The Connelly Trap: How a Unanimous Supreme Court Decision Broke Decades of Buy-Sell Agreements—and What Co-Owners Must Do Now

Two brothers in Missouri owned a building supply company. They did everything by the book: they signed a written buy-sell agreement, the company bought $3.5 million of life insurance on each of them, and they had a clear succession plan in place. When the older brother died, the company used the insurance proceeds to redeem his shares for the agreed price.

Then the IRS audited the estate—and the United States Supreme Court handed down a unanimous decision that punched an extra $889,914 hole in the family's estate tax bill.

That case is Connelly v. United States, decided June 6, 2024. Nearly two years on, most closely held businesses still have not fixed their succession plans. If you co-own a business with one or more partners and your buy-sell agreement is funded by company-owned life insurance, there is a meaningful chance your plan now does the opposite of what you intended. This guide explains what happened, why it matters, and what to do about it.

What a Buy-Sell Agreement Is—And Why Almost Every Co-Owned Business Needs One

A buy-sell agreement is a contract among the owners of a closely held business that controls what happens to an owner's interest when a "triggering event" occurs—typically death, but also disability, retirement, divorce, or voluntary departure. Without one, when a co-owner dies, the heirs inherit voting shares. The surviving owners can suddenly find themselves in business with a former spouse, an adult child with no industry experience, or a probate court.

A well-drafted buy-sell agreement does three things:

1. Restricts transfer. Heirs cannot sell shares to outsiders or refuse to sell back.
2. Sets a price or formula. Everyone knows in advance what a departing interest is worth.
3. Identifies a funding mechanism. Usually life insurance, sometimes installment notes or sinking funds.

For decades, the simplest and most common structure has been the redemption agreement funded with company-owned life insurance. The company is the policy owner, beneficiary, and premium payer. When an owner dies, the proceeds flow into the company, and the company uses the cash to buy back the deceased owner's shares from the estate. Clean, centralized, simple to administer.

That is exactly the structure the Connelly brothers used. And that is exactly the structure the Supreme Court just told us is dangerous.

The Connelly Facts in Plain English

Michael and Thomas Connelly were the only two shareholders of Crown C Supply, a building materials business. They wanted to keep the company in the family if either died. So they signed an agreement: when one brother died, the survivor had the option to buy the deceased's shares; if he declined, Crown itself was required to redeem them.

To make sure Crown could pay, the company purchased $3.5 million of life insurance on each brother. Crown owned the policies, paid the premiums, and would receive the death benefit.

Michael died in 2013. Thomas declined to buy the shares personally, so Crown's redemption obligation kicked in. Michael's son and Thomas agreed Michael's stake was worth $3 million. Crown collected the $3.5 million death benefit and paid $3 million to the estate, keeping $500,000 as working capital. Michael's estate filed a Form 706 reporting his shares at $3 million.

The IRS audited and disagreed. The IRS argued that on the date of Michael's death, Crown owned an extra $3 million asset—the receivable from the life insurance company—and that asset had to be counted in the company's value. The redemption obligation, the IRS said, was not a true offsetting liability because once you redeem, you simply have fewer shares outstanding; the company itself is not poorer.

Under the IRS valuation, Crown was worth roughly $6.86 million. Michael's 77.18% stake was therefore worth about $5.3 million, not $3 million. The estate owed an extra $889,914 in federal estate tax.

The Connellys lost in district court, lost again at the Eighth Circuit, and on June 6, 2024, lost a third time at the Supreme Court—unanimously, in an opinion written by Justice Thomas.

The Logic of the Holding

The Court's reasoning is short and devastating. Imagine a company worth $10 million with 100 shares outstanding. One shareholder owns 50 shares, which are therefore worth $5 million. The company collects $5 million of life insurance and uses it to redeem those 50 shares.

Before redemption: company worth $15 million ($10M operating value + $5M cash from insurance), 100 shares outstanding, each share worth $150,000.

After redemption: company worth $10 million ($15M minus $5M paid out), 50 shares outstanding, each remaining share still worth $200,000.

The surviving owner's economic position is unchanged or improved. Therefore, the Court held, the redemption obligation does not offset the value of the insurance proceeds for estate tax purposes. A willing buyer of the deceased shareholder's interest, on the date of death, would have factored in the $5 million asset—because the company really did have it. The contractual obligation to spend that money on a redemption is not the kind of liability that reduces fair market value.

