Supreme Court’s Connelly decision: Why Business Owners Should Revisit Their Buy-Sell Agreements

Brian Ford

If you own an interest in a closely held business, a recent decision by the U.S. Supreme Court may cause you to rethink how you value and structure your buy-sell agreement. In Connelly v. United States, the court ruled that a company’s obligation to redeem a deceased owner’s stock did not offset the value of corporate-owned life insurance (COLI) used to fund the buyout. As a consequence, some companies with redemption-type buy-sell agreements may want to consider restructuring them.

Tale of two brothers

The company in Connelly was a building supply corporation owned by two brothers. One brother owned 77.18% of the corporation’s outstanding shares and the other owned the remaining 22.82%. To keep the company in the family, the brothers and the corporation entered into a buy-sell agreement. In the event that one of the brothers died, the agreement gave the surviving brother the option to purchase his shares. If the surviving brother chose not to exercise that option, then the company would be required to redeem the stock. To fund a potential redemption, the company purchased $3.5 million in COLI for each brother.

In 2013, the brother who owned 77.18% of the stock died, and the surviving brother declined to purchase his shares. Instead, he and the deceased brother’s son agreed that the corporation would redeem the stock, pursuant to the buy-sell agreement, for $3 million. The deceased brother’s estate filed an estate tax return reporting the value of his stock at $3 million. However, the IRS determined that the stock was worth $5.3 million and assessed additional estate taxes of nearly $900,000.

Dueling numbers

The IRS and the estate agreed that the COLI proceeds were an asset that increased the company’s fair market value. They also agreed that the company assets were worth $6.86 million, consisting of $3 million in COLI proceeds earmarked for the stock redemption and $3.86 million in “other assets and income-generating potential.” (When the Court issued its decision, it was unclear on what happened to the $500,000 in insurance proceeds not used for the redemption.)

However, the parties disagreed about the impact of the company’s obligation to redeem the deceased brother’s stock. The estate argued that the obligation offset the COLI proceeds, so that the value of the stock was approximately $3 million (77.18% of $3.86 million). The IRS argued that the redemption obligation did not reduce the company’s value, so that the stock was worth approximately $5.3 million (77.18% of $6.86 million).

Court’s decision

The Supreme Court needed to resolve a conflict among the federal appellate courts. To this end, it accepted the IRS’s argument that “no real-world buyer or seller would have viewed the redemption obligation as an offsetting liability.”

The Court offered an example: A corporation has one asset, $10 million in cash, and two shareholders, A and B, with 80 shares and 20 shares, respectively. The shares are worth $100,000 each. If the company redeems Shareholder B’s shares for fair market value ($2 million), the company will be left with $8 million in cash and 80 outstanding shares, all owned by Shareholder A. Shareholder A still owns 80 shares worth $100,000 each and Shareholder B has $2 million in cash, so the redemption has no economic impact on either owner. Based on this reasoning, the value of the company in Connelly was not reduced by its redemption obligation and the deceased brother’s stock was worth $5.3 million.

Weigh your options

If your company’s redemption-type buy-sell agreement exposes you to additional estate taxes, you may want to consider restructuring it as a cross-purchase agreement. In a cross-purchase agreement, surviving shareholders purchase a deceased shareholder’s stock.

The Court acknowledged that such an arrangement would avoid the result in Connelly. But keep in mind that in a typical cross-purchase arrangement, each shareholder maintains insurance on the lives of the other shareholders, which can be costly and complicated with multiple or unequal owners. Discuss the pros and cons of this option with your advisors.

For more information, contact your ORBA advisor or Brian Ford at [email protected] or 312.670.7444. Visit ORBA.com to learn more about our Wealth Management Services.

Preventing Heirs from Contesting Your Estate Plan

Robert Huesing

A well-prepared estate plan that includes trusts may still be subject to beneficiary disputes after you are gone. While working with a qualified estate or tax planning professional greatly reduces this risk, it is not absolute. To help protect your plan from legal disputes, you should consider adding a no-contest clause. It is a provision that discourages beneficiaries from challenging your will or trust in court by penalizing them should they attempt to dispute it. Adding a no-contest clause may help to ensure that your assets are distributed according to your intentions.

Understanding No-Contest Clauses: Jurisdiction Matters

No-contest clauses are often included in estate plans to discourage beneficiaries from filing baseless legal challenges that may delay distributions and increase costs. These provisions generally state that anyone who disputes the will or trust, often by claiming undue influence or lack of mental capacity, risks losing their inheritance.

However, the enforceability of no-contest clauses depends on state law. While many states recognize them, scope and application vary. In some jurisdictions, certain legal actions, such as disputing the choice of executor or trustee, may not trigger the clause. Other states allow enforcement only if there is no “probable cause” behind the challenge.

Even if your current state does not uphold these clauses, it may still be worth including one in your estate documents. It may still apply should you relocate or own property in a state where such clauses are valid. You may also consider establishing a trust under the laws of a state that enforces no-contest provisions to strengthen your estate plan’s protection.

Minimize incentives

While a no-contest clause may help deter legal challenges, it is equally important to reduce the motivation for heirs to contest your estate. To strengthen your plan:

• Work exclusively with experienced, reputable tax and legal professionals.
• Obtain written confirmation of your mental capacity from a licensed physician or mental health professional around the time you sign key documents.
• Select trustworthy witnesses who are likely to be credible if called to testify.
• Consider recording the signing process for added evidence of intent and sound judgment.

It is also wise to communicate your decisions clearly. This is most important should your plan include unexpected choices, such as leaving a large portion of your estate to a nonprofit. Transparency can prevent confusion or resentment. If you intend to exclude someone who would normally inherit, note that a no-contest clause may not be enough to prevent a challenge as they have nothing to lose. In such cases, leaving them a modest share might discourage disputes by making the risk of contesting less appealing.

Related Read: Trust Protectors Can Help Back Up an Estate Plan

Protecting Your Wishes

You understand your family and potential heirs best. However, if your estate or tax advisor recommends a no-contest clause as an added layer of protection for your will or trust, it is worth careful consideration. It can help ensure your assets are distributed according to your wishes with minimal risk of dispute.

For more information, contact Robert Huesing at [email protected]  or 312.670.7444. Visit ORBA.com to learn more about our Wealth Management Services.