Revisited: Buy-Sell Planning After the Connelly Decision

When the Eighth Circuit handed down its decision in Connelly v. United States, it sent a ripple through the world of business succession planning. Quietly but definitively, the court pulled the rug out from under one of the most widely used assumptions in buy-sell agreements: that life insurance used to fund a stock redemption does not affect the value of the business for estate tax purposes. In practice, it always mattered—but now, it’s a liability that can’t be ignored.

The facts of Connelly are simple but packed with consequences. Two brothers owned 100% of a closely held building supply company. Like many family businesses, they set up a buy-sell agreement to ensure a smooth transition when one of them passed away. The company itself—Crown C Supply, Inc.—took out a $3.5 million life insurance policy on Michael Connelly, one of the brothers. When Michael died in 2013, the business used $3 million of those proceeds to redeem his shares from his estate.

This is where most planners and business owners would assume the tax picture was settled. The company received insurance to buy out the shares. A clean transaction. But the IRS had a different view—and the courts agreed. The estate had valued Michael’s shares based on the company’s worth prior to the insurance payout. The IRS, however, argued that the $3.5 million in insurance proceeds became part of the company's value the moment they were received. Since it was a stock redemption, not a cross-purchase, the life insurance sat on the company’s books, enhancing its net worth. According to the IRS, that enhancement directly impacted the fair market value of Michael’s shares at the time of death.

The result? The estate underreported its value. The court held that because the life insurance was an asset of the company, the value of the business increased, and so did the value of the deceased’s ownership interest. Instead of reducing the estate tax burden, the insurance proceeds added to it. The IRS got a larger bite, and the estate got an unpleasant surprise.

For decades, tax and succession planners have relied on the logic that the funding mechanism for a buy-sell agreement—particularly in redemptions—would not inflate the value of the company itself. That logic has now cracked. What makes Connelly such a wake-up call isn’t just the ruling, but the precedent it sets for how valuation must be approached going forward. It exposes a blind spot that many business owners don’t even know they have.

Most buy-sell agreements are structured as redemptions because they’re easier. The company takes out the insurance, pays the premiums, and buys back the shares when a triggering event occurs. But under the reasoning of Connelly, that convenience comes with a cost. The insurance benefits the company directly, which means the proceeds show up in the value of the business unless the agreement is airtight—and even then, that’s no guarantee.

A cross-purchase plan avoids this problem because the surviving owners—not the company—own the policies. When a death occurs, the insurance proceeds go directly to the buying shareholders, not the business. Therefore, the company’s value doesn’t change, and the deceased’s shares can be bought at a price that reflects the business’s true pre-death value. But cross-purchase plans aren’t always practical. In businesses with more than two or three owners, managing multiple policies gets messy. That’s why redemptions have become the default—but Connelly just made that default much riskier.

What the court is really saying here is that substance trumps form. You can’t assume that just because the purpose of the life insurance was to redeem shares, the IRS will ignore the balance sheet impact. If the company benefits from the payout, then so does the estate—at least in the IRS’s view. And unless the buy-sell agreement includes strong valuation mechanisms that are regularly updated and binding under applicable tax law, that argument is hard to refute.

The practical result is that buy-sell agreements now need to be reviewed with greater scrutiny. Many were drafted years ago and haven’t been revisited. Others rely on vague or outdated valuation clauses that won’t hold up to IRS challenge. Simply saying, “the purchase price shall be the fair market value of the shares” isn’t enough. If your agreement doesn’t establish a fixed formula or a binding appraisal method, and if it doesn’t anticipate the impact of life insurance on the company’s value, you’re exposed.

There are options, but none of them are one-size-fits-all. Some owners may want to switch to a cross-purchase model or explore the use of a trusteed cross-purchase arrangement to handle multiple shareholders more cleanly. Others might consider a hybrid approach, where the company funds the policy but places it in an irrevocable life insurance trust (ILIT) or similar structure to keep the proceeds out of the business’s value. All of these solutions require careful coordination among financial advisors, tax professionals, and attorneys. And all require more than a handshake agreement or a dusty document from ten years ago.

In an era where estate tax exemptions are poised to drop and IRS scrutiny is increasing, the margin for error has shrunk. Business owners can’t afford to treat their buy-sell agreements as back-burner items. These are living documents, and Connelly has made it clear: if you’re not updating them, you’re gambling with your estate.

You don’t have to be a billion-dollar company to need elite planning. In fact, in a post-Connelly world, the small and mid-size closely held businesses are the ones most at risk—because they’re often the least aware of how exposed they are.

Buy-sell planning was never supposed to be a trap. But if you don’t respond to what the courts are saying, that’s exactly what it can become.