Supreme Court Rules Against Popular Tax Exempt Business Transfers

By Bruce Crumley, Inc. (TNS)

The Supreme Court has issued a number of controversial decisions in its most recent term. But one that was barely noticed when it was delivered in June ends the strategy of closely held companies using life insurance-based methods to reallocate ownership stakes—tax-free—when a major shareholder dies.

The generally overlooked high court decision in Connelly v. United States last month was the topic of a recent Wall Street Journal report highlighting its consequences for certain types of smaller businesses. In particular, closely held companies—that is, those that are not personal service corporations (which include law firms, accounting practices, architects, doctors etc.), and in which a majority of shares are owned by five or fewer people.

Previously, many of those used life insurance plans covering its main stockholders to facilitate redistribution of their ownership when they die. Why? Because the strategy was designed to permit—indeed, oblige—the company to repurchase a deceased co-owner’s holding using payouts from those policies. Under a 2008 appeals court ruling, that shifting of funds and titles had escaped taxation.

No more, according to the Supreme Court’s interpretation of Connelly v. United States.

Contrary to the 2008 precedent, justices unanimously decided funds paid out from those life insurance policies don’t in fact represent one link in a chain of liabilities that are exempted from taxes. That succession involves the business paying premiums for primary owners until they die, at which time it is contractually bound to use insurance payouts to finance repurchase of the deceased’s shares. Until last month’s ruling, that strategy for reconsolidating ownership among surviving partners was considered a legally contracted obligation, making it tax-free. That’s no longer the case.

Moreover, insurance payments to those companies must now also be added to federal estate tax calculations, thereby increasing the value of the defunct co-owner’s holdings—and the IRS share of it.

The Supreme Court decision applies specifically to a case lodged by Thomas Connelly. He used the arrangement with his brother Michael to facilitate share transmission of their co-owned St. Louis building supply company, Crown C Supply. When Michael died in 2013, Thomas agreed the company would use the $3 million insurance payment to acquire his brother’s 77 percent stake, all beyond the reach of tax authorities.

But following an audit and valuation that increased Michael’s ownership holding to nearly $4 million, the IRS ruled the $3 million in insurance money must be added to that new appraisal, and the total taxed accordingly. Thomas Connelly filed suit, ultimately losing last month before the Supreme Court—and he’s now nearly $900,000 in back taxes poorer as a result.

But Connelly’s woes are a warning to all closely held small companies that embraced the ownership redistribution strategy.

“This case is a wake-up call to business owners using life insurance to fund stock redemptions,” Florida-based tax and insurance planning expert John Resnick told the Journal. “Traps for the unwary can wreak havoc on families when the owner dies.”

So what should companies that had been relying on that strategy do to avoid trouble?

First off, accept the fact you’ll need to pay for tax or legal advice to determine what the most solid and least expensive transmission solution for your company is. That expert help will be all the more vital with the IRS now expected to audit more businesses employing the insurance approach—and with the current $13.6 million estate tax exemption rate set to drop back to $7 million in 2025.

Awaiting that advice, business co-owners should bone up an shareholding transmission methods. According to legal and business news site JDSupra, those include:

Cross-purchase accords under which majority holders take out life insurance policies on each other to repurchase the shares of those who pass.
Special Purpose LLCs used for overseeing insurance policies, payouts, and ownership redistribution.
Insurance Trusts that hold polices and remove those “from the gross estate for federal estate tax purposes,” according to JD Supra.

But no matter which option a closely held company’s owners choose, bringing in an expert to consult or even carry out the ownership transition is a must.

“Taxpayers should never think they’ll beat the IRS if they ignore the terms of their own agreements,” New York estate-planning attorney Martin Shenkman told the Journal.

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