Succession planning for closely held business owners has always carried estate tax risks, but the Supreme Court's 2024 decision in
The
If you don't think the Connelly decision impacts you as a CPA, think again.
First, insurance-funded redemptions with buy-sell agreements are fundamental tools in succession planning. Thousands of closely held businesses have these arrangements in place. As a CPA, you're likely advising many of these businesses. The Connelly decision essentially pulls the rug out from under established planning strategies.
There's also professional liability risk. CPAs who continue advising clients using pre-Connelly assumptions could face malpractice claims. Getting qualified appraisals and proper documentation are now more important than ever. More on that in a minute.
Finally, the Connelly decision creates a fundamental disconnect between economic reality and tax valuation. This can lead to double taxation, i.e., both the redemption payment and the underlying proceeds. CPAs involved in business valuations need to understand how this changes their methodology.
Life insurance has long helped closely held businesses provide liquidity for redemptions when an owner dies. These policies are usually paired with buy-sell agreements that mandate redemption, keeping ownership in the intended hands. Until recently, the estate tax consequences of this approach were generally understood and not controversial.
The Connelly ruling puts planning tools at odds with how estate value is measured. It diverges from the Eleventh Circuit's earlier decision in
What happened in Connelly?
Crown C Supply, a Missouri-based building supply business, was owned by brothers Michael and Thomas Connelly. Their buy-sell agreement gave the surviving brother the first right to purchase the other's shares, with a mandatory corporate redemption if declined. The company bought $3.5 million of life insurance on each brother. When Michael passed away in 2013, Thomas declined to buy shares, and the company used $3.0 million in life insurance proceeds to redeem Michael's 77.18% interest.
The purchase price was informally agreed upon, based largely on the insurance proceeds and a $500,000 working capital adjustment, without a formal valuation. It's important to note that the best practice would be to get a qualified appraisal and attach it to the estate tax return to meet "adequate disclosure" and significantly reduce audit risk.
The estate reported the fair market value of Michael's shares at $3.0 million. The IRS disagreed, asserting that the full amount of the life insurance should be included in the company's value. It valued Michael's interest at $5.3 million (for the addition of the life insurance proceeds, $3.0 million × 77.18% = $2.3 million) triggering about $890,000 in additional estate tax.
The estate paid the tax and sued for a refund. While the District Court sided with the estate, the Eighth Circuit reversed, and the Supreme Court affirmed the IRS's position. Here's a
The Supreme Court's reasoning
Justice Clarence Thomas, writing for a unanimous court, focused on whether a corporate redemption obligation reduces share value under Section 2031 of the Internal Revenue Code. The Supreme Court held that it doesn't, because the obligation is to shareholders and does not diminish third-party claims. Therefore, the insurance proceeds increased the company's value, regardless of their use.
This reasoning, however, overlooks the economic substance of the transaction. A rational buyer would never pay $5.3 million for shares knowing the company must immediately pay out $3.0 million. The decision assumes a willing buyer unaware of basic financial facts.
This strategy has been widely used and has long been considered a settled issue from a valuation perspective for the past 20 years.
Revisiting Blount
In Blount, the Eleventh Circuit reached a different conclusion. William Blount owned 83% of a company with a buy-sell agreement and life insurance. The estate reported his shares at $4.0 million, the agreed redemption price. The IRS argued for a higher value, but the court found the proceeds were not available for general use and were offset by the redemption obligation.
The Eleventh Circuit emphasized that life insurance proceeds used solely for redemption do not increase enterprise value. It reasoned that including them artificially inflates estate value without reflecting what a willing buyer would actually pay. This logic shaped estate planning for nearly 20 years—until Connelly reversed course.
Reality meets redemption
In Connelly, the Supreme Court treated the life insurance proceeds as unencumbered assets, despite their required use. Under ASC 480-10-25-4, a mandatory redemption triggered by death would be booked as a liability. The triggering event had occurred, the obligation was measurable, and it likely had priority over other equity in liquidation.
When life insurance is used solely to fund a redemption, the proceeds briefly enter (and exit) the balance sheet. They do not enhance income potential or provide capital that can be used for distribution. What exists is a transitory moment of increased cash immediately followed by a mandatory outflow, structure or long-term value. Treating them as accretive misstates the buyer's actual position.
This results in a double taxation that would make a C corp blush. The estate receives the redemption payment yet is taxed again as if those proceeds increased the business's value. In large estates, this can leave little to nothing after tax. Fair market value should reflect a real-world transaction between a willing buyer and willing seller; it should not reflect accounting entries in isolation.
In Blount, the Eleventh Circuit got this right with substance over form. Insurance proceeds used for redemption do not enhance enterprise value. They merely support ownership transition. Including them in value ends up mistaking cash movement for the creation of wealth.
The Connelly decision complicates estate planning, but it does not replace the need for careful valuation analysis. It is now more important than ever to distinguish between temporary funding mechanisms and true value accretion. A qualified appraisal remains the best defense in an estate tax audit, reducing the risk of added tax and penalties. Advisors should reassess plans that rely on insurance-funded redemptions.
CPAs who understand these implications can provide superior advisory services, helping clients navigate the new landscape while competitors may still be operating under outdated assumptions.
