Closely Held Companies Face New Tax Burdens After Connelly v. United States

The Supreme Court’s recent ruling in Connelly v. United States has reshaped the way closely held businesses handle ownership transfers after a shareholder’s death. This under-the-radar decision has far-reaching tax implications for small businesses that previously used life insurance-funded buyouts to transfer ownership tax-free.

Under the new ruling, insurance payouts used to buy out a deceased owner’s shares are now subject to taxation. Additionally, these payments must be included in federal estate tax calculations, significantly increasing the estate’s value—and the IRS’s cut.

For small business owners relying on this strategy, the tax landscape has changed overnight.

How Businesses Used to Avoid Taxes on Ownership Transfers

Many closely held businesses have long used life insurance-based buyout agreements to ensure smooth transitions when a key owner dies. The setup worked like this:

1. The business pays for life insurance policies covering its key shareholders.
2. When an owner dies, the insurance payout funds the repurchase of their shares.
3. Under a 2008 court ruling, these transactions were not taxed because they were considered a contractual obligation.

This strategy helped businesses avoid estate taxes, simplify ownership transitions, and ensure financial stability. But the Connelly ruling dismantles this approach.

The Supreme Court’s Decision in Connelly v. United States

The case involved Thomas and Michael Connelly, co-owners of Crown C Supply, a St. Louis building supply company.

1. When Michael died in 2013, the company used a $3 million life insurance payout to buy out his 77% stake—expecting to avoid taxation.
2. However, the IRS audited the estate, valued Michael’s shares at nearly $4 million, and added the $3 million insurance payout to the estate’s value.
3. The result? An extra tax bill of nearly $900,000.

Thomas Connelly fought the IRS ruling all the way to the Supreme Court, but the justices unanimously sided with the IRS.

Key Takeaways from the Ruling:

1. Life insurance proceeds used for share buyouts must now be included in estate tax calculations.
2. Closely held businesses can no longer use this method to transfer ownership tax-free.
3. IRS scrutiny of business estate transfers will likely increase.

What Business Owners Need to Do Now

Business owners must adapt quickly to avoid unexpected tax burdens. Experts recommend re-evaluating ownership transition plans and considering alternative methods.

1. Cross-Purchase Agreements

Instead of the business owning the life insurance policies, individual shareholders take out policies on each other. When one dies, the surviving owners buy the shares directly—keeping the business out of the taxable equation.

2. Special Purpose LLCs

A separate LLC can be created to manage life insurance policies and payouts. This structure shields the business itself from tax complications.

3. Irrevocable Life Insurance Trusts (ILITs)

These trusts own life insurance policies, keeping the proceeds outside of the taxable estate. This method can significantly reduce estate tax exposure.

Why Expert Guidance is Now Essential

With the Supreme Court’s ruling in place, business owners can’t afford to navigate estate planning alone. Legal and tax experts can help restructure ownership transition strategies and ensure compliance with the new tax rules.

Additionally, with the current estate tax exemption of $13.6 million set to drop to $7 million in 2025, businesses must act now to minimize tax liabilities.

Conclusion: A Major Shift for Small Business Owners

The Connelly ruling is a game-changer for small businesses. It eliminates a long-standing tax-free transfer strategy and makes estate planning more complex and costly. Business owners must reassess their transition plans immediately to protect their companies and families from unexpected IRS tax bills.

Next Steps:

1. Consult a tax or estate planning professional to reassess your strategy. 
2. Explore alternative transfer methods like cross-purchase agreements or ILITs. 
3. Act now before the estate tax exemption drops in 2025.

Failing to plan could mean a hefty tax bill for your heirs—just like Thomas Connelly learned the hard way.

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