Attention Small Business Owners: The Supreme Court Has Weighed in on Succession Plans

Will your buy-sell agreement hold up or are you at risk for a bigger tax bill?

by Carol Butrus, Attorney/Shareholder

The Wall St. Journal recently reported on a Supreme Court decision that affects more than 90% of small business owners across the country – those who are closely held [read article here, subscription required]. In short, the ruling “blew up” the small-business succession plan that leans on life insurance to pay for the transfer of ownership after an owner passes away. Based on this ruling, if a company owner passes away and the insurance policy is owned by the company, the company’s value is increased by the amount of the insurance death benefit. Likewise, the deceased owner’s taxable estate increases. The point: Expect a larger tax bill unless you update your buy-sell agreement.

The case brought to the Supreme Court, Connelly v. United States, involved two brothers who were the sole shareholders of a closely held corporation. They had an agreement that if one died, the surviving brother could buy the deceased brother’s shares. If the surviving brother declined, the corporation would be required to buy the shares. The company purchased $3.5 million in life insurance on each owner to cover the potential cost. Years later after one brother passed away, the survivor chose not to purchase the shares. The court had to decide whether the $3.5 million death benefit which was used to purchase the shares should be included in the company’s value for estate tax purposes despite the company’s apparent obligation to purchase the shares. The decision: Yes, they should be included. (Also note that the deceased owner’s interest in the company was valued at more than $3.5 million even without the addition of the death benefit.)

What are the implications for small business owners?

It is very common for closely held businesses to purchase life insurance on partner/owners; however, it is also very common for the owners to fail to update their agreements as circumstances change. So, in the event a death of an owner occurs, if the buy-sell agreement has not been revised the deceased owner’s family may be looking at a much higher estate tax bill and the amount passing to the deceased owner’s family suddenly looks a lot different.

Here is a quick real-life, client example. A wholesale kitchen supplier has two owners. Their buy-sell agreement was more than 10 years old. And not surprisingly, the value of their company had risen exponentially, so the life insurance they had originally bought wasn’t adequate to purchase the company. Both also had taxable estates. We counseled them to change the ownership of the policies to the individual owners, a trust or LLC to keep the death benefit value out of the company and the deceased owner’s taxable estate. If they hadn’t made that change, and let’s assume the policy was $10 million, (which would add $5 million to the deceased owner’s taxable estate) the deceased owner would have owed an additional $2 million in estate taxes.

What you can do…Now

The good news is that you can take action and protect your small business from this kind of exorbitant tax bill. Here are a few important questions to consider:

• Do you have a buy-sell agreement funded with insurance?
• Does the insurance cover the current value of the company?
• When was the last time you looked at the buy-sell agreement and who owns the policy?

If the company owns the policy, then the time is now to rework the buy-sell agreement and consider ownership outside the company. It is also always a good time to relook at your business-succession plan.

We have found that small business owners are often very busy, sign the buy-sell agreements, put them on a shelf, and do not revisit their plans. If there’s one thing this Supreme Court decision has taught us, it’s that it is time to dust those agreements off, reread them, and connect with an attorney if you have questions on how this may impact you.