The recent Connelly and Huffman cases spotlighted critical tax and structural traps for buy-sell agreements—especially when funded by life insurance. Below is a practitioner-friendly checklist to help avoid missteps.
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Do’s
1. Do distinguish related vs. unrelated parties.
- With unrelated owners, negotiated buyouts are more likely to be respected.
- With related parties (e.g., parent–child), courts scrutinize whether the deal hides a disguised bequest.
2. Do respect agreements during life.
- Update valuations and apply terms consistently—not just at death.
- Failure to honor agreements during life undermines enforceability later.
3. Do review regulatory requirements.
- Reg. § 20.2031-2(h): Agreement must be a bona fide business arrangement and not a device to transfer wealth below FMV.
- IRC § 2703: Adds a comparability test when family members hold 50%+ collectively. Terms must reflect arm’s-length practices.
4. Do use contemporaneous evidence.
- Keep drafts, appraisals, valuation reports, and negotiation records.
- This may create a defensible file if challenged by the IRS.
5. Do consider cross-purchase agreements.
- Life insurance proceeds are paid directly to surviving owners—not to the company—avoiding corporate value inflation under Connelly.
- Cross-purchase agreements also provide a step-up in basis to the purchasers.
6. Do explore Life Insurance LLCs.
- Centralize policy ownership to ease administration and avoid transfer-for-value problems.
- Use capital accounts to track contributions and benefits among owners.
7. Do consult appraisers strategically.
- Use industry multiples or other appropriate measurements when available.
- Document how values were set—even if no full appraisal is done.
8. Do review tax treatment of premium payments.
- For S corps: beware of disproportionate distributions.
- For C corps: fund through deductible compensation rather than nondeductible dividends.
- For S corps and partnerships: consider fairness issues in allocating between distributions and compensation to those owners paying premiums
9. Do anticipate creditor and operational concerns.
- Company-owned insurance may trigger loan covenant issues.
- Cross-purchase avoids corporate creditor risk but raises shareholder creditor exposure.
10. Do weigh practicality vs. perfection.
- Absolute protection from IRS challenge is impossible.
- Aim to reduce risk in a cost-effective way appropriate to the client’s size and goals.
Don’ts
1. Don’t assume life insurance is an “operating” asset.
- Connelly clarified that redemption-funded life insurance generally increases corporate value.
- Loss of key person may decrease company value and be offset partially or wholly by death benefits
2. Don’t rely on outdated valuation formulas.
- Book value formulas may have worked decades ago but fail if they no longer reflect reality (True case).
3. Don’t let controlling owners change terms unilaterally.
- Courts disregard agreements if majority owners can reset pricing without checks.
4. Don’t forget the comparability test under §2703.
- Family businesses must show their terms resemble what unrelated parties would agree to.
- Isolated comparables may work, but vague references or missing documents (Huffman) won’t.
5. Don’t underestimate litigation risk.
- Even well-drafted agreements can be second-guessed.
- Be realistic about “settlement value” if disputes arise.
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Promotional material only; not considered legal advice
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