family business Tag

by Chris Swiecicki

The Impact of SCOTUS Decision in Connelly v. United States on Buy-Sell and Estate Taxes

If you’re a business owner who’s ever set up a buy-sell agreement or taken out life insurance to help fund one, the recent U.S. Supreme Court decision in Connelly v. United States should give you pause. In a ruling that could carry serious tax implications, the Court held that life insurance proceeds paid to a company must be included in the company’s valuation for estate tax purposes—even if those proceeds are immediately used to buy out a deceased shareholder’s interest.

This isn’t just a technical shift. It’s a reminder that even well-meaning planning can backfire without the right structure. If your company owns life insurance on a partner or key shareholder, you may want to reevaluate your current setup—because your heirs could end up with a tax bill nearly as large as the payout itself.

Connelly v. United States: The Court’s Decision

Micheal and Thomas Connelly were joint shareholders in Crown C Supply in St. Louis, MO. Micheal owned 77.18% of Crown’s shares. The brothers agreed that the surviving brother would have the option to purchase the deceased brother’s shares, otherwise the corporation would be required to purchase the shares. To ensure the company was able to repurchase the shares, Crown took out a $3 million life insurance policy for each brother. Upon Micheal’s death, Thomas declined to purchase Micheal’s shares; therefore, the company was obligated to purchase the shares under the terms of the agreement.

Relying on the Eleventh Circuit’s decision in Estate of Blount v. Commissioner, 428 F. 3d 1338 (11th Cir. 2005), the accounting firm’s analyst excluded the $3 million in insurance proceeds that were used to purchase Micheal’s shares from the company’s valuation. The analyst believed, based on the Estate of Blount decision, that the company’s obligation to repurchase Micheal’s shares was a liability that offset the value of the insurance proceeds. Accordingly, the valuation of Crown C Supply was determined to be $3.86 million, and the value of Micheal’s shares were approximately worth $3 million.

By contrast, the IRS said that Crown’s obligation to purchase Micheal’s shares did not offset the value of the life insurance proceeds. Therefore, the $3 million was required to be added to the company’s valuation before determining the value of Micheal’s shares. Using the higher valuation, the IRS determined Micheal’s shares were worth approximately $5.3 million. Consequently, Micheal’s estate owed an additional $899,914 in estate taxes. The District Court and the Court of Appeals agreed with the IRS’s calculation, which was then appealed to the Supreme Court for review.

Upon review, the Supreme Court also agreed with the government. The Court held that the life insurance proceeds should be included in the valuation of a company, even if the total amount of proceeds are used to fulfill a contractual obligation to repurchase shares.

Impact for Businesses

The impact of the Court’s decision in Connelly is higher estate tax liability for business owners or key employees that are shareholders in a business. The current estate tax threshold for 2025 is $13,990,000 per individual. The value of the decedent’s estate above this threshold will be taxed at 40%. Businesses that have a key man policy will need to add the life insurance proceeds when determining the value of the business. Accordingly, the increased valuation will be used to determine the overall stock price and the value of the decedent’s shares when determining estate tax liability.

Given the Court’s ruling, it’s essential to carefully review all buy-sell agreements and their funding mechanisms. It is important to ensure these agreements are structured in a way that minimizes estate tax liability. Finally, alternatives that could be more tax-efficient include cross-purchase agreements or irrevocable life insurance trusts (ILITs) that would act as the owner of the policy rather than the corporation itself.

Cover photo by Mikhail Nilov via Pexels

by Chris Swiecicki

What is the “Representations and Warranties” Section of a Purchase Agreement for, and Why is it Important?

When buying or selling a business, an accurate representations and warranties section of a purchase agreement is critical for ensuring a smooth transition. Any size entity, whether a small family business or larger corporation, is bound to the facts stated in the agreement in order to close the transaction.

Because there are so many legal details that could result in indemnification (compensation for loss and harm) for either party if not accurate, it’s always best to have a trustworthy attorney by your side who can explain what everything means during all contract negotiations.

What Are Representations and Warranties?

Representations and warranties are contractually binding statements assuring both parties of a sale that the business is what the buyer believes it to be. They give both parties legal recourse if the transaction does not go through as expected. Both the buyer and seller make representations and warranties, but the majority of them are made by the seller. 

Representations

A representation is an assertion that everything in a contract is true as stated. Especially in M&A transactions, sellers must include information about the target company or business and the stock or assets and liabilities being transferred. 

Warranties

A warranty can result in indemnification, or compensation, if the assertion is false. The seller will warrant information given to the buyer during the diligence process, such as that:

• The business is in compliance with all relevant government regulations.
• All financial statements are true and accurate.
• All property—whether tangible or intangible—is free of any encumbrances.

The buyer will need to make warranties as well, such as that:

• They have enough money on hand to pay the purchase price.
• They are a duly formed corporation with the power to execute the contemplated transaction. 

Exceptions 

Representations and warranties are drafted as general statements in most M&A transactions. The seller must disclose exceptions to those statements in a disclosure schedule attached to the purchase agreement. As long as the exception is properly disclosed, the buyer has been given official notice of the fact. If a seller fails to make a disclosure, it may result in a claim of fraud against the seller.

