After a recent Supreme Court decision, attorney Anne Marie Robbins said there’s a new need to get your ducks in a row financially for a subset of New Jersey’s small business owners.
The June decision by the nation’s highest court in the seemingly esoteric case, Connelly v. United States, poses some easy-to-understand consequences for certain business owners: a potential tax hit.
Robbins, who is a partner in the Wills, Trusts & Estates Group at Lindabury, McCormick, Estabrook & Cooper, said the case dealt with something common for a lot of closely held business enterprises, which is a shuffle to protect the business after a major company shareholder’s death.
That’s because, when a shareholder in a small business dies, their estate is entitled to some value of the shares they owned. That company may not be able to purchase those shares outright, but also might not want to be in business arrangements with that person’s surviving spouse or children.
It’s a tricky situation — one that some companies resolve proactively by making buy-sell agreements funded by life insurance that company owners purchase for one another.
“And, it’s not an uncommon setup for small businesses, who often don’t have the cash at the ready to fund a purchase obligation in the event of a shareholder death, and don’t want to sell business assets to do so,” Robbins said. “Insurance is an easy way to fund that purchase obligation.”
That type of agreement was the subject of this summer’s Connelly v. United States. In that case, one of two brothers died and left the other as the sole shareholder in a company. They had life insurance in place so that, if one died, the company could use those proceeds from that insurance plan to redeem the other’s shares.
The Internal Revenue Service later assessed federal estate taxes that factored in the stock redeeming insurance payout when looking at the company’s fair market value. In the past, offsets to a company’s value (for tax purposes) had been allowed by lower courts when there’s an obligation to purchase a shareholder’s interest in the company after their death.
However, the Supreme Court decided, in essence, that life insurance proceeds paid out to a company should be included in a company’s value when calculating federal estate taxes.
Robbins said the decision wasn’t necessarily surprising. Despite the fact that lower courts have held for years there wouldn’t be valuation increases and potentially new tax liability for business owners in these situations, she explained that there were rumblings of the IRS attempting to make a claim to the contrary.
“So, for a while, I have been wary of this type of planning,” she said. “I made sure that all clients with whom I’ve worked (accounted for it).”
As for how well accounted-for this is generally by small businesses with similar buy-sell agreements in place, Robbins said that’s difficult to pinpoint.
“Because, I think, if a small business has enough of a value, the shareholders would’ve thought of the possibility of death of shareholders,” she said. “And it’s probably not the case that businesses have done this on their own, but have worked with advisers that hopefully alerted to them all of the possibilities.
“At the same time, a lot of businesses out there may have worked with advisers decades ago, got things set up, and haven’t talked to that adviser in the decades since. And, especially for anyone not following tax law, or reading ROI-NJ or other publications to keep up to date, it’s potentially concerning for those folks.”
Robbins clarified this will be most relevant for equity owners in closely held businesses with a taxable estate that’s bumping up against allowable exemptions. This year, that’s a hefty $13 million. Next year, it’s slated to reduce to $7 million.
Those with estates approaching those tax exposure figures ought to be reexamining their agreements, she added, and potentially making changes where they’re needed.
“Of course, you have to also weigh the cost of changes versus leaving things in place, because it’s not inexpensive to make a change that involves redoing legal agreements and obtaining new policies,” she said. “It’s all going to depend on the individual circumstances and what your risks are, which an attorney or CPA can help you determine.”
