Estate Tax Surprises: How Connelly Changed the Game for Business Succession Planning

Imagine thinking your business succession plan was airtight—only to have the IRS slip through the cracks and inflate your estate tax bill overnight. That’s exactly what happened in Connelly v. United States (2024), and if your business has a buy-sell agreement funded with life insurance, you could be next. What was once a tax-efficient, foolproof strategy now has a nasty little surprise lurking in the fine print—one that could leave your heirs with a massive estate tax bill they never saw coming.

Let’s get into it, because ignoring this case isn’t an option.

How Estate Tax Planning Used to Work—And Why Connelly Shook It Up

For years, closely held businesses have used buy-sell agreements funded with life insurance to ensure a smooth transition when an owner dies. The idea was simple:

1. The company (or the remaining partners) buys a life insurance policy on each owner.

2. When one owner dies, the insurance payout funds the purchase of their shares.

3. The business or surviving partners buy out the deceased owner’s estate at a pre-agreed price, avoiding liquidity issues.

Neat. Clean. Predictable.

But then Connelly happened. And the IRS? Oh, they’re loving it.

The Supreme Court ruled that if a company owns the life insurance, those proceeds must be counted as part of the business’s fair market value when determining estate taxes. The IRS argues that since the business receives the insurance proceeds, it effectively increases the company’s worth—just like any other liquid asset would. In other words, what used to be a neutral transaction suddenly became a tax time bomb. The insurance money that was supposed to fund the buyout? Now it’s inflating the taxable estate value, meaning your heirs could owe estate taxes on money they never even see.

The Hidden Tax Trap No One Saw Coming

Here’s where it gets ugly. Let’s say your business is worth $5 million. You and your partner take out $3 million life insurance policies on each other, assuming that’s enough to cover a buyout if one of you passes. Under the old rules, the estate would only pay taxes based on the agreed-upon buyout price—nice and simple.

Now? The IRS steps in and says, “Actually, that $3 million payout is part of the business’s value.” So instead of a $5 million valuation, your heirs are staring down an $8 million taxable estate. If the estate tax exemption shrinks as expected in 2026, the bill on that extra $3 million could be devastating.

And here’s the kicker—your heirs don’t even get the insurance money. It goes straight to the business for the buyout, but they’re still stuck paying taxes on the inflated valuation.

So, What’s the Fix?

You don’t have to scrap your succession plan—you just have to be smarter about how it’s structured.

1. Ditch the Entity-Purchase Agreement – If the business owns the life insurance, it’s time to reconsider. Those policies are now a tax liability waiting to happen.

2. Move to a Cross-Purchase Agreement – Instead of the company owning the policies, each owner should personally own a policy on the others. This keeps the insurance payout out of the company’s valuation and away from the IRS’s grasp.

3. Explore Life Insurance LLCs – A Life Insurance LLC holds the policies outside of the business entity, so the proceeds never touch the company’s balance sheet. This structure ensures tax efficiency without the logistical nightmare of multiple owners holding policies on each other.

4. Reevaluate Your Business Valuation Strategy – If your buy-sell agreement still assumes an outdated valuation method, now is the time for a reality check. The IRS is watching.

Act Now—Before the IRS Gets Even Bolder

If you’re thinking, “This sounds like a problem for future me,” let me stop you right there. The federal estate tax exemption is set to drop in 2026, meaning more businesses will get caught in the estate tax net. If you wait too long to adjust your succession plan, you could be handing the IRS a bigger chunk of your legacy than you ever intended.

Final Thoughts

The Connelly ruling changed the game for business succession planning, and ignoring it isn’t an option. What worked yesterday could create an estate tax nightmare tomorrow. The good news? With the right adjustments, you can still protect your business, your heirs, and your financial legacy. But you have to act now.

If you haven’t reviewed your buy-sell agreement in the last year, now is the time. Talk to your financial advisor, update your strategy, and make sure you’re not handing the IRS more than they deserve. The future of your business depends on it. Because when it comes to estate taxes, the biggest surprises are never the good kind.