The result: company-owned life insurance in a redemption structure inflates the deceased owner's estate, generating estate tax on phantom value the family never receives.

Why This Quietly Punishes Surviving Owners Too

The pain in Connelly fell on the deceased owner's estate. But the surviving owner takes a quieter hit that often goes unnoticed.

In a redemption, when the company buys back shares, surviving shareholders do not receive a step-up in basis. Their original cost basis in their own stock stays the same, even though their percentage ownership has increased. If the surviving owner later sells, the entire post-redemption appreciation is taxed as capital gain on top of the original embedded gain.

A cross-purchase, by contrast, gives the survivor a new basis equal to what they paid for the deceased's shares. That can mean six or seven figures of avoided capital gains tax on a future sale. Connelly is therefore a double penalty for redemption agreements: more estate tax now, more capital gains tax later.

The Five Workable Alternatives

For closely held businesses with meaningful insurance funding, there are five primary paths forward.

1. Convert to a Cross-Purchase Agreement

In a cross-purchase, the owners buy life insurance on one another personally. When one dies, the survivors collect the proceeds personally and use them to buy the deceased's shares directly from the estate.

Advantages:

• Death benefit never enters the company's balance sheet, so it does not inflate the deceased's stake under Connelly.
• Surviving owners receive a stepped-up basis in the acquired shares.
• Generally cleaner from an estate tax standpoint.

Disadvantages:

• The number of policies grows quickly: with n owners you need n × (n − 1) policies. Three owners means six policies; four owners means twelve.
• Premiums can be uneven if owners are different ages or in different health categories.
• Coordinating premium payments and ownership across individuals is administratively heavier.

For two-owner businesses, this is usually the right answer. For more than three or four owners, the policy proliferation problem makes a different solution more practical.

2. The Special-Purpose Insurance LLC

A growing approach is to form a separate manager-managed LLC—often called an insurance LLC or a "buy-sell LLC"—that owns one policy on each business owner. The owners contribute premium payments to the LLC. When an owner dies, the LLC collects the death benefit and distributes the cash to the surviving members, who then use it to fund a cross-purchase under a stand-alone buy-sell agreement.

This structure delivers several benefits at once:

• Only n policies needed instead of n × (n − 1).
• Death benefits stay outside the operating company, sidestepping Connelly.
• Centralized administration through the LLC manager.
• Creditor protection for the policies.
• Step-up in basis for surviving owners on the acquired interests.

There is a wrinkle worth knowing: the federal "transfer-for-value" rule generally taxes life insurance proceeds as ordinary income when a policy has been transferred for consideration. There is, however, a safe harbor for transfers to a partnership in which the insured is a partner—and an LLC taxed as a partnership qualifies. That is the structural reason planners prefer LLCs over corporations for this purpose.

The IRS has signaled in recent guidance that it will no longer issue private letter rulings on whether a buy-sell insurance LLC qualifies as a true partnership for transfer-for-value purposes. That uncertainty is real, but the underlying tax law has not changed; sophisticated draftspeople can still build a structure that meets the safe harbor, particularly if the LLC has genuine business substance beyond holding insurance.

3. Irrevocable Life Insurance Trust (ILIT) Cross-Purchase

For larger estates already approaching the federal exemption, an Irrevocable Life Insurance Trust can hold the policies. When an owner dies, the trust receives the proceeds outside both the deceased's estate and the operating company's balance sheet. The trustee uses the cash to acquire the deceased's shares for the surviving owners' benefit.

This is the most aggressive estate-planning structure, but it requires careful drafting to avoid incidents of ownership, gift-tax Crummey notices for premium contributions, and the three-year rule on policies transferred into the trust within 36 months of death.

4. Hybrid or "Wait-and-See" Agreements

A hybrid agreement preserves optionality. The surviving owners get the first option to buy personally; if they decline, the company has a second option; if both decline, the agreement falls back on a redemption. Insurance can be split between the company and individuals, or held in an insurance LLC.

The benefit: flexibility to choose the most tax-efficient path at the moment of death, when actual numbers are known. The cost: drafting complexity and the need to retest the structure under Connelly each time a triggering event approaches.

5. Stay With Redemption, but Plan Around the Math

For some businesses—particularly those with values well below the federal estate tax exemption ($15 million per person under OBBBA-extended provisions, doubled for married couples)—a redemption agreement may still be acceptable. Estate tax inflation under Connelly is irrelevant if the estate is not taxable.

