How Corporate-Owned Life Insurance Can Inflate Estate Tax Liabilities
For years, business owners have been sold on corporate-owned life insurance (COLI) as the perfect tool for succession planning. It’s supposed to be simple: the business buys a policy on each owner, pays the premiums, and when one of them dies, the payout funds the buyout of their shares. No liquidity crunch, no disputes, just a seamless transition. Sounds great, right? Well, thanks to Connelly v. United States (2024), this strategy could now create a massive estate tax headache that no one saw coming.
And let’s be honest—nothing wrecks a well-laid business succession plan faster than a surprise estate tax bill.
The IRS’s New Take on Corporate-Owned Life Insurance
Here’s the problem: If your company owns the life insurance policy, the IRS is now treating those proceeds as a corporate asset when valuing the business for estate tax purposes. That means your estate could be taxed on an inflated business valuation that includes money your heirs will never actually see.
Let’s put this into perspective. Suppose your business is valued at $5 million, and it owns a $3 million life insurance policy on you. In the past, your estate would only owe taxes based on your ownership share of that $5 million valuation. But now? The IRS argues that the company’s total fair market value includes the $3 million insurance payout, making your business worth $8 million on paper. Your estate tax liability just went up—on money that was never meant to be part of your taxable estate.
It’s the tax equivalent of a magician making your wealth disappear… but only after the IRS gets its cut.
Why This Catches Business Owners Off Guard
Most business owners assume that because life insurance is there to fund a buyout, it won’t impact estate taxes. That was true—until Connelly. Now, those corporate-owned policies don’t just provide liquidity; they inflate the taxable value of the business. And because the company owns the policy, not the individual owners, the proceeds never pass directly to the deceased owner’s estate. Instead, the estate’s tax bill goes up based on money it never sees.
So not only does your estate get taxed on this phantom value, but your heirs don’t even get the benefit of the insurance payout. The business gets the money. The IRS gets its cut. And your heirs? They get the bill.
How to Avoid the Estate Tax Trap
So, what’s the fix? It comes down to structure. If you’re still relying on an entity-purchase (stock redemption) buy-sell agreement, it’s time to rethink your approach. Here’s how you can sidestep the Connelly estate tax trap:
Switch to a Cross-Purchase Agreement – Instead of the company owning the insurance, each owner personally owns policies on the others. This keeps the payout out of the company’s valuation and prevents estate tax inflation.
Consider a Life Insurance LLC – A life insurance LLC can own policies on behalf of business partners, keeping the proceeds outside of both the company’s valuation and the individual owner’s taxable estate.
Reevaluate Business Valuation Methods – Work with your advisors to ensure your valuation strategy accounts for the new IRS stance on COLI. Proper planning can mitigate surprises when it’s time to settle an estate.
Review Your Buy-Sell Agreement ASAP – If your agreement was drafted before Connelly, there’s a strong chance it wasn’t designed to handle this new tax reality. Update it now before it’s too late.
Final Thoughts: It’s Time to Adapt
Connelly has changed the rules, and business owners who ignore it do so at their own peril. Corporate-owned life insurance was once a go-to strategy for ensuring business continuity, but now it comes with unintended tax consequences that could leave heirs struggling with a bigger estate tax burden than expected.
The good news? This problem is fixable—if you act now. Review your agreements, reconsider how your life insurance is structured, and make sure your business transition plan doesn’t hand the IRS more than it should. Because the only thing worse than paying estate taxes is paying them on money you never actually received.
