Estate Planning for Family-Owned Businesses (4 Key Considerations)
Most estate tax cases are settled in lower courts, and very few are ever heard at the Supreme Court level—especially when the case pertains to a $7 million family-owned business.
But, last year, the Supreme Court ruled in Connelly v. United States that the life insurance money received by the corporation on a policy insuring the decedent’s life must be included in the company’s value included in the insured decedent’s estate.
Michael and Thomas Connelly, co-owners of Crown C Supply, had a shareholders’ agreement that stated when either one died, the company would redeem the deceased brother’s shares if the surviving brother chose not to purchase. Crown C Supply obtained $3.5 million in life insurance on both Michael and Thomas to be sure that it would have the funds to purchase the shares according to the agreement.
When Michael died, Thomas declined to buy his shares, and the company bought them for $3 million, which was paid to Michael’s estate. However, the IRS valued the shares at $5.3 million, leading to a higher estate tax assessment. The Court upheld the IRS’s valuation, stating that the redemption obligation did not lower the shares’ value for estate tax purposes.
While this high-level description only provides a summary of the case itself, Connelly v. United States ultimately provides lessons that all family businesses should learn when it comes to estate planning. Consider these four important takeaways and how you should apply them to your own family business and estate planning.
1. Family Business Estate Plans Impact All Owners of the Business
Estate taxes are the responsibility of the individual shareholders and not the family business. However, estate plans involving a family business will have implications for all stakeholders involved.
The family business in Connelly owned life insurance on the life of the deceased shareholder. After redemption using the life insurance proceeds, the surviving owner, who only owned a 22.8% minority interest before his brother’s death, owned a 100% controlling interest in the business.
This increase in value to the surviving shareholder was not apparent as a wealth transfer through the normal reporting of transfers on gift and estate tax returns; therefore, it likely gained additional scrutiny by the IRS.
2. Shareholder Agreements Must Be Followed To Be Upheld
Shareholder agreements typically have terms that require regular follow-up and maintenance, such as updates to stated company values or valuation methodologies. However, a lack of compliance with the terms can unravel the plan.
In the Connelly case, the shareholder redemption agreement required the shareholders to annually determine the value of the company shares and had provisions for the appraisal process. None of these provisions were followed before the death of one of the shareholders.
If the shareholders do not respect the formalities of shareholder agreements, then the IRS and Courts will not respect them either.
3. Agreements Must Be Drafted Properly
While buy-sell agreements can establish the value for estate or gift tax purposes if they are properly drafted, the IRS has established strict rules that disregard actual values supported by transactions if those rules are not followed.
If not complying with IRC Sec. 2703, the decedent’s estate can be bound to the agreed purchase price (usually lower) and the IRS has the right to value the subject stock at a higher fair market value using acceptable standards of valuation.
Buy-sell agreements or other restrictive agreements need to be drafted properly to have the desired outcome. To be respected, the buy-sell agreement must:
- Be a bona fide business arrangement
- Not be used as a device to transfer property for less than full and adequate consideration
- Have terms comparable to similar arrangements entered into by unrelated parties in arm’s length transactions
4. Appraisals by Qualified Professionals Are a Requisite
Fair market value is specifically defined in case law, and it is the standard of value for estate and gift tax purposes. When fair market value cannot be readily established by other means, estate plans should incorporate appraisals by qualified professionals.
Opinions of management representatives or “persons familiar with the business” do not serve as an opinion of value of a qualified appraiser. “Rule of thumb” or “net capital” values are also not suitable options.
Crown C Supply did not engage a qualified appraiser to issue an opinion of fair market value. Instead, the redemption price was agreed upon by the surviving shareholder (brother of the decedent) and the executor of the decedent’s estate (son of the decedent).
The Court found that the failure to establish a supportable fair market value for the company led to an incorrect valuation of the shares.
Learn More About Estate Planning for a Family Business
When it comes to the effectiveness of estate and gift plans, it’s important to get it right from the start and to carry out all of the necessary actions. However, errors are made often when carrying out the planning for transfers of family-owned businesses.
These errors commonly include maintenance of the business entity’s governance book, minutes documenting decisions of the leadership and officers, ownership changes, stock certificates, operational agreements and stated values for redemption or buy-sell agreements.
But with the right information and the right approach, you can plan well for your business’s and your family’s futures.
If you have questions, connect with your Warren Averett estate planning advisor directly, or ask a member of our team to reach out to you.
