Owners of closely held and family businesses utilize buy‑sell agreements and, at times, incorporate life insurance to fund a plan for transition upon an owner’s death. A new look at a U.S. Supreme Court decision has sparked a potential income tax planning opportunity for certain taxpayers with life insurance-funded transition plans. While the case was initially seen as only being unfavorable to taxpayers with taxable estates, the ruling may also produce a meaningful tax benefit for estates valued below the estate tax exemption.
Insight from Forvis Mazars: This opportunity may not always be around. A key element of this planning opportunity is the historically high federal estate tax exemption currently offered. As exemption amounts and tax laws continually change, those who act early can lock in a planning advantage that may not be available in future years.
What Did the Supreme Court Decide & Why Does It Matter for Business Owners?
In Connelly v. United States,1 the Supreme Court addressed how life insurance proceeds should be treated for estate tax valuation purposes when the insurance proceeds are intended to fund an ownership interest redemption upon an owner’s death. The court held that, for estate tax purposes, the buy-sell arrangement may be ignored.
Further, and of more substance to business owners, the court held that insurance proceeds received by the business must be included in the company’s fair market value at the owner’s death, even if those proceeds must be used to buy the decedent’s ownership in the business; the existence of such obligation does not reduce the value of the business for estate tax purposes. While this ruling initially increased estate tax exposure for business owners, the decision may have income tax implications possibly not intended or foreseen by the IRS at the time of the court’s ruling.
How a Higher Estate Valuation Can Translate Into a Usable Capital Loss
When life insurance proceeds are included in the value of a closely held business for estate tax purposes, that higher valuation generally results in a corresponding increase in the income tax basis of the business.2 For estates not subject to federal estate tax,3 this valuation increase may be effectively tax neutral for estate tax purposes, but consequential from an income tax perspective.
That higher basis can become meaningful when the business subsequently redeems the decedent’s ownership interest. If the redemption is properly structured to qualify as a sale or exchange for tax purposes,4 the difference between the stepped‑up basis and the redemption price may generate a capital loss. For families and business owners who apply this outcome into a properly executed estate plan, the court’s decision creates a narrow but potentially valuable opportunity to generate a beneficial income tax attribute.
Assume a closely held business with two equal owners has an agreed‑upon value of $6 million, reflecting fair market value for estate tax purposes, exclusive of life insurance, and a buy‑sell agreement requiring the company to redeem a decedent’s ownership interest. The agreement is funded with $3 million of company‑owned life insurance. Each 50% owner views their interest as worth $3 million, and the buy‑sell agreement reflects that amount as the redemption price.
Upon the death of one owner, the company receives the $3 million life insurance proceeds. Under the Supreme Court’s decision in Connelly, those proceeds must be included in the value of the company for estate tax purposes. As a result, the company is now valued at $9 million for estate tax purposes ($6 million fair market value plus $3 million of insurance proceeds). The decedent’s 50% ownership interest is therefore valued at $4.5 million, even though the redemption price under the buy‑sell agreement remains $3 million.
If the estate is below the federal estate tax exemption, this higher valuation does not have an effect on any federal estate tax liability, but it does establish an income tax basis of $4.5 million in the ownership interests. When the company later redeems the ownership interests for $3 million, and assuming the redemption qualifies as a sale or exchange, the estate recognizes a $1.5 million capital loss.
Who May Benefit From This Opportunity & Who May Not
This planning opportunity is highly fact‑specific, and it may not benefit every business or family in the same way. It is most relevant for owners of closely held or family‑owned businesses that use company‑owned life insurance to fund an ownership redemption under a buy‑sell agreement, particularly where the owner’s estate is expected to fall below the federal estate tax exemption.
While exploration of this strategy may make sense for executors of estates that may have been subject to buy-sell arrangements that meet similar fact patterns to Connelly, for business owners who are currently living, there are many factors that must be considered in an overall buy-sell arrangement. Therefore, buy-sell arrangements should be evaluated not only from a tax perspective, but also for cash flow, business succession, and continuity planning.
It is also important to consider that the value of the capital loss depends on who ultimately uses it, as capital losses generally only offset capital gains. Estates or beneficiaries who generate capital gains, such as from the sale of investments, business interests, or other qualifying assets, may benefit from a capital loss. Alternatively, taxpayers with little or no capital gain activity may not be able to meaningfully utilize capital losses.
In addition, estates subject to federal estate tax, redemptions that fail to qualify for sale or exchange treatment, or arrangements structured as cross‑purchases rather than redemptions may not possess the necessary elements to pursue this strategy.
Insight from Forvis Mazars: A loss created in the estate or passed through to beneficiaries is only as valuable as the taxpayer’s ability to use it. Taxpayers who evaluate capital gain potential early, before a redemption occurs, are in a better position to determine whether this opportunity represents a real economic benefit or a theoretical one.
How Forvis Mazars Can Help
Identifying whether this opportunity applies requires careful evaluation of a company’s buy‑sell structure, the anticipated estate tax situation, and how any capital losses could ultimately be used. Professionals at Forvis Mazars work with closely held and family‑owned businesses to integrate estate planning, income tax planning, and succession strategies into a coordinated approach tailored to each client’s circumstances.
Taxpayers who believe this strategy may be relevant to their situation should contact one of our professionals to see whether this opportunity could translate into meaningful future tax benefits for them and their families.
- 1Connelly v. United States, 602 U.S. 257 (2024).
- 2Internal Revenue Code (IRC) Section 1014.
- 3The federal estate tax exemption for 2026 is $15 million per individual and $30 million for married couples using portability. The amount is indexed for inflation annually.
- 4See IRC §§302(a) and 302(b) (providing sale or exchange treatment for qualifying stock redemptions); §302(b)(3) (complete termination of shareholder’s interest); §318 (constructive ownership rules); and §302(c)(2) (waiver of family attribution).
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