If you take this route, two safeguards matter:

• Update the buy-sell agreement to make clear how valuation is computed for non-tax purposes.
• Periodically check that the company's value plus insurance proceeds will not push beneficiaries over the exemption threshold, especially as exemptions could change in future legislation.

What to Do This Quarter If You Are a Co-Owner

The biggest mistake right now is inertia. A 2024 ruling from the highest court in the land has rewritten the math on agreements drafted as recently as last year, and most owners have not yet reviewed their documents. Here is a practical sequence.

1. Pull the agreement. Find your shareholders' agreement, partnership agreement, or operating agreement. Locate the buy-sell provisions.

2. Identify the structure. Is it redemption, cross-purchase, or hybrid? Who owns the life insurance policies? Who pays the premiums? Who is the named beneficiary?

3. Estimate the company's value with and without insurance proceeds. A back-of-envelope calculation will tell you whether Connelly inflates an owner's estate above the federal or state exemption thresholds.

4. Get an updated valuation. Even informal valuations can reveal whether your buy-sell pricing formula is still defensible. Connelly emphasized that fair market value, not the contract price, controls for estate tax.

5. Talk to your attorney, CPA, and insurance professional together. A typical post-Connelly redesign requires coordinated changes across legal documents, tax planning, and policy ownership. Doing it piecemeal often introduces inconsistencies.

6. Document everything. If you change policy ownership, transfer policies between entities, or set up a new insurance LLC, the paper trail matters. Section 101(j) of the Internal Revenue Code requires written notice and consent before any employer-owned life insurance contract is issued; failure to comply can convert death benefits into ordinary taxable income to the company. Watch for deadlines on transfers.

A Word on Bookkeeping and Why It Matters Here

Buy-sell planning lives or dies on whether the underlying numbers are clean. Connelly turned in part on a documented, agreed-upon valuation between the family and the surviving brother—a number the IRS later rejected because it did not reflect fair market value. Every closely held business needs a financial reporting trail that supports its valuation in case of audit: clean balance sheets, consistent revenue recognition, properly classified policy premiums, and tracked basis in each owner's interest.

That is especially true for partnerships and LLCs, where capital accounts and inside/outside basis directly affect the tax outcome of any redemption or cross-purchase. Sloppy books make every other piece of the plan harder.

Common Mistakes That Make a Bad Situation Worse

• Forgetting to update beneficiary designations when restructuring policies, leaving the operating company as beneficiary of a policy that should now be paid to an insurance LLC or trust.
• Triggering the transfer-for-value rule by transferring an existing company-owned policy directly to another shareholder for cash, instead of using a partnership-safe-harbor entity as the intermediary.
• Failing to comply with Section 101(j) by missing the written notice and consent requirements before issuing or replacing employer-owned policies.
• Letting the buy-sell formula drift from market reality. A formula written in 2010 with a fixed multiple of book value will rarely match fair market value in 2026, and the IRS will not be bound by it.
• Treating the buy-sell as a one-time legal task. Like a will, it needs review every two to three years, and immediately after any major transaction, retirement, marriage, divorce, or death.

The Bottom Line

Connelly v. United States did not invent a new rule so much as expose what the existing rule always meant: a corporation that owns a life insurance policy on a shareholder owns a real, valuable asset—and that asset counts when valuing the corporation for estate tax purposes. The decision was unanimous because, on the math, it is simply correct. Decades of business succession planning rested on a different assumption that the Court rejected.

For most co-owned businesses near or above the estate tax thresholds, the practical answer is to migrate away from straight redemption agreements toward cross-purchase structures, often through an insurance LLC or trust. The work is not glamorous, but it can save heirs hundreds of thousands of dollars and prevent the very disputes the buy-sell was designed to avoid.

Keep Your Books Audit-Ready From Day One

Every Connelly-style dispute eventually comes down to whether the numbers can be defended. Clean valuations, well-documented capital accounts, and a transparent record of premium payments and policy ownership are what stand up under examination. Beancount.io gives you plain-text accounting with full version control—every journal entry, every balance, every change is auditable, and there is no black-box software between you and your data. For closely held businesses planning succession, that transparency is exactly what your attorney and CPA will thank you for. Get started for free and see why developers, finance professionals, and family-business owners are choosing plain-text accounting.