The Big Picture: Buy-Sell Agreements, Business Partners, and the Connelly Test Revolution

Do you have a business and partners? Do you have a buy-sell agreement in place? Does it pass the Connelly test?

If you can't answer these questions confidently, you might be sitting on a tax time bomb that could cost your family millions. The 2024 Supreme Court decision in Connelly v. United States just rewrote the rulebook for business succession planning, and the implications are staggering.

What Exactly Is a Buy-Sell Agreement?

Think of a buy-sell agreement as your business's "last will and testament." It's a contract between business owners that spells out what happens when life throws you curveballs: death, disability, divorce, or retirement.

These agreements answer the big questions every business partnership faces:

• Who gets to buy an existing owner's shares?

• Is the purchase mandatory or optional?

• How do we determine the price?

• Where does the money come from?

There are two main types of buy-sell agreements:

Cross-Purchase Agreements: The surviving owners buy out the departing owner directly. Each partner typically carries life insurance on the others to fund the buyout.

Entity-Purchase Agreements: The business itself buys back the departing owner's shares. The company holds life insurance policies on each owner to generate the cash needed.

For decades, these seemed like straightforward, sensible arrangements. Then came the Connelly brothers.

The Connelly Case: When Traditional Planning Backfired

Michael and Thomas Connelly owned a family business together: Michael held 77%, Thomas owned 23%. Like thousands of other family businesses, they had an entity-purchase agreement funded by life insurance. The company held $3.5 million policies on each brother's life.

Their agreement included what seemed like reasonable valuation provisions: either maintain an annual "Certificate of Agreed Value" or get a formal appraisal after a triggering event.

When Michael died, everything seemed to go according to plan. The company used $3 million of the life insurance proceeds to buy Michael's shares from his estate. The estate valued those shares at $3 million for tax purposes: exactly what was paid. Case closed, right?

Wrong.

The Supreme Court Bombshell

The IRS challenged the $3 million valuation, and the Supreme Court sided with the government in a decision that shocked the estate planning world.

The Court's reasoning was brutal in its simplicity: If the business had $3.86 million in assets before the life insurance payout, and then received $3.5 million in life insurance proceeds, the total value available was $6.86 million. Since the business paid $3 million to Michael's estate, that left $3.86 million in the business.

Therefore, the Court reasoned, the business must have been worth $6.86 million before the redemption. Michael's 77% stake should be valued at $5.29 million for estate tax purposes: not the $3 million actually received.

The result? Michael's estate got hit with taxes on an extra $2.29 million in value they never actually received.

Why This Changes Everything

The Connelly decision created what practitioners are calling a "tax trap" for family businesses. Here's what makes it so dangerous:

The Life Insurance Paradox: The very life insurance meant to fund the buyout now increases the estate tax burden. The deceased owner's estate gets taxed on money that went right back out the door to pay for their own shares.

The Survivor's Windfall: Thomas Connelly's remaining 23% stake quadrupled in value overnight: without him investing another dime. He got a massive tax-free benefit while Michael's estate got stuck with a massive tax bill.

The Agreement Didn't Matter: Even though they had a buy-sell agreement, the Court ruled it couldn't control the valuation because the brothers hadn't followed their own procedures (they skipped the required appraisal) and the price wasn't truly "fixed."

The New Rules: What the Connelly Test Requires

For a buy-sell agreement to pass muster under the new Connelly standard, it must meet strict requirements under Internal Revenue Code Section 2703:

Fixed or Determinable Price: Vague valuation formulas won't cut it anymore. You need concrete, predetermined pricing mechanisms.

Procedural Compliance: If your agreement requires annual valuations or formal appraisals, you must actually do them. No shortcuts, no informal handshake deals.

Legitimate Business Purpose: The IRS will scrutinize whether your agreement serves real business needs or is just a tax avoidance scheme.

Regular Updates: Agreements gathering dust in file drawers are worthless. They need annual maintenance and professional review.

What This Means for Your Business

If you have an entity-purchase agreement funded by life insurance, you're potentially in the crosshairs. The Connelly decision means:

Higher Estate Taxes: Your heirs might face tax bills on money they never receive.

Valuation Uncertainty: Traditional valuation methods may no longer protect you from IRS challenges.

Planning Complexity: Simple solutions are gone. Everything now requires sophisticated professional analysis.

Immediate Action Needed: Existing agreements may need complete restructuring.

Strategic Solutions in the Post-Connelly World

Smart business owners are exploring several paths forward:

Cross-Purchase Restructuring: Moving from entity-purchase to cross-purchase agreements can avoid some Connelly problems, though it creates new complexities around insurance ownership and tax basis.

Installment Purchase Arrangements: Rather than using life insurance proceeds directly, some businesses are structuring buyouts as installment sales to spread the tax impact.

Split-Dollar Life Insurance: Advanced insurance arrangements that keep policy proceeds outside the business valuation may offer solutions for larger companies.

Wait-and-See Purchases: Some agreements now include provisions that allow flexibility in how buyouts are structured after a triggering event occurs.

The Bigger Picture: Why This Matters Now

The Connelly decision isn't just about one family's tax bill: it's a wake-up call for every business owner with partners. Consider these statistics:

• Over 70% of businesses fail to successfully transfer to the next generation

• Most existing buy-sell agreements haven't been updated in over five years

• The average estate tax bill for a closely-held business just increased dramatically post-Connelly

With federal estate tax exemptions potentially decreasing in coming years, the stakes are higher than ever.

How BlackFin Wealth Group Helps You Navigate the New Reality

At BlackFin Wealth Group, we've been helping business owners adapt to the post-Connelly landscape. Our approach includes:

Comprehensive Agreement Audits: We review existing buy-sell agreements for Connelly compliance and identify potential tax traps.

Strategic Restructuring: When needed, we help redesign agreements to minimize tax exposure while preserving business succession goals.

Ongoing Maintenance: We provide the annual valuations and procedural compliance that modern agreements require.

Integration with Estate Planning: Buy-sell agreements don't exist in a vacuum: we ensure they work seamlessly with your broader wealth transfer strategy.

Tax Efficiency Analysis: We model different scenarios to find the most tax-efficient structure for your specific situation.

The Bottom Line

The Connelly decision fundamentally changed the game for business owners. What used to be straightforward succession planning now requires sophisticated analysis and ongoing professional oversight.

The question isn't whether you need to review your buy-sell agreement: it's how quickly you can get started. Every day of delay potentially increases your family's tax exposure.

Don't let your business partnership become the next Connelly case study. The time to act is now.

---

Ready to ensure your buy-sell agreement passes the Connelly test? Contact BlackFin Wealth Group today for a comprehensive review of your business succession strategy. Our team of experts can help you navigate the new landscape and protect your family's financial future.