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Breaking News: Life Insurance Proceeds Now Impact Company Valuation and Estate Tax Obligations

By Jeffrey Lewis, Anthony Duffy, Michael Binz, on June 12th, 2024

For many years, since 2004 in the Blount case (11th circuit), tax courts have held that a company owned life policy, to be used to redeem stock from an owner upon their death, is NOT part of the company value. Not for estate tax reporting and not part of the actual redemption obligation owed to the shareholder’s estate. The life insurance was merely a form of long-term financing to lessen the cash flow burden on the company when a shareholder dies. It also allowed for quicker payouts to estate of the decedent.

This is how professional advisors have treated these situations, or at least we might accrue the redemption obligation as a liability to offset the insurance proceeds, in instances where the redemption is less than the insurance proceeds received.

In 2023 a new case has thrown a monkey wrench in past practices. Connelly v U.S. in the 8th circuit sided with the IRS, saying that the insurance proceeds DID increase the company value as of date of death with no redemption liability offset.

On December 13, 2023, the Supreme Court agreed to hear arguments on the case, this being a conflict within the two tax circuits. The hearing of arguments was done in March and a Supreme Court decision was issued June 7, 2024.

Life Insurance Proceeds are Additional Company Value as of the Date of Death

The Supreme Court Ruled in favor of IRS, and henceforth, these life insurance proceeds, received after death, do represent additional company value for estate tax reporting purposes.

What….? Here is an Example:

A and B are two equal owners of a business. In the event one of them dies, their agreements call for the company to redeem the decedent’s ownership at Fair Market Value. As the business achieves success, the owners begin to realize that the value of the business has increased to the point that the redemption obligation would be a huge burden on a company, its operations, cash flows, banking, etc. In order to quantify the magnitude of the issue, the owners obtain a valuation of the business, which comes in at $3.0M.

To mitigate the financial burden of the redemption obligation, the company buys a $1.5M life insurance policy on each owner. Now, if A dies, the company will have the $1.5M of insurance proceeds to cover the redemption obligation to A’s estate. The owners think they have adequately addressed the issue. This has been a great tool used to protect the company, its on-going operations and allow the company to better handle this redemption obligation without potentially being chopped in half. This is a very common set up in many companies.

Not so fast!

IRS comes in on the Connelly Estate and takes the position that upon the death of A, the company is not worth just $3.0M as all had agreed, but rather $4.5M (the operations are $3.0M plus the $1.5M of insurance proceeds). Because of the “fair market value” redemption clause, when A dies, his/her share of the company should actually be valued at $2.25M (one-half of the $4.5M value). So, while there is $1.5M of insurance money, the company now has to come up with an additional $750,000 to effectuate the redemption.  Based on the IRS’s position, which was just upheld by the Supreme Court, the company was not adequately insured at all!

This is a simple example, if your company is worth more like $20M, the problem could be ten-fold.

Suddenly, the beneficiary of the insurance policy matters. If the company is the beneficiary of the insurance policy (as in the example above), the Fair Market Value of the company has increased, which has the unintended effect of significantly increasing the redemption obligation. Alternatively, if owner B was the beneficiary of the insurance policy, the Fair Market Value of the company is unaffected, and the redemption obligation stays at the anticipated $1.5M.

It’s an interesting situation to think about:

  1. If the company were sold to a third party shortly before A’s death, the value of his/her shares would likely have been around $1.5M.
  2. If A agreed to sell his/her shares to B prior to death, the value of his/her shares would likely have been $1.5M.
  3. If each shareholder purchased insurance on the other (as opposed to the company purchasing insurance), the value of A’s shares would be $1.5M.
  4. But if the company purchased insurance on both shareholders, the value of A’s shares would be $2.25M.

Strange, but true. This is the situation which we now will have to deal with. There is no valuation alternative. This applies to any type of operating entity, partnership, LLC, corporation, whether C-Corp or an S-Corp.

What to Do?

Any company owned insurance policies where the proceeds are paid to the company as beneficiary must be re-visited, and this should be done soon.

  • Examine the life policies, where do proceeds go?
  • Examine the ownership agreements to see who has the obligation to redeem shares from a shareholder’s estate upon death.
  • Assess the company’s current value as an operating company, plus any insurance proceeds due under the current set-up. How big of a problem do you have?
  • What should we do with old policies? Moving these policies to new ownership can cause a tax, in some cases a significant tax (see Interpolated Terminal Reserve). Caution here!
  • Should the ownership documents be re-drafted to provide for a different obligation to a decedent? What needs to be changed? Something needs to be done!
  • How should we be buying any new insurance? Personally? What if there are 10 owners??
  • Can we use some form of trust or trusts (ILIT’s?) to shelter insurance proceeds?
  • Will someone smarter than I come up with a new solution, something totally different?

Don’t sit by and hope this goes away. An overly burdensome company redemption obligation can cripple the company.

For our assistance, please reach out to Anthony Duffy at aduffy@boandio.com, Jeff Lewis at jlewis@bonadio.com or Mike Binz at mbinz@bonadio.com.

If you need further guidance or have any questions on this topic, act soon—contact your advisors and ask them to help you establish a plan that meets your goals and your situation. And as always, please do not hesitate to reach out to our trusted experts to discuss your specific situation.

This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.

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Written By

Jeffrey Lewis June 21
Tony Duffy Feb 20 Uploaded
Anthony Duffy
Senior Counsel
Mike Binz
Michael Binz
Managing Director
Insights

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