Navigating New Challenges in Closely Held-Business Succession Planning

Written by David J. Neuman, JD Tax & Legal Manager

The recent developments in business succession planning have introduced new challenges that business owners must carefully navigate. Traditionally, many closely held businesses have relied on life insurance policies on their owners as a key component of their succession strategy. These policies were designed to ensure a smooth transfer of ownership and provide the necessary funds to buy out a deceased owner’s shares without putting additional financial strain on the company. However, owners of closely held businesses may need to reassess their business succession plan after the U.S. Supreme Court ruling in Connelly v. United States. More specifically, companies whose business succession planning includes the use of life insurance policies to fund a buy-sell agreement may have to go back to the drawing board to address potential tax implications that business owners need to be aware of.

The Importance of Revisiting Succession Plans

For closely held business owners, the unexpected changes in succession planning regulations highlight the need for regular review and updating of buy-sell agreements. These agreements are crucial as they define how ownership will be transferred in the event of an owner’s death, retirement, or departure from the business. Regular evaluations ensure that the agreements are aligned with the current legal landscape and accurately reflect the business’s value.

Failing to keep buy-sell agreements current can lead to significant financial consequences, especially when it comes to tax liabilities. As laws and regulations evolve, what once seemed like a sound strategy, may no longer provide the expected benefits. Business owners must ensure their succession plans are both legally compliant and financially sound, protecting the business and its stakeholders from unexpected burdens.

Understanding the Tax Implications

One of the key areas impacted by these changes is the tax treatment of life insurance proceeds used to fund stock redemptions. While the intent behind using life insurance in succession planning is to offer a tax-efficient solution for buying out a deceased owner’s shares, recent interpretations have shown that these proceeds may not always be exempt from taxation as previously assumed.

The estate-tax exemption is a critical factor in this context. Currently, it is set at $13.6 million per individual, but may decrease when existing tax laws expire at the end of 2025. For many closely held businesses, this change could mean that life insurance proceeds added to the company’s value might push the estate’s total value above the exemption threshold, resulting in an unexpected tax bill.

To avoid these potential pitfalls, business owners should consider alternative succession strategies. For example, using cross-purchase agreements, where each owner purchases life insurance on the others, can help prevent the life insurance proceeds from increasing the company’s taxable value. This approach can also offer tax advantages, such as a higher cost basis for surviving owners, which could reduce future capital gains taxes.

Proactive Planning is Essential

Given the complexities of these new tax implications and the evolving legal landscape, it is more important than ever for business owners to engage in proactive planning. This involves not only revisiting buy-sell agreements and life insurance policies but also consulting with professionals who can provide expert guidance tailored to the business’s unique situation.

At LMC, we understand the importance of protecting your business and providing sound tax guidance. Our team is dedicated to helping you navigate these changes by providing strategic advice and developing customized plans that minimize tax liabilities and support your long-term business goals. By working with your LMC professional, you can rest assured that your succession plan is robust, legally compliant, and financially advantageous, securing the future of your business for the next generation.

LMC is dedicated to staying updated on these developments and advising clients effectively. For more information or questions, please reach out to your LMC professional.