Life insurance and estate planning for family businesses

The United State Supreme Court’s recent decision in Connelly v. United States involved two brothers who were the only shareholders of a small business. The entered into an agreement to ensure that the company would stay in the family. Accordingly, their agreement provided that upon the death of the first of them, the survivor would have the option to purchase the deceased brother’s shares. If the surviving brother did not purchase the deceased brother’s shares, then the company would be required to purchase the shares back from the deceased brother’s estate.

The IRS ruled that the entirety of the $3.5 million life insurance payout increased the value of the company and, therefore, the value of the deceased brother’s estate. Therefore, the IRS ruled (and the Court agreed) that the estate tax imposed required an adjustment.

The takeaway in this case is that it’s important to be deliberative in how you set up your business succession planning. There was nothing necessarily wrong with the brothers’ plan. It just resulted in more estate tax upon the death of the first brother. As the Court noted, the brothers could have structured their planning a little bit differently.

For example, the brothers could have structured their plan in a way such that they took out life insurance policies on each other, thereby ensuring that the surviving brother would have sufficient liquidity to purchase the shares from the deceased brother’s estate. The downside in that plan is that the planning could fall through in the event one of the brothers doesn’t maintain the policy (i.e., pay the premiums).