For business owners, planning for succession often involves creating a buy-sell agreement to ensure a smooth transition of ownership upon retirement, death, or disability. However, the 2024 federal Connelly decision has significantly altered how the IRS views certain buy-sell agreements—particularly entity purchase agreements (meaning buy-sell agreements in which the entity is the recipient of the life insurance proceeds and will use them to redeem a decedent shareholder’s shares).
This ruling exposes a critical problem: when proceeds from a buy-sell agreement flow back into the company (as they often do in traditional buy-sell agreements), the IRS will now include that value in the company’s overall valuation, increasing estate tax liability. If you currently have an entity purchase buy-sell agreement in place, it likely no longer offers the tax protections you intended.
What Happened in the Connelly Case?
In Connelly v. United States, the IRS examined a family-owned business’s entity purchase buy-sell agreement. Upon the death of one of the owners, the agreement stipulated that the company itself would buy back the deceased owner’s shares using proceeds from life insurance policies held by the company.
The business argued that the buy-sell agreement was both an asset and a liability on the books. However, the IRS disagreed and determined that:
- Proceeds from the life insurance policies were added to the company’s value: The IRS reasoned that when the company received the life insurance proceeds, they became part of the company’s assets, inflating its overall value.
- The estate’s tax liability increased: Because the company’s value now included the insurance proceeds the estate owed significantly more in federal estate taxes than anticipated.
The court upheld the IRS’s position, setting a precedent that undermines the effectiveness of entity purchase buy-sell agreements for reducing estate tax exposure and breaking with decades of lawyers’ and tax professionals’ understanding of how such agreement operate.
Why Entity Purchase Buy-Sell Agreements Are Problematic After Connelly
Entity purchase agreements (also known as redemption agreements) place the responsibility for buying out a departing owner’s shares on the business itself. While this approach has historically been popular for its simplicity, Connelly has exposed major drawbacks:
- Inflated Business Valuation: When life insurance proceeds are used to fund the buyout, they are added to the company’s value for estate tax purposes. This means the estate may face a much higher tax burden than if the proceeds had been excluded.
- Estate Tax Double Counting: The IRS effectively “double counts” the life insurance proceeds—once as part of the company’s value and again when they are used to pay the departing owner’s estate.
- Loss of Tax Certainty: One of the primary goals of a buy-sell agreement is to provide clarity and certainty regarding the value of a business owner’s interest. After Connelly, entity purchase agreements fail to provide this protection.
The Tax Implications for Business Owners
Under current federal law, estates exceeding the federal estate tax exemption of $12.92 million (as of 2025) are subject to estate tax. The Oregon estate tax exemption is the lowest in the US at only $1 million (in 2025). The Connelly decision increases the likelihood that the value of closely held businesses will exceed these thresholds, especially if life insurance proceeds are included in the company’s valuation.
For example:
- A business valued at $10 million holds $5 million in life insurance policies to fund a buyout.
- After the owner’s death, the $5 million in insurance proceeds flows into the company, increasing its value to $15 million.
- The owner’s estate is now taxed on the full $15 million, leading to a much higher tax liability than anticipated.
This outcome highlights the need for alternative strategies to mitigate the tax impact on your estate.
Alternative Strategies to Avoid Connelly Issues
To reduce estate tax liability and address the problems highlighted by Connelly, business owners may consider the following alternatives:
- Cross-Purchase or Cross-Endorsement Buy-Sell Agreements
In a cross-purchase agreement, the remaining owners—not the company—agree to purchase the departing owner’s interest. Each owner typically holds life insurance policies on the others to fund the buyout. This structure avoids life insurance proceeds being added to the company’s value and provides more favorable estate tax treatment, but can be unwieldy and requires the shareholders to trust each other to maintain proper insurance.
In a Cross-Endorsement Buy-Sell, each shareholder is responsible for purchasing a life insurance policy on themselves, but endorses the policy naming the other shareholders as beneficiaries. This structure avoids life insurance proceeds being added to the company’s value and puts the fallout for improperly maintaining a policy on the individual shareholders. This is a simpler arrangement than is a cross-purchase.
- Irrevocable Life Insurance Trusts (ILITs)
An ILIT removes life insurance proceeds from both the company’s and the estate’s valuation. The trust holds the life insurance policies, and the proceeds are used to fund the buyout directly, bypassing the estate tax entirely.
- Estate Planning with Discounts
Leverage valuation discounts for lack of control or marketability to reduce the taxable value of your business interests. While these discounts must align with fair market value requirements, they remain an effective tool when properly applied.
How Bridgeport Law Group Can Help
The Connelly decision has fundamentally changed how the IRS evaluates entity purchase buy-sell agreements, creating new challenges for business owners. At Bridgeport Law Group (BLG), we specialize in business succession planning tailored to the unique needs of Oregon and Washington business owners.
Our experienced attorneys can:
- Review your existing buy-sell agreement for potential tax pitfalls.
- Recommend alternative structures that protect your business and minimize estate taxes.
- Collaborate with your financial advisors to ensure your plan reflects the latest legal developments.
Take the Next Step
If your succession plan relies on a buy-sell agreement, now is the time to revisit your strategy. Contact BLG today to schedule a consultation and ensure your business—and your estate—are protected from unnecessary tax burdens.
Note: This article is for informational purposes only and does not constitute legal advice. For personalized guidance, please consult with a qualified attorney.