Insufficient Life Insurance to Fund the Buyout of a Deceased Business Owner

By Bryce W. Morrison

The death of one of the owners of a business has a significant impact on the business and the other owners. Owners typically establish a buy/sell agreement among themselves and the business. This agreement may require the business or the remaining owners to purchase the business interests of a deceased owner. To mitigate the financial impact on business operations and the remaining owners, the business often will purchase life insurance policies on the lives of each owner so that the business can use proceeds from these policies to fund the purchase of a deceased owner’s interests.

A recent United States Supreme Court has implications for calculating the necessary amount of life insurance. In the Connelly case, the Court ruled that the value of a business includes the proceeds from a business-owned life insurance policy when the business receives the proceeds from the policy. This ruling affects the amount of life insurance that a business needs to have in order to buy out the interests of a deceased owner.

For example, consider a business with three equal owners. The owners and the business have a buy/sell agreement stating that the business must buy the interest of a deceased owner at fair market value at the time of death. The business has a going concern value of $3 million and owns three $1 million life insurance policies, one for each owner. According to the Connelly decision, when one owner passes away, the business’s value will increase to $4 million because it will receive $1 million in life insurance proceeds, which must be added to the business’s $3 million value. Consequently, the $1 million in life insurance proceeds that the business receives will not be sufficient to purchase the deceased owner’s business interest, which is valued at $1,333,333.00 at the time of death (calculated as $4 million divided equally among three owners).

In light of the Connelly decision, every business should review the buy/sell agreements among its owners and the associated life insurance policies. If the business relies on life insurance to fund its obligations to purchase the business interests of a deceased owner, the amount of that life insurance may be insufficient because of the Connelly decision. Businesses and owners should also consider whether alternative buy/sell arrangements, such as requiring each surviving owner to purchase a proportionate share of a deceased owner’s interest, might be more suitable. Each business should consult with its professional tax advisors and life insurance providers to determine the most appropriate solution.