Supreme Court Shakes Up Small Business Succession Path

A recent Supreme Court ruling means small businesses may have to re-examine a part of their succession strategy.

The ruling in Connelly v. Internal Revenue Service challenges the way life insurance proceeds earmarked for the redemption of a deceased owner’s stake in a business are counted toward how that company is valued for federal estate tax purposes. Simply put, after the death of an owner, their life insurance proceeds can be counted towards the value of a family owned business. And that’s upending a common succession strategy used for years in the small business world.

Rethinking Buy-Back Agreements

Here’s how the tactic used to work: Business owners would buy life insurance policies and in case of one owner’s death, the remaining party or parties would use the insurance proceeds to buy the deceased’s shares in the business, ensuring that the corporation remains in the hands of the family or original group.

The IRS has argued that the obligation to use the insurance proceeds for these purposes shouldn’t mean that the company’s value for estate purposes gets reduced by the insurance payout. And in a June ruling, the Supreme Court agreed. The result could be higher estate tax bills following the death of an owner, if an insurance policy payout was used.

Small business owners who have insurance funded buy-back agreements are advised to consult their tax advisors to reevaluate such arrangements following this ruling.

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