Your buy-sell agreement may now create tax that isn't there
A unanimous Supreme Court decision in June 2024 changed how life insurance is counted when valuing a business for estate tax purposes, and for companies that hold policies to fund buy-sell agreements, the ruling may have just increased the tax bill an estate will face.
What the Supreme Court decided
In Connelly v. United States, decided 6 June 2024, the Court held that life insurance proceeds used to redeem a deceased owner's shares increase the value of the business for estate tax purposes, and that the company's obligation to buy those shares back does not reduce it. The case involved two brothers who owned a building supply corporation in St. Louis. They had a standard redemption agreement: when one died, the company would use life insurance proceeds to buy out his shares. Michael Connelly died in 2013. The company collected $3.5 million in insurance and redeemed his stock. His estate valued the business at $3 million. The IRS said the life insurance raised that figure to $6.86 million, producing an additional estate tax bill of $889,914.
The estate argued that the redemption obligation was a liability that offset the insurance proceeds. The Supreme Court disagreed, 9 to 0. Treasury Regulation 20.2031-1 requires that a business be valued at fair market value — what a willing buyer would pay a willing seller, both with reasonable knowledge of the facts. A hypothetical buyer would pay more for a company holding $3.5 million in cash than for the same company without it. That the company plans to spend the cash on a share redemption does not change what it is worth the moment before it does.
The Court also rejected the argument that the redemption obligation was a deductible liability under Section 2053 of the Internal Revenue Code. The company owed the obligation, not the estate. The estate's liability ended the moment the shares were redeemed.
Which agreements this affects
The decision applies to entity redemption agreements funded with corporate-owned life insurance. In this structure, the company owns the policy, pays the premiums, collects the proceeds when a shareholder dies, and uses the cash to buy back that shareholder's stock. This is one of the two common ways to structure a buy-sell. The other is a cross-purchase agreement, where each owner holds a policy on the others and buys the shares individually.
Redemption agreements exist because they are simpler to administer. In a company with four owners, a cross-purchase requires twelve policies — each owner holding one on each of the other three. A redemption agreement requires four. The premiums come out of the business rather than after-tax personal income, and there is one policy per insured life rather than a thicket of individual contracts to manage. That simplicity carried a cost nobody was pricing in. As we read the Connelly holding, a company holding life insurance to fund a redemption now holds an asset that increases the value of the deceased owner's interest without any offsetting reduction.
Cross-purchase agreements are not affected the same way. The insurance is not a corporate asset, so it does not appear in the business valuation. The structure has its own complications — basis tracking, the number of policies, and what happens when an owner becomes uninsurable — but the Connelly problem does not reach it.
How large the exposure is
The tax depends on the size of the estate and the exemption in the year of death. The federal estate tax exemption for deaths in 2024 stands at $13.61 million per person, and the figure adjusts annually for inflation. Estates below that threshold pay no federal estate tax. Estates above it are taxed on the amount over the line, at rates that reach 40 percent. The exemption is scheduled to drop sharply after 2025 unless Congress extends it, which would bring more business owners into taxable range.
The additional value the Court's decision creates is the face amount of the life insurance. In Connelly, $3.5 million in proceeds added $3.5 million to the estate. Whether that produces tax depends on how close the estate was to the exemption before the addition. For an estate already $5 million over the threshold, the insurance may add $1.4 million in tax. For an estate $2 million under it, the first $2 million of insurance value is sheltered and the rest is taxed.
Florida does not impose a state estate tax, so the exposure here is federal. A number of states do impose their own estate tax, and their exemptions are generally far lower than the federal figure, which would increase the number of estates affected and the size of the bills.
Why agreements drafted years ago may now be the problem
Many closely held businesses put buy-sell agreements in place a decade or more ago, often at the time of formation or when a key employee was brought into ownership. The agreements tend not to be revisited unless someone leaves, someone is added, or the valuation formula stops working. The life insurance that funds them is treated as a separate matter, managed by the agent who sold it or by nobody at all. Connelly changes the outcome of a structure that may not have been expected to carry this risk.
