company's value from receiving the proceeds of a life insurance policy upon the death of a major shareholder. The case marks the second of the term in which most experts agreed that the justices sounded inclined to rule for the government's side on a tax question rather than upend existing laws and standard practices.

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The Connelly case illustrates why alternatives to that family company's buy-sell agreement could help some clients who face a potentially higher estate value and accompanying taxes accruing to the surviving shareholders, according to David Handler, partner in the Trust and Estates Practice Group of Kirkland & Ellis, and Howard Sharfman, a senior managing director at NFP Insurance Solutions. Handler and Sharfman advise high net worth clients and families that own closely held businesses. Using other avenues that have a lesser potential tax hit to an estate can also ensure that the families retain the company after the shareholder's death.

"These buy-sell agreements are very common," Handler said. "Parties can agree on anything they want. … The issue here is the IRS isn't bound by that for estate-tax purposes."

Structuring the business continuation plan as a cross-purchase agreement moves the tax implications to the individuals receiving the proceeds of the policy, rather than the company itself, Sharfman noted. In the arguments at the Supreme Court in late March, lawyers on both sides of the case mentioned that very approach as another option to the structure used by the Connelly family — and a hypothetical scenario proving their position. The family maintained that the deceased shareholder's estate should not have been subject to an additional tax of $889,914 based on the company's higher value after the insurance proceeds.

"We're talking about just the delta between the cash value and the death benefit," Sharfman said. A cross-purchase agreement "avoids all of this craziness" upon the death of one of the shareholders by enabling beneficiaries to use the proceeds to buy the shares without affecting the company's underlying value, he added.

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A family-owned insurance policy could provide liquidity that won't add to the valuation of the shares in the business at death either, according to Handler. Regardless of the method, advisors and their clients should plan ahead for any adverse tax or business outcomes related to buy-sell agreements or key person coverage, which is another common life-insurance policy for companies, Sharfman said.

The business owners may have "a lot of people counting on them making the right decision" about insurance and estate planning, he said.

"Most companies could not afford to pay out the majority owner or a significant owner without hurting the operations of the company," Sharfman said. "By having this planning, we're protecting not just the families, but we're protecting all of the employees."

Those estate planning issues took center stage at the Supreme Court. 

U.S. Department of Justice Assistant to the Solicitor General Yaira Dubin pointed out that a cross-purchase agreement would "be a much simpler way" of transferring the shares without "this problem that we're dealing with here, where you have corporate assets that [the] petitioner has to argue shouldn't be counted as corporate assets." In one of many times during the hearing that the justices struggled to grasp the complex ramifications to an estate and a business from its life insurance policies, Chief Justice John Roberts asked for clarification.

"In the situation that happened here, you had Crown [the company] paying the premiums, Crown had the benefits and burdens of ownership, and that's why, in the end, when Crown then gets the proceeds, it's treated as a corporate asset. In the cross-insurance arrangement, it would be the brothers personally responsible for maintaining those life insurance policies," Dubin said. "These different tactics do have different economic consequences, but those are the choices taxpayers can make as they're navigating how can we minimize the estate tax consequences of a large estate."

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Earlier in the hearing, the lawyer for the plaintiffs, Kannon Shanmugam, brought up the idea of a cross-purchase agreement in the course of arguing that the government would agree that "it would be subject to tax treatment along the lines of what we are suggesting here." The family business received a benefit from the insurance proceeds, but not a new valuation, he said.

"The reason why the corporation is paying the premiums is precisely because the corporation derives a benefit from this arrangement, and that benefit, as I said in my very first words, is continuity of ownership," Shanmugam said. "That is an incredibly valuable benefit to closely held corporations in this context. And so this is not a situation in which the corporation itself derives any sort of windfall. The corporation is paying premiums and it gets the life insurance proceeds in return."

The justices expressed some skepticism, though, about the claim that the redemption of the policy carried no additional value to the business. In doing so, they illuminated the main topic that effective estate planning could address.

"You agree that the relevant value is of the corporation as a whole," Justice Neil Gorsuch said to Shanmugam. "And, really, the question is, what do we do with the $3 million in life insurance proceeds. How should that be dealt with?"