Stockholders’ Agreements: Plan Ahead for Owner Exits, Part II
May 01, 2025
Owners of small and mid-sized businesses can spend nearly all of their time running their business, and many times, they do not make time to consider the life changing events that should be addressed in their stockholders’ agreement. After the initial basics of forming a corporation, stockholders’ agreements – also known as buy-sell agreements – are a critical step to protect the stockholders of a corporation regarding potential transactions involving their shares in their corporation. We discussed these issues in our article of several years ago. https://www.peroslaw.com/news/business-lawyer-stockholders-agreements-owner-exits-md-dc/
A new twist has been added by the decision in the recent 2004 U.S. Supreme Court case, Connelly v. United States, regarding life insurance in stock redemptions of closely held corporations. This article summarizes the case and possible changes to be made to one’s stockholders’ agreement.
For years, lawyers have drafted buy-sell agreements and included terms and conditions for purchase of stock by third parties. They also include terms and conditions for the purchase of stock by another stockholder via a cross-purchase, and if that does not occur, then for the purchase of the stock by redemption by the company. Many times, these terms and conditions also include a requirement to fund the purchase by another stockholder or the redemption of the stock by the corporation via a life insurance policy.
In Connelly v. United States, two brothers were shareholders in a building supply company – a closely held corporation. They had a stockholders’ agreement which provided that if one died, the other could buy out the stock of the decedent via cross-purchase, and if the remaining brother did not buy the stock, then the company would have to buy the stock via redemption. In either case, the purchase price would be at fair market value. The company purchased life insurance on each stockholder’s life to fund the obligation. One brother died and the other brother did not buy the stock, leaving the company to redeem the stock.
The company purchased the stock using $3 million from the life insurance proceeds. The company was valued at about $4 million and the redeemed stock represented about 80 percent of total stock.
The U.S. Supreme Court tackled a fundamental question. The underlying tax code was not changed. However, the U.S. Supreme Court ruled that the insurance proceeds were assets of the company at the time of death and must be included in the company’s fair market value. When determining the value of corporate stock, the value of a corporate-owned life insurance policy on the decedent’s life is not offset by the corporation’s obligation to redeem the stock. The company was then valued at about $7 million.
The U.S. Supreme Court explained that a fair market value redemption would necessarily reduce a corporation’s total value. And, because there are fewer outstanding shares of stock after the redemption, the remaining stockholders are left with a larger proportional ownership interest in the less valuable corporation. The U.S. Supreme Court further discussed that it would turn this ordinary process upside down to treat the redemption as something that left the surviving stockholder with a larger ownership stake in a company with the same value as before the redemption.
To address these challenges, companies and their advisors should evaluate changes to structuring buy-sell agreements. The company would not participate in a stock redemption. An approach would be to use only the cross-purchase provision so that the other stockholders would buy the stock of the deceased stockholder via life insurance policies held by the other stockholders. This works best when there is a limited number of stockholders in the company. This approach bypasses the company, keeping the insurance proceeds out of the corporate valuation.
Clearly defining the purchase price in the buy-sell agreement may help reduce valuation disputes among stockholders. However, the Internal Revenue Service is not obligated to accept the contractually defined price if it does not reflect fair market value.
The company should consider having regular valuations prepared. Companies can use the periodic valuations to evaluate whether their existing insurance policies provide sufficient coverage to meet obligations without inflating the company’s valuation excessively.
In conclusion, the ruling in Connelly v. United States focuses the valuation landscape for companies, especially those that rely on life insurance to fund buy-sell agreements. Modifications to the company’s stockholders’ agreement should be considered.
1 Vasilios Peros is founder and principal of Law Office of Vasilios Peros, P.C. His practice is focused primarily on business, technology and intellectual property law. He has been recognized as one of Greater Baltimore’s top attorneys, including SmartCEO’s 2016 Centers of Influence, 2015 CPA + ESQs, 2014 Power Players, and Legal Elite in 2011, 2010 and 2009. He can be reached at (410) 274-2053 and VPeros@PerosLaw.com.
2 This article is provided for informational purposes only and should not be construed as a legal opinion or legal advice. The reader should not rely on this article in making business, legal or other decisions on any matter without first consulting an attorney regarding any such decision or undertaking.