For many family-owned and closely held companies, a buy-sell agreement is intended to provide certainty at a difficult time. The agreement may keep ownership in the family, create a market for otherwise illiquid shares, and give the business a funding source through life insurance. The recent Supreme Court decision in Connelly v. United States shows why those arrangements should not be treated as “set it and forget it” documents.

In Connelly, two brothers owned a supply company and had an agreement designed to address what would happen when one of them died. The company purchased life insurance on each brother, and after Michael Connelly’s death, the business used the proceeds to redeem his shares from his estate. The estate valued the interest without treating those insurance proceeds as an increase in company value. The IRS took the opposite position, and the difference resulted in additional estate tax.

The Valuation Trap

The key issue was whether the company’s obligation to redeem the shares reduced the value created by the insurance proceeds. The Court concluded that it did not. For estate tax purposes, the company was valued at the date of death, before the redemption payment was made. At that point, the insurance proceeds were an asset of the company, and the redemption obligation did not operate as a dollar-for-dollar offset.

That distinction is easy to overlook. A plan may work exactly as intended from a cash-flow perspective, with the company having the money to buy the shares, while still producing a higher estate tax value than the owners expected. In other words, the funding mechanism and the tax valuation result are not always aligned.

Lessons from Earlier Case Law

The result also brings renewed attention to earlier disputes involving company-owned life insurance and redemption agreements, including Estate of George C. Blount. Those cases illustrate that courts may analyze two related but separate questions: whether insurance proceeds increase the value of the company, and whether the buy-sell agreement is strong enough to control the value reported for estate tax purposes.

That second question often turns on the requirements of Section 2703. A buy-sell agreement generally must provide a fixed or determinable price, bind the parties during life and after death, reflect a bona fide business arrangement, avoid functioning as a disguised transfer of wealth, and resemble terms that unrelated parties might negotiate at arm’s length.

What Owners Should Review Now

Business owners and their advisors should revisit agreements that have not been reviewed in several years, especially when the company owns life insurance intended to fund a redemption. The review should focus on how value is determined, whether the process is actually followed, who owns the insurance, and whether the agreement still fits the ownership structure and succession plan.

Alternative structures may be worth considering. A cross-purchase agreement, partnership-owned arrangement, insurance trust, or other planning structure may better match the owners’ estate tax, cash-flow, and continuity goals. Any change should be reviewed carefully, including possible transfer-for-value, ownership, income tax, and estate tax consequences.

The Practical Takeaway

Connelly is not a warning against buy-sell agreements or life insurance. It is a warning against assuming that liquidity planning and estate tax valuation will reach the same answer. For closely held businesses, the best time to identify that gap is before a shareholder’s death, not during an estate tax audit.