Before the decision, a planning assumption existed — reflected in at least one circuit court's reasoning — that insurance proceeds used to fund a redemption would not increase the taxable value of the business, either because the obligation to redeem offset the proceeds or because the transaction was complete by the time value had to be determined. In Estate of Blount v. Commissioner, 428 F.3d 1338 (11th Cir. 2005), the Eleventh Circuit, which includes Florida, had ruled in favour of taxpayers in a case involving a similar fact pattern, holding that a company's obligation to redeem shares reduced the value available to the estate. The Ninth Circuit had adopted a version of that view in Estate of Cartwright v. Commissioner, 183 F.3d 1034 (9th Cir. 1999). Connelly reversed that line of reasoning and resolved the split. Businesses that structured their agreements in reliance on the Eleventh Circuit's approach now face a different result.
The ruling does not void the agreements. The contracts remain enforceable, and the redemptions will proceed as written. What changed is the tax treatment. An agreement that was expected to transfer ownership cleanly and fund itself with insurance may now produce an estate tax bill the family was not planning for, drawn from assets outside the business if the estate holds them or financed against the business if it does not.
What happens if the estate cannot pay the tax
Estate tax is due nine months after death. If the estate's value is concentrated in the business and the business holds no liquid assets beyond what the redemption consumes, the family may face a bill with no cash to pay it. Section 6166 of the Internal Revenue Code allows an estate to defer tax attributable to a closely held business interest and pay it in instalments over as long as fourteen years, but qualification depends on the business interest making up more than 35 percent of the adjusted gross estate, and interest accrues on the deferred amount. The instalment option keeps the estate out of a forced liquidation. It does not eliminate the tax.
Where the estate lacks liquidity and does not qualify for deferral, the options narrow quickly. The estate may borrow, using business assets or other property as collateral. It may negotiate a partial redemption of the deceased owner's interest for less than the agreement calls for, if the surviving owners and the estate can agree on terms. It may sell other assets at a loss if the timing is wrong. These are decisions made under pressure, often by family members who were not involved in the business and who are reading the buy-sell agreement for the first time.
The alternatives and their trade-offs
One response is to convert a redemption agreement to a cross-purchase. The insurance moves out of the company and into individual ownership. Each owner holds a policy on each other owner and uses the proceeds to buy that owner's shares when they die. The insurance is not a corporate asset, so it does not increase the business valuation under Connelly. The buyer receives a step-up in basis equal to the purchase price, which can reduce capital gains tax on a later sale. The structure avoids the problem the Court identified, but it introduces others. The number of policies multiplies — three owners require six policies, four require twelve. If one owner becomes uninsurable, the structure breaks. Premium payments come from after-tax income rather than business revenue. Tracking basis and maintaining the correct ownership of each policy over time requires attention most operating businesses do not give it.
Another option is to have the company own the insurance but have the surviving shareholders — rather than the company — purchase the deceased owner's shares, with the company distributing the insurance proceeds to them as a dividend or redemption of part of their own interests to fund the purchase. This is sometimes called a hybrid structure or a wait-and-see agreement. The insurance stays in one place, but the actual purchase is structured as a cross-purchase at death. The dividend or distribution to the surviving owners may itself be a taxable event, and the operating agreement or corporate documents must permit the distribution. The structure requires careful drafting and assumes the surviving owners are willing to take a taxable distribution in order to buy out a deceased partner's family.
Some agreements abandon insurance funding entirely and rely on instalments, with the business paying the deceased owner's estate over a period of years. This avoids the Connelly problem — no insurance, no increase in value — but it leaves the family dependent on the business's future performance and creates a creditor relationship between the estate and the surviving owners that may last a decade. The business carries the financing risk, and the estate carries the credit risk.
A fourth alternative is to remove the insurance from the business and place it in an irrevocable life insurance trust that will purchase the shares. The trust owns the policy, collects the proceeds and buys the stock from the estate. The insurance is not in the business, and if the trust is properly structured, the proceeds are not in the insured's estate either. This eliminates the Connelly issue and may avoid estate tax on the insurance entirely, but it requires the trust to be funded — usually with gifts that use part of the insured's lifetime gift and estate tax exemption — and it must be managed as a separate entity with its own trustee, tax returns and administrative obligations. The trust structure is more complex than most operating businesses want to carry, and it must be established well before it is needed in order to avoid estate inclusion under the three-year rule.
