Does the IRS really add the life insurance to my company's value when the money goes straight back out to my family?

Yes, and the Supreme Court agreed with it unanimously in Connelly v. United States on June 6, 2024. The proceeds are corporate cash on the date of death, and Treas. Reg. §20.2031-2(f)(2) directs the appraiser to count nonoperating assets including life insurance payable to the company. The redemption comes afterward, and because it happens at fair market value it leaves every remaining shareholder in the same economic position, so it is not a liability that reduces the company's value.

Do I need to fix my buy-sell agreement if my estate is under the $15 million exemption?

Often yes. The federal basic exclusion amount is $15,000,000 per person for 2026, but Oregon taxes estates above $1,000,000 and Massachusetts above $2,000,000, and neither cares about the federal number. A company-owned policy that adds $2,500,000 to the value of your shares produces a real state estate tax bill well below the federal threshold, and the business itself usually grows toward that threshold over the years the agreement sits untouched.

Is a cross-purchase agreement always better than a redemption?

No. A cross-purchase keeps the proceeds out of the corporation and hands the buyer basis in the shares he purchases, which a redemption never does. It also needs n times n minus 1 policies, so five owners means twenty, and it breaks down when one owner is uninsurable or so much older that the premiums are lopsided. An insurance LLC taxed as a partnership gets most of the benefit with one policy per insured, and for a two-owner company a straight cross-purchase is usually the cleanest answer.

Can we just transfer our existing company-owned policies to the owners personally?

Not directly, or the death benefit becomes taxable. Under IRC §101(a)(2) a policy transferred for valuable consideration loses its income exclusion above the consideration and premiums paid, and the exceptions cover transfers to the insured, to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is a shareholder or officer. A transfer to a co-shareholder is not on that list, which is why the fix is usually an LLC taxed as a partnership rather than a direct swap between owners.

One of our owners just died and we still have the old redemption agreement. What do we do now?

Value the stock with the insurance proceeds counted in, because that is the position the IRS will take and it now has the Supreme Court behind it. Form 706 is due nine months after the date of death, and Form 4768 buys an automatic six-month extension of time to file. Check whether the agreement actually fixed a price under §2703(b) and whether the owners followed its own valuation mechanism, since a documented, arm's-length price is the one argument still available. Then rewrite the agreement before the next death.

The Journal / Estate & Wealth

Buy-Sell Agreement Life Insurance Estate Tax: The Connelly Rule.

By Ewan Morkel, EAAugust 31, 20268 min read

A company-owned policy that funds a buy-sell agreement is a corporate asset on the date of death, and the obligation to redeem the shares does not offset it. The Supreme Court settled that in 2024, and most shareholder agreements still have not caught up.

Senior couple reviewing and signing planning documents

Two partners own a machine shop 50/50. The company buys a $5,000,000 policy on each of them, and the shareholder agreement says that when one dies, the company buys his shares back from his estate. Everyone understands the deal: the insurance funds the buyout, the survivor keeps the shop, the family gets cash. What nobody priced is that buy-sell agreement life insurance also raises the estate tax value of the shares it is buying, and the Supreme Court settled that against taxpayers in 2024.

The case

What the Supreme Court held in Connelly.

Michael and Thomas Connelly owned Crown C Supply, a building supply company in St. Louis. Michael held 77.18% and Thomas held the rest. Their agreement gave the survivor an option to buy the deceased brother's shares, and if he declined, Crown had to redeem them. Crown carried $3,500,000 of life insurance on each brother to fund that. Michael died in 2013, Thomas declined the option, and Crown paid the estate $3,000,000 for the shares, a number the two sides settled on between themselves. The Form 706 reported that $3,000,000.

The IRS valued Crown at $6,860,000: $3,860,000 of operating value plus the $3,000,000 of insurance used for the redemption. That put Michael's 77.18% at $5,300,000 and produced $889,914 of additional estate tax. The estate paid it and sued for a refund, then lost on summary judgment in the Eastern District of Missouri, lost in the Eighth Circuit, and lost again before a unanimous Supreme Court.

The reasoning in the opinion is a hypothetical you can check on paper. A corporation holds $10,000,000 of cash and nothing else. A owns 80 shares and B owns 20, so each share is worth $100,000. Redeem B for $2,000,000 and A is left with a corporation worth $8,000,000 and 80 shares, still $100,000 a share. Nobody got poorer, so no willing buyer would discount the stock for the obligation.

