Succession planning for intently held enterprise house owners has at all times carried property tax dangers, however the Supreme Courtroom’s 2024 resolution in
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Should you do not suppose the Connelly resolution impacts you as a CPA, suppose once more.
First, insurance-funded redemptions with buy-sell agreements are basic instruments in succession planning. 1000’s of intently held companies have these preparations in place. As a CPA, you are probably advising many of those companies. The Connelly resolution primarily pulls the rug out from beneath established planning methods.
There’s additionally skilled legal responsibility danger. CPAs who proceed advising purchasers utilizing pre-Connelly assumptions may face malpractice claims. Getting certified value determinations and correct documentation at the moment are extra vital than ever. Extra on that in a minute.
Lastly, the Connelly resolution creates a basic disconnect between financial actuality and tax valuation. This could result in double taxation, i.e., each the redemption cost and the underlying proceeds. CPAs concerned in enterprise valuations want to grasp how this adjustments their methodology.
Life insurance coverage has lengthy helped intently held companies present liquidity for redemptions when an proprietor dies. These insurance policies are normally paired with buy-sell agreements that mandate redemption, conserving possession within the supposed arms. Till just lately, the property tax penalties of this strategy had been typically understood and never controversial.
The Connelly ruling places planning instruments at odds with how property worth is measured. It diverges from the Eleventh Circuit’s earlier resolution in
What occurred in Connelly?
Crown C Provide, a Missouri-based constructing provide enterprise, was owned by brothers Michael and Thomas Connelly. Their buy-sell settlement gave the surviving brother the primary proper to buy the opposite’s shares, with a compulsory company redemption if declined. The corporate purchased $3.5 million of life insurance coverage on every brother. When Michael handed away in 2013, Thomas declined to purchase shares, and the corporate used $3.0 million in life insurance coverage proceeds to redeem Michael’s 77.18% curiosity.
The acquisition value was informally agreed upon, based mostly largely on the insurance coverage proceeds and a $500,000 working capital adjustment, and not using a formal valuation. It is vital to notice that one of the best apply could be to get a professional appraisal and fasten it to the property tax return to satisfy “ample disclosure” and considerably cut back audit danger.
The property reported the honest market worth of Michael’s shares at $3.0 million. The IRS disagreed, asserting that the total quantity of the life insurance coverage must be included within the firm’s worth. It valued Michael’s curiosity at $5.3 million (for the addition of the life insurance coverage proceeds, $3.0 million × 77.18% = $2.3 million) triggering about $890,000 in extra property tax.
The property paid the tax and sued for a refund. Whereas the District Courtroom sided with the property, the Eighth Circuit reversed, and the Supreme Courtroom affirmed the IRS’s place. Here is a
The Supreme Courtroom’s reasoning
Justice Clarence Thomas, writing for a unanimous court docket, targeted on whether or not a company redemption obligation reduces share worth beneath Part 2031 of the Inner Income Code. The Supreme Courtroom held that it does not, as a result of the duty is to shareholders and doesn’t diminish third-party claims. Due to this fact, the insurance coverage proceeds elevated the corporate’s worth, no matter their use.
This reasoning, nevertheless, overlooks the financial substance of the transaction. A rational purchaser would by no means pay $5.3 million for shares understanding the corporate should instantly pay out $3.0 million. The choice assumes a prepared purchaser unaware of primary monetary info.
This technique has been extensively used and has lengthy been thought-about a settled challenge from a valuation perspective for the previous 20 years.
Revisiting Blount
In Blount, the Eleventh Circuit reached a unique conclusion. William Blount owned 83% of an organization with a buy-sell settlement and life insurance coverage. The property reported his shares at $4.0 million, the agreed redemption value. The IRS argued for the next worth, however the court docket discovered the proceeds weren’t out there for basic use and had been offset by the redemption obligation.
The Eleventh Circuit emphasised that life insurance coverage proceeds used solely for redemption don’t enhance enterprise worth. It reasoned that together with them artificially inflates property worth with out reflecting what a prepared purchaser would really pay. This logic formed property planning for almost 20 years—till Connelly reversed course.
Actuality meets redemption
In Connelly, the Supreme Courtroom handled the life insurance coverage proceeds as unencumbered property, regardless of their required use. Underneath ASC 480-10-25-4, a compulsory redemption triggered by dying could be booked as a legal responsibility. The triggering occasion had occurred, the duty was measurable, and it probably had precedence over different fairness in liquidation.
When life insurance coverage is used solely to fund a redemption, the proceeds briefly enter (and exit) the stability sheet. They don’t improve revenue potential or present capital that can be utilized for distribution. What exists is a transitory second of elevated money instantly adopted by a compulsory outflow, construction or long-term worth. Treating them as accretive misstates the client’s precise place.
This ends in a double taxation that might make a C corp blush. The property receives the redemption cost but is taxed once more as if these proceeds elevated the enterprise’s worth. In massive estates, this could go away little to nothing after tax. Truthful market worth ought to mirror a real-world transaction between a prepared purchaser and prepared vendor; it shouldn’t mirror accounting entries in isolation.
In Blount, the Eleventh Circuit bought this proper with substance over kind. Insurance coverage proceeds used for redemption don’t improve enterprise worth. They merely assist possession transition. Together with them in worth finally ends up mistaking money motion for the creation of wealth.
The Connelly resolution complicates property planning, but it surely doesn’t substitute the necessity for cautious valuation evaluation. It’s now extra vital than ever to differentiate between non permanent funding mechanisms and true worth accretion. A professional appraisal stays one of the best protection in an property tax audit, lowering the chance of added tax and penalties. Advisors ought to reassess plans that depend on insurance-funded redemptions.
CPAs who perceive these implications can present superior advisory companies, serving to purchasers navigate the brand new panorama whereas rivals should still be working beneath outdated assumptions.