Each alternative solves one problem and creates others. Which structure fits depends on the number of owners, their insurability, the likely timing of the first exit, the estate tax position of each owner, and how much administrative burden the business is willing to manage. There is no default answer, which is itself the reason this requires a review rather than a form.
Considerations for existing agreements
For a business with a redemption agreement funded with corporate-owned life insurance, three documents are relevant to examine at the same time: the buy-sell agreement, the insurance policies, and a current valuation of the business. A business attorney should read the agreement to determine what it requires, whether it can be amended, and whether the redemption is mandatory or permissive. An accountant should estimate what the company would be worth with and without the insurance proceeds included, and what the estate tax would be under each scenario. The insurance carrier or the agent of record should confirm the face amount, the cash value, the owner and beneficiary of each policy, and the annual premium.
Once those three pieces are clear, the question is whether the structure produces a tax problem in fact or only in theory. If a business owner's total estate is well under the federal exemption even with the insurance added, Connelly changes nothing that matters. If the estate is close to or over the threshold, or if it will be after the exemption drops in 2026, the insurance may be adding tax that was not in the plan. The size of the tax depends on the size of the policy, the value of the business, and what else is in the estate. That is an arithmetic problem before it is a legal one, and the arithmetic should be done with current numbers rather than the assumptions that were in place when the agreement was signed.
Where the review identifies a material tax cost, the next step is to compare the alternatives — cross-purchase, hybrid structure, instalment sale, irrevocable trust — against the cost of doing nothing. Changing the structure is not free. Redrafting agreements, retitling insurance, establishing a trust, and managing multiple policies all carry cost, and the cost has to be justified by the tax it avoids. In some cases the most sensible answer is to leave the redemption agreement in place, accept that it will produce some incremental estate tax, and plan for liquidity to pay it. That is a choice worth making deliberately rather than inheriting by default.
The valuation question the agreement may not settle
Many buy-sell agreements include a formula for valuing the business — a multiple of revenue, a capitalisation of earnings, a fixed price adjusted annually, or a price set by the most recent appraisal. The purpose is to avoid a fight over value when an owner leaves or dies. Connelly does not change how the agreement values the business between the parties. What it changes is whether that value controls for estate tax purposes. Section 2703 of the Internal Revenue Code provides that a buy-sell restriction is disregarded for estate and gift tax purposes unless it meets three tests: it is a bona fide business arrangement, it is not a device to transfer property to family members for less than full consideration, and its terms are comparable to those negotiated at arm's length. Even where an agreement satisfies those tests, the IRS may argue that the fair market value for estate tax purposes differs from the contractual price, particularly where the agreement was signed years ago and the business has changed materially since.
In the Connelly case, the buy-sell agreement set the price by reference to the company's book value, but the estate and the IRS both discarded that figure and argued over fair market value. The agreement bound the parties to the transaction. It did not bind the tax calculation. That gap — between the price the family receives and the value the estate is taxed on — can itself be a source of liquidity strain, because the estate may owe tax on a value higher than the cash it actually collects.
Bottom line
Connelly v. United States held that life insurance held by a corporation to fund a buy-sell agreement increases the value of a deceased shareholder's estate, and that the company's obligation to redeem the shares does not offset it. The ruling affects entity redemption agreements funded with corporate-owned insurance. It does not void those agreements, but it may produce estate tax that was not part of the original plan. Whether that tax is material depends on the size of the estate, the amount of insurance, and the exemption in the year of death. The alternatives — cross-purchase agreements, hybrid structures, instalment sales, irrevocable trusts — each carry trade-offs in cost, complexity and risk. Which structure is appropriate is a question of fact, not a question of form, and the answer depends on information that can be obtained only by reviewing the actual documents and the actual numbers for a specific business.
This article describes how the law appears to operate following the Supreme Court's decision in June 2024. It is not advice about any particular business or estate. A business attorney should review the operating agreement and the buy-sell contract. An accountant should model the estate tax under the current structure and under the alternatives. A valuation professional may be required to produce a defensible figure for estate tax purposes. Written to the law as it stood in January 2025.