For years businesses have used key person life insurance as a common estate planning tool to secure capital for redemption of a deceased owner’s shares as well as to offer funding for operating expenses. It was assumed that life insurance proceeds would be received tax-free. However, the Supreme Court Connelly v. United States (June 6, 2024) decision has up-ended previous planning.

Tax Treatment Clarification:

Before the Connelly case, key person life insurance policies were generally treated favorably for tax purposes. The death benefits were typically not included in the company valuation and could be used to redeem shares without impacting cashflow or disrupting the balance sheet.

Impact of Connelly Case:

In the Connelly case, the Supreme Court ruled that death benefits could be included in the company valuation. It created additional tax exposure and significantly impacted the value received by heirs. For example, by increasing the company valuation by $3.5M from life insurance proceeds, Michael Connelly’s heirs could find themselves with more than $1 million in additional estate taxes. Estimates in this case indicate that heirs stand to lose nearly half their expected payout as a result.

Planning Implications:

This ruling highlights the importance of planning where businesses rely on key person life insurance to provide funds in the event of the death of an owner. Now, businesses may need to reconsider their operating agreements and possibly structure them differently to ensure tax efficiency.

In light of the Connelly case, we recommend business owners of closely held corporations review buy-out terms and life insurance ownership and benefit amounts. Safe-harbor provisions of IRC Section 2703(b) and Treasury Regulation Section 20.2031-2(h), include requirements for redemption terms. In many cases, adjustments will not need to be made. However, if there is additional tax liability exposure, there can be changes made to reduce or eliminate that exposure.

Overall, the Connelly case overturned previous assumptions about the tax treatment of key person life insurance policies, particularly when it comes to company valuation and the value received by the heirs of a deceased owner. This is forcing businesses to review and potentially revise their insurance planning strategies to mitigate the risk of unexpected tax liabilities and still be able to fully provide for the heirs.

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