Supreme Court Ruling Affects Small Business Valuations

By Attorney Kelly Jesson

The Supreme Court has issued many newsworthy rulings recently, but one you might not be familiar with is the Connelly Case.  In Connelly v. United States, the Supreme Court held that the value of life insurance proceeds paid out to a business after the death of one of its owners must be included in the date of death valuation of the business. 
 
For the past twenty years, life insurance paid to a business as the result of an owner’s death has not been included in the business valuation if the business had an obligation to purchase the deceased owner’s interest in the business back. The reasoning was that this was a liability that the business owed.  If a business was paid $3 million dollars in life insurance but it was obligated to pay the deceased owner’s family $3 million dollars, then it’s a wash. 

The implications of this ruling are significant.  A business that is the beneficiary of life insurance proceeds may be valued much higher than it “really” is.  For example, let’s say there are two owners of Widget Corp.  The business is worth $5 million, so the owners each had $2.5 million dollars in insurance taken out by the corporation.  At the death of one of the owners, the corporation was to redeem the deceased owner’s shares, which were worth $2.5 million prior to death.  After the Supreme Court ruling, the business is actually worth $7.5 million ($5 million + life insurance).  If the agreement was to pay half the value, the corporation would owe the family $3.75 million but only have $2.5 million in cash to do so. 
 
For people who may have to pay estate taxes (oftentimes business owners!), the difference in a few million dollar valuation can result in huge tax payments. And to add insult to injury, the family could end up paying taxes on assets they didn’t really get.  In the above example, the true value of the business interests was $2.5 million but they would have to pay tax on the $3.75 million valuation if it was a taxable estate.

The ruling requires business owners to carefully review their buy-sell and operating agreements to see how valuations will be determined.  Is it the date of death value, or the value put on the business at the beginning of the year, or the value of the life insurance?  While you can’t exclude life insurance for IRS purposes, you may be able to for buy-out valuation purposes.

One way around this ruling is to use cross-purchase agreements.  Instead of the business owning the life insurance policy, the individual owners will own life insurance policies on each other. When one owner dies, the life insurance is paid out to the other owners, not the business.

Also, more people may utilize LLCs to own life insurance policies.  The problem with cross-purchase agreements is that if you have a lot of owners, you have a lot of policies.  If there are three owners, for example, there are six policies.  If you set up an LLC to own the insurance policies (and then the LLC uses the money to buy the deceased owner’s interest), there are fewer policies. In this example, there would be three instead of six.

If you would like additional information, or if you need a review of your business’s insurance and operating agreements, please don’t hesitate to contact the attorneys at Jesson & Rains.