Did your partnership setup buy-out life insurance policies to ensure a clean buy-out?
Thanks to the US Supreme Court’s ruling in Connelly v. United States, you need to rethink that strategy or face surprise taxes.
Buy-out life insurance worked by a company insuring the life of its partners. If that partner passed, the policy pays the company which is contractually bound to repurchase the shares of the deceased partner. This is a win/win for both the bereaved, who lacked the interest or skill to own a business, and the company, who otherwise lacked the cash to repurchase the equity. And, since life insurance proceeds are not taxable income, it was a tax-efficient strategy.
Brothers Michael and Thomas Connelly had exactly this type of buy-out insurance in place for their small business, Crown C Supply, when Michael passed away. The business received $3M in insurance proceeds, which they used to repurchase Michael’s equity from his estate.
Unfortunately for both the Connelly’s and Crown C Supply, Connelly v. United States ruled that the value of the business increased $3M upon receipt of the insurance proceeds. This meant the cash proceeds were no longer enough to repurchase 100% of Connelly’s shares, leaving his estate with an illiquid minority share of a small business. Even worse, the value of the estate increased by $3M, creating an additional $890k in taxes.
With SCOTUS’ ruling in place, the IRS will be ready to apply the same consideration to your buy-out.
If you have an old buy-out partner insurance in place, it will no longer function as you intended. You need to review the agreement with a CPA and financial planner. There are a few alternative arrangements of varying complexity which you may implement to lower your tax burden.
