Company-owned insurance is factored into the valuation.

The decision in Connelly v. United States was issued by the United States Court of Appeals for the D.C. Circuit in June 2023. The case involved a dispute over whether the value of a company should include a portion of a life insurance benefit used to purchase the deceased shareholder's stock. The court concluded that the value of the company should be determined without regard to the stock purchase agreement. In addition, the IRS did not err in including the insurance proceeds as part of the corporation's market value because the proceeds were a significant asset of the corporation at the time of Michael Connelly's death. The decision in the case has implications for the valuation of a company in buy-sell and M&A agreements, as it clarifies that the value of a company should be increased by the amount of life insurance proceeds owned by the company when these funds are used to purchase the shares of a deceased shareholder.

The ruling also emphasizes the importance of establishing a clear value of an heir's interest in a business for inheritance tax.

because a buy-sell agreement that does not establish such a value could lead to disputes about the value of the company. The Connelly v. United States decision has potential tax implications for buy-sell agreements. Here are the main implications:

• Tax liability: The decision imposes a significant tax liability on the estate of a deceased shareholder. The IRS argued persuasively that the value of a company for inheritance tax purposes was increased by $3.5 million because of the inclusion of insurance claim funds used to purchase stock.
• Effect on valuation: The decision clarifies that the value of a company for buy-sell agreements must include a portion of the insurance proceeds used to purchase the deceased shareholder's stock. The court concluded that the share purchase agreement at issue did not affect the valuation of the company.
• Fixed and definite price: The court concluded that the stock purchase agreement at issue did not establish a fixed and definite price for federal tax purposes. This is important because a buy-sell agreement that does not establish a clear value for the heir's interest in the company can lead to disputes about the value of the company.
• Certification of agreed value: In the Connelly case, the taxpayers did not agree to a specific redemption amount and signed a certificate claiming that they did not have an agreed value.

There are several strategies to avoid including insurance claims in the valuation of a company, including:

• Use of a cross-purchase agreement:In a cross-purchase agreement, each shareholder agrees to purchase the shares of a deceased shareholder. A life insurance policy is owned by each shareholder and the insurance proceeds are used to purchase the deceased shareholder's stock. Thus, insurance claims are not included in the valuation of the company.
• Use of a Continuous Irrevocable Life Insurance Trust (ILIT): An ILIT is a trust that holds a life insurance policy. The fund is irreparable, meaning that the policy owner cannot change the terms of the trust or access the cash value of the policy. At the death of the policy owner, the insurance benefit is paid to the fund and is not included in the owner's inheritance. The trustee can then use the funds to purchase the deceased shareholder's shares.
• Use of a fixed price buy-sell agreement: A fixed price buy-sell agreement establishes a clear value for the heir's share of the business. The agreement should specify that the value of the company should not include a portion of the insurance proceeds used to purchase the deceased shareholder's stock.
• Use of investor-owned life insurance:In this strategy, the investor, as the purchaser of the stock, owns the life insurance policy. The investor pays the premiums and is the reimbursement recipient. When a shareholder dies, the investor uses the insurance proceeds to purchase the deceased shareholder's shares. Thus, insurance claims are not included in the valuation of the company.

In general, the Connelly v. United States decision emphasizes the need for careful consideration of tax consequences when structuring buy-sell agreements. It is important to establish a clear valuation method and ensure that the agreement complies with federal tax law to avoid unforeseen tax liabilities. Business owners should review their buy-sell agreements in light of this ruling and consult with tax professionals to ensure compliance and mitigate tax risks.