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Business owners have another matter to be aware of in addition to the new Corporate Transparency Act which requires most corporations and limited liability companies to provide various information on the owners of those entities with the Financial Crimes Enforcement Network. Another matter that business owners need to be aware comes about as a result of a recent court decision. In the Connelly v. IRS court case, the Court decided that entity‑owned life insurance used for buyout purposes shall be considered an asset and considered when valuing the business. For a business that has more than one owner, it is common for a business to purchase life insurance on the lives of its owners so that the business has liquid assets to purchase the ownership interest of a deceased owner. This case discussed a number of aspects to be considered in that situation.
Let’s look at an example of this situation. Let’s say we have a business that is valued at $4 million. The business has two owners, and therefore, each of their interests are worth $2 million. The owners enter into a buy-sell agreement. This agreement describes how the business should be valued at the death of an owner, who will buy the deceased owner’s interest in the business, how the buyout will take place, and the specific terms of the buyout. The business has also purchased a $2 million life insurance policy on each owner as well.
In the Connelly case, the agreement stated that the owners would agree on the value of the business each year by executing a document called a stipulation of value. Despite this requirement in the agreement, the owners never executed the stipulation of value. The agreement also provided that if the stipulation of value was not executed, upon the death of an owner, a formal valuation of the business by a valuation expert would be needed. One owner died and the other owner, his brother, who was also named as the executor of the deceased owner’s estate, worked out an agreement where the business would buyout the deceased owner’s interest in the business for $2 million without obtaining an appraisal and without factoring in the $2 million of life insurance proceeds the business received.
The IRS argued and the Court agreed that the actual value of the business should have been $6 million since the business was worth $4 million plus the $2 million of life insurance proceeds that the business received. Thus, the value of the deceased owner’s interest in the business would be $3 million instead of $2 million. The deceased owner’s estate tax return listed the value of his business interest at $2 million instead of $3 million. This created a discrepancy and a potential estate tax on the extra $1 million. The case does not specifically discuss this fact, but that excess could’ve created a $400,000 estate tax that the deceased owner’s estate would have to pay.
The Court was concerned that the formalities of the agreement that the owners entered into were not followed. The Court also determined that life insurance owned by a business should be included when valuing that business even though those life insurance proceeds come into the business after the death of an owner. It is uncertain whether the lack of following the formalities of the agreement created this result, or if the IRS will actually be following this line of thinking when dealing with buy-sell agreements and the estate tax returns of owners.
If you currently own a business that has a buy-sell agreement and that business has purchased life insurance on the lives of the business owners to fund the buyout at the death of an owner, you should contact your attorney, accountant, and life insurance professional to review the current status of these matters in light of this recent Court decision. In addition, please make sure you also discuss your reporting requirements under the Corporate Transparency Act.
NOTE: This general summary of the law should not be used to solve individual problems since slight changes in the fact situation may require a material variance in the applicable legal advice.
James F. Contini II, Esq.
Certified Specialist in Estate Planning,
Trust & Probate Law by the OSBA
Krugliak, Wilkins, Griffiths & Dougherty Co., LPA
405 Chauncey Avenue NW
New Philadelphia, Ohio 44663
Phone: (330) 364-3472
Fax: (330) 602-3187
Email: jcontini@kwgd.com