Your buy-sell agreement may be doing the opposite of what you think it does.
For decades, business owners have used a common structure to protect their partners at death. The company takes out a life insurance policy on each owner. When one owner dies, the company receives the insurance proceeds and uses them to buy back the deceased owner's shares from the family. Clean. Orderly. Widely used.
A 2024 United States Supreme Court ruling changed the math on that structure in a way that most businesses have not yet addressed.
The Connelly Ruling: What Changed
In Connelly v. United States, decided in June 2024, the Supreme Court ruled on a case involving two brothers who co-owned a closely held corporation. When one brother died, the company received life insurance proceeds and used them to redeem the deceased brother's shares from his estate.
The IRS argued that those insurance proceeds increased the company's fair market value for estate-tax purposes. The brothers' estate argued that the company's obligation to redeem the shares should offset the insurance proceeds when calculating the company's value. The Supreme Court sided with the IRS.
The result: the deceased owner's estate was larger than anticipated for tax purposes. Not because the business grew, but because the insurance proceeds that were supposed to fund the buyout instead inflated the estate's taxable value.
Why This Matters to Your Business
A buy-sell agreement funded with company-owned life insurance is called an entity-redemption or stock-redemption arrangement. It is one of the most common structures in use among closely held businesses today.
Under Connelly, when you die, the life insurance proceeds your company receives may increase the value of your company for federal estate-tax purposes. The company's obligation to buy back your shares does not reduce that inflated value.
For owners whose total estates are above or approaching the federal estate-tax exemption, currently $15 million per individual under the One Big Beautiful Bill Act, this can create a significant and unexpected tax bill for the people the plan was designed to protect.
The Fix: Cross-Purchase Structure
The Supreme Court pointed to the solution within its own ruling.
A cross-purchase buy-sell agreement is structured differently. Instead of the company owning the life insurance policies on the owners, the surviving owners own and are the beneficiaries of policies on each other.
When one owner dies, the surviving owners receive the insurance proceeds directly and use that money to purchase the deceased owner's shares from the family. The company never receives the insurance proceeds. There is no inflation of the company's estate-tax value.
A cross-purchase structure provides an additional benefit the entity-redemption structure does not: the surviving owners receive a stepped-up cost basis in the shares they purchase. If they later sell the business, that higher basis reduces capital-gains exposure.
When Cross-Purchase Gets Complex
For businesses with more than two owners, a straightforward cross-purchase arrangement requires each owner to hold a separate policy on every other owner. Three owners: six policies. Four owners: twelve. The administration becomes complicated quickly.
Two structures help manage this without sacrificing the tax treatment:
An insurance limited liability company (LLC) is formed solely to hold all the life insurance policies. The structure is designed so that death benefits flow to the surviving owners rather than to the business, preserving the cross-purchase tax treatment without multiplying the number of policies each owner manages individually.
An Irrevocable Life Insurance Trust (ILIT) can hold the policies outside both the individual owners' estates and the company, providing estate-tax exclusion on the death benefit and clean distribution to surviving owners or family members according to the agreement's terms.
What This Looks Like in Practice
Consider two equal partners in a business valued at $8 million. The company holds a $4 million life insurance policy on each partner to fund the buy-sell.
Under the old assumption: Partner A dies. The company collects $4 million. It buys back Partner A's 50% interest for $4 million. The estate receives $4 million. Done.
Under Connelly: when Partner A dies, the company receives $4 million in insurance proceeds. At the moment of death, the company's value includes those proceeds. If the operating business was worth $8 million before the death, the company may now be valued at closer to $12 million. Partner A owned 50%, so the taxable estate interest could be $6 million rather than the $4 million the family expected.
Frequently Asked Questions
Do I need to act right away?
The Connelly ruling is settled law. An existing entity-redemption buy-sell should be reviewed by an advisor and attorney familiar with business succession planning. How urgent the action is depends on the size of the estate and how close the business is to the exemption threshold, but the review should not be deferred indefinitely.
Does this affect every business?
Entity-redemption and stock-redemption buy-sell agreements funded with company-owned life insurance are the structures affected. Cross-purchase arrangements are not impacted by this ruling. If you are unsure which structure your agreement uses, that is the first question to answer.
Can an existing entity-redemption agreement be converted to cross-purchase?
Yes. The conversion requires updated legal documents and may involve reassigning or replacing existing insurance policies. There are cost and tax considerations in the conversion that a qualified advisor can walk through with you.
The estate-tax exemption is $15 million now. Does that protect me?
The current exemption provides more room than the pre-2026 level, but it does not change how the IRS calculates your estate's value under Connelly. The valuation issue and the exemption threshold are separate questions.
What King Legacy Group Does
King Legacy Group works with business owners to review, restructure, and properly fund buy-sell agreements so the plan accomplishes what it was designed to do. We coordinate with your business attorney on the legal structure and handle the insurance design so the policies serve the agreement, not work against it.
If you have a buy-sell agreement and have not reviewed the structure since the Connelly ruling, a strategy review is the right starting point.
Schedule your strategy review here.
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