Navigating the Connelly v. IRS Buy-Sell Agreement Ruling​

Every so often, the IRS wanders into the business world and drops a bombshell that changes the way you run your company. Thanks to the recent—and now infamous—Connelly v. IRS buy-sell agreement case, you might need to overhaul your succession plan if you want to steer clear of this impending tax minefield. Here’s what you need to know about this ruling as a business owner.

What Happened in the Connelly v. IRS Buy-Sell Agreement Case?

Not familiar with the Connelly v. IRS buy-sell agreement ruling? Brothers Thomas Connelly and Michael Connelly were co-owners of a business with an entity-purchase agreement in place. This means each brother had a life insurance policy with the company itself as the beneficiary. If a brother died, the business could then buy out his shares.

Historically, these kinds of succession agreements have been tax-free—but not this time. After Michael’s death, the IRS argued that the proceeds from the policy were to be included in the business’s valuation for estate tax purposes. Thomas Connelly challenged that determination, but the IRS ultimately prevailed.

Why Does It Matter?

In a nutshell, entity-purchase agreements may no longer be tax-free. For some companies, this is a tax-season disaster, and it often means you need a whole new succession plan. These are some of the consequences of the Connelly v. IRS buy-sell agreement ruling:

• Proceeds from life insurance are now factored into a business’s value, dramatically increasing the taxable estate.
• Because the top federal estate tax rate is 40%, heirs may face a massive hike in tax liability.
• In 2025, the current estate tax exemption of $13.61 million drops by half, so more business owners may be affected.

That doesn’t leave you a whole lot of time to restructure your entire exit plan. The Connelly v. IRS buy-sell agreement ruling is endlessly frustrating for countless business owners, many of whom have meticulously put together their current exit plan. Still, you don’t need to panic yet; you have a few options to consider.

Potential Fixes and the Risks That Come With Them

There’s no simple fix for the changes that came with the Connelly v. IRS buy-sell agreement, but these strategies are worth a look:

Transferring Business-Owned Life Insurance Policies to Individual Owners

This might be a way to dodge estate taxes, but it’s incredibly risky. Transferring a life insurance policy to another person or entity can trigger the “transfer-for-value” rule. If that happens, the death benefit can be taxed as income.

Creating a Buy-Sell Insurance LLC

This is another risky option. You can create a specific insurance LLC to move life insurance policies off your company’s books. However, creating a special-purpose LLC like this is practically inviting the IRS to investigate you.

If the IRS determines that your LLC doesn’t have a legitimate business purpose, which is a very likely determination in this case, the death benefit becomes taxable. You might be hit with other tax penalties too.

Another Option: Cross-Purchase Agreements

If your business has a small group of owners, cross-purchase agreements might be an option. Each owner takes out life insurance policies on the others. That way, when one owner dies, the other can individually buy their shares in the company.

Cross-purchase agreements mean the life insurance proceeds aren’t sent directly to the business, so they won’t inflate its value for tax purposes. As you can imagine, this process becomes insanely difficult with larger companies. But if it works for your business, you can save yourself hours of future planning.

Strategizing for the Future

The Connelly v. IRS buy-sell agreement case throws a massive wrench into exit planning for companies of all sizes. Adjusting to this change isn’t going to be easy, and you’re going to need an innovative, creative strategy to shield your assets.

At BOSS (Business Owner Succession Strategies), we’ve navigated decades of change in the business landscape, and we can help you get through this particularly daunting development.

Content in this material is for general information only and not intended to provide specific legal or tax advice or recommendations for any individual.  This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific issues with a qualified tax/legal advisor.