Has your small business purchased life insurance on its owners as a succession strategy? It may be time to check the company’s buy-sell agreements and plan next steps with your advisors to avoid unexpected estate taxes!
A common succession strategy for small closely-held businesses is for the company to buy life insurance policies on the life of its owners (or key executives). When an owner passes, the insurance payout can be used to repurchase their share. A big advantage to this strategy is that insurance payouts were considered estate-tax free … until the recent Supreme Court decision (Connelly v. United States) decided otherwise and changed the game. Now, estate taxes are still owed even when insurance payouts are used. An insurance payout is no longer considered to be offset by a liability – the repurchase of shares – because the company actually gains value from the repurchase through the exchange of shares for dollars.
For small business owners who may be affected by this new decision, here are some things to consider. It is important to learn about potential income and estate tax consequences.
- Check the company’s buy-sell agreements and look at the provisions providing next steps when an owner passes, retires or leaves the company.
- Many agreements require an independent appraisal of the company with annual adjustments. Make sure that valuations are updated!
- Check the insurance policies – If insurance policies were bought to fund a repurchase of the deceased owner’s shares, are these policies owned and payable to the company?
- If so, beware that this structure may cause the deceased owner’s estate to owe higher taxes.
- Be sure to learn about the effect of payout on the owner’s estate taxes. The estate tax exemption is currently $13.6M per individual, but may be reduced back to about $7M if the 2017 tax changes expire at the end of 2025.
- Consider other types of arrangements:
- Cross-purchase agreement where each owner buys life insurance on the others to repurchase the shares if one passes.
- Pro: Prevents insurance payouts from inflating the value of the company and the estate of the deceased owner.
- Con: Impractical approach if the company has multiple owners as each owner would have to buy insurance on all the other owners. Difficult to track whether premiums are actually paid.
- Create an LLC to hold the life insurance on the owners. Prevents insurance payouts from inflating the value of the company and the estate of the deceased owner. Provide a cost-basis step up to survivors. Ensure that premiums are paid.
For more information about the recent decision, check out the WSJ article – The Supreme Court Blows Up a Popular Small-Business Succession Plan - WSJ. As always, remember to reach out to your advisors for customized planning and advice!
-- Lilian Xie | PB Law Summer Law Clerk
JD Candidate Class of 2026, William S. Boyd School of Law | University of Nevada, Las Vegas
Photo by Thought Catalog (@thoughtcatalog) | Unsplash Photo Community