Footnote 2 leaves one narrow door open: a redemption obligation can sometimes cut value, as when it forces a company to sell operating assets and lose future earning capacity. An insurance-funded redemption is the opposite. The cash arrives before the obligation comes due.

The mechanics

Why buy-sell agreement life insurance raises the estate tax on the very shares it buys.

Section 2031 values the gross estate at fair market value on the date of death, and Treas. Reg. §20.2031-2(f)(2) tells the appraiser to count nonoperating assets, including proceeds of life insurance payable to or for the benefit of the company. The proceeds are corporate cash at the moment of death. The redemption happens after.

This is not a §2042 problem. The decedent held no incidents of ownership in the policy (no control over it), so nothing enters the estate as insurance. It enters through the stock, as valuation, which is why owners who were careful to put the policy in the company's name still got hit.

The result is a gap the estate has to fund elsewhere. In the machine shop above, the estate reports $7,500,000 of stock and receives $5,000,000 for it. The §1014 step-up sets basis at that same $7,500,000, and a complete redemption of the estate's whole interest is an exchange under §302(b)(3), so the estate books a $2,500,000 capital loss. Most estates have no gains to absorb it and §1211(b) releases the rest at $3,000 a year, so the loss is decoration.

A $10,000,000 machine shop, two 50/50 owners, one death in 2026.

Operating value of the corporation at the date of death: $10,000,000
Life insurance the corporation collects on the decedent: $5,000,000
Value of the corporation under §2031: $15,000,000
Decedent's 50% interest as the agreement priced it: $5,000,000
Decedent's 50% interest after Connelly: $7,500,000
Increase in the taxable estate: $2,500,000
Federal estate tax on the increase at 40%: $1,000,000
Cash the estate actually receives for the shares: $5,000,000

Tax year 2026. Two equal shareholders, no valuation discounts applied, and the corporation's operating value assumed unchanged by the death. The decedent's other assets are assumed to absorb the $15,000,000 basic exclusion amount for 2026 under Rev. Proc. 2025-32, so the increase is taxed at the 40% top rate in IRC §2001(c). State estate tax is not shown.

The fix

Three ways to keep the proceeds out of the company.

Cross-purchase. Each owner personally owns and is the beneficiary of a policy on the other. The proceeds never touch the corporation, so the company is still worth $10,000,000 and the estate's half is $5,000,000. The survivor also buys basis: he pays $5,000,000 for the shares and owns $5,000,000 of basis in them, which a redemption never gives him. The cost is policy count, which runs at n times n minus 1. Four owners means twelve policies.
An insurance LLC taxed as a partnership. The owners form a separate LLC holding one policy per insured, and the operating agreement allocates each death benefit to the surviving members. That is twelve policies down to four. Moving existing policies in fits the transfer-for-value exception in §101(a)(2)(B) for a transfer to a partnership in which the insured is a partner, which a transfer to a co-shareholder does not. The allocation language has to push the proceeds past the decedent's own LLC interest, or Connelly follows you in.
Keep the redemption and pay for the result. Size the coverage to fund the buyout plus the tax on the inflated value. Simplest, most expensive, and with one uninsurable owner it is sometimes the only one left.

The paperwork

Two documents that decide whether any of this holds up.

The agreement has to fix a price and the owners have to follow it. Under §2703(b) a buy-sell price binds the IRS only if the agreement is a bona fide business arrangement, is not a device to pass value to family for less than full consideration, and has arm's-length terms. The Connelly agreement failed before it reached that test. It set no price and no formula, only a mechanism calling for a new Certificate of Agreed Value each year or two appraisals instead. The brothers never executed one, and an undocumented price is one the IRS gets to ignore.

The policy has to clear §101(j). For employer-owned contracts issued after August 17, 2006, the death benefit above premiums paid is taxable income to the company unless the insured got written notice and gave written consent before the policy issued, and unless the company files Form 8925 each year. The exceptions in §101(j)(2) open only once §101(j)(4) is satisfied, and there is no carve-out for an owner insuring himself. Miss the consent and the same dollars are taxed twice, as corporate income and again inside the share value.

The $15,000,000 federal basic exclusion amount for 2026 convinces a lot of owners this is somebody else's problem. State estate tax disagrees. Oregon starts at $1,000,000 and does not index it, and Massachusetts starts at $2,000,000. A $2,500,000 swing in what the shares are worth is a live number in those states, and it is live federally for any owner whose company is most of an estate near the exemption. A GRAT moves future growth out and is worth pricing alongside the buy-sell.