For example: Except as set forth in Section 1.1 of the Disclosure Schedule, the Company has no current litigation. Disclosure: A claim for XXX was filed in the Superior Court for Perry County on March 3, 2020, under Case No. 1234.

Remedies and Enforcement

The indemnification obligations of the parties, provided in the purchase agreement, is what enforces the representations and warranties. Indemnification language typically states that for a limited time after closing, the parties can indemnify each other for breach of or inaccuracy in the representations and warranties provided by that party.

For example, if a deal closes and the buyer discovers that the seller’s financial statements are inaccurate, the buyer can seek indemnification for losses incurred.

Because of the repercussions that can happen if any inaccuracies occur, it’s extremely important to have a lawyer help craft the deal at an early stage. A simple mistake made here can actually have larger ramifications on if the deal goes through, or whether a seller can get paid if it doesn’t.

Representation and Warranties Insurance

Insurance to protect both parties of an M&A transaction has become fairly common, although it is more often requested by the seller as protection from post-closing indemnity claims. Because the policies pay out claims that arise from breaches in the representations and warranties, those covered by insurance tend to be less concerned about deal friction and closing issues. 

The insurance issuer is involved in due diligence and negotiation of the representations and warranties. Every policy has different exclusions and conditions under which the policy will not cover indemnification claims. Exclusions are determined based on the insurance company’s due diligence review, and usually include issues the parties knew of prior to closing and other extraordinary risk issues.

What Information is Included in Representations and Warranties?

In general, the seller and target of the M&A will include the following information in this section of the purchase agreement. 

Financial Information

Financial Statements

This ensures that financial statements delivered to the purchaser:

• Are true and complete.
• Were prepared from the financial records of the target.
• Were prepared with sound accounting principles.
• Reflect actual transactions and have been maintained in accordance with sound business practices.

No Liabilities

This states that there is no debt or liabilities other than:

• Those disclosed in or reserved against in the aforementioned financial statements.
• Those incurred in the ordinary course of business since a particular date.

Tax Matters

This clarifies all information about taxes, stating that:

• The target has filed all required tax returns. 
• All tax returns are true, complete and correct in all material respects.
• All taxes have been paid in full and there are no liens or contests.

Ownership Issues

Authority

This states that the target and each seller party has:

• The full legal right and authority to execute the purchase agreement.
• Authorizations, consents and approvals required by law.

Corporate Power

This states that the target and each seller party has the power and authority to:

• Own, lease, operate and use its assets and properties. 
• Perform all its obligations under its contracts.

Ownership of Target Company; No Subsidiaries

This states that the seller owns the issued equity interests of the target and that:

• They are free and clear of all liens, encumbrances and rights of third parties. 
• There are no subsidiaries of the target. 
• All issued equity securities of the target were issued in compliance with federal and state laws.

Title and Sufficiency of Purchased Assets

This states that each seller party owns the goods sold, and that:

• At closing, the seller will transfer and deliver to the buyer all purchased assets.
• All goods and assets will be free and clear of liens and rights of third parties.
• Purchased assets constitute all of the material assets, properties and rights necessary. 
• The tangible personal property is in good operating condition and repair, except for with the exception of normal wear and tear. 
• All items of tangible personal property are located at the target’s premises.

Laws

Legal and Authorized Transactions

The purchase agreement constitutes the legal, valid and binding obligation of the target and each seller party. 

Compliance with Laws 

There are no violations by the target of any law relating to the target, its equity, assets or the transaction.

Licenses and Permits

The target has all required licenses and permits.

Litigation

There are no claims, lawsuits, investigations or judgments relating to the target.

Organization

The target and each seller party is in good standing under the laws of its jurisdiction of organization. 

Full Disclosure 

This explains that the purchase agreement does not contain any untrue statement or omit any information that would make the statements false or misleading.

Contracts

This states that except what is included in the disclosure schedule, the target is not bound by any contract or other agreement. The contracts set forth on the applicable disclosure schedule:

• Are a legal, valid and binding obligation of the target and the other parties.
• In full force and effect in accordance with its terms.
• May be assigned to the purchaser and will continue after closing.

Other Information

The representations and warranties section may also include information regarding:

• Product Warranties to Customers.
• Customer Credits.
• Intellectual Property and Confidential Information.
• Employee and Labor Matters.
• Environmental, Health and Safety Matters.
• Inventory.
• Real Estate.
• Insurance Matters.

A Knowledgeable M&A Attorney Should Be Involved in All Parts of a Purchase Agreement

Regardless of why you are buying or selling a business, it is best to have an M&A lawyer at the earliest stages of the deal. They should be the ones obtaining a valuation and crafting the agreement, along with ensuring the representations and warranties are complete and accurate. Instead of waiting until a deal is on the table and contracts are already drafted, contact  Swiecicki & Muskett, LLC to help you navigate your merger or acquisition.

Cover Image by tomazl by Getty Images Signature by Canva.com