Question:        My company maintains a buy sell agreement funded by insurance. What must I do in light of the recent U.S. Supreme Court decision?

Answer:           You will need to review your company’s buy sell agreement. There likely are alternative structures you can employ to avoid the adverse consequence that can result from the recent Supreme Court ruling.

It is common for a closely held business owned by more than one person to enter into an agreement, often called a buy sell agreement, providing for the purchase of the ownership interest of a deceased owner upon the decedent’s death. In cases where the purchasing party is the company itself, the agreement is a redemption agreement where the company is obligated to repurchase the deceased owner’s interest in the company. Oftentimes, businesses purchase insurance on the lives of shareholders to fund the buyout obligation.

In a unanimous decision, the U.S. Supreme Court recently held that the valuation of a decedent’s interest in a business must include the value of insurance policies on the decedent’s life which are owned by the company. Moreover, even though the company is obligated to purchase the interest of the decedent with the company owned insurance policies, the Court held that there should be no reduction in the value of the business due to the company’s repurchase obligation. This creates an adverse tax consequence for the estate of the deceased shareholder which is obligated to value the decedent’s interest with a price which includes the policy proceeds paid to the company upon the decedent’s death without an offset to that valuation for the company’s repurchase obligation.

To illustrate the effect of the Supreme Court’s decision, consider a closely held corporation worth $2,000,000 equally owned by Mike and Beth. To fund the buy sell agreement, the corporation purchases $1,000,000 of insurance on each shareholder’s life. If Mike dies, the corporation will collect the policy proceeds on Mike’s life and use the policy proceeds to repurchase Mike’s shares. While intuitively, one would think that the value of Mike’s shares for Federal estate tax purposes is $1,000,000, the Supreme Court’s decision indicates otherwise. Based on the Court ruling, the value of Mike’s interest for estate tax purposes would be $1,500,000, the sum of one-half of the $2,000,000 business value and one-half of the $1,000,000 of insurance proceeds the company will receive as a result of Mike’s death. Mike’s estate must therefore report a value of $1,500,000 for Federal estate tax purposes. If Mike’s estate is subject to Federal and/or State estate taxes, the estate tax obligation will have increased as a result of the inclusion in Mike’s estate of the insurance proceeds the corporation will have received.

Suffice it to say that shareholders who are parties to buy sell redemption agreements funded by life insurance must review their agreements to determine how, if at all, they are affected by the Supreme Court ruling. In some cases, the increased value may have no impact if the estate of the deceased shareholder is not large enough to be subject to Federal and/or State estate taxes.

One obvious alternative is to utilize a different type of buy sell agreement, a cross-purchase agreement, whereby the other business owners, not the business itself, purchase the ownership interest of the deceased shareholder. In this case, the policies of insurance are not owned by the operating entity so the policies will not included in determining the value of the business interest held by the decedent’s estate. However, each situation is different and the Court’s ruling most certainly will complicate the process of creating and funding buy sell agreements.

For more information on this topic, please contact Bruce Bell by e-mail at [email protected] or call (312) 648-2300.