Small businesses are very different from other assets, because small businesses may have significant financial value that is not readily saleable or “liquid.”
Small businesses’ lack of liquidity becomes problematic when an owner of a small business dies leaving other owners with an inability to buy out the deceased owner’s family without selling the business itself.
To overcome this, small businesses often buy life insurance so the death benefit can be used to buy out a deceased owner’s family upon that owner’s death. The life insurance policy is usually purchased contemporaneously with all stakeholders’ agreement that the small business must use the death benefits to buy out the deceased owner’s family (called a redemption agreement). In principle, this idea works brilliantly.
However, the IRS has recently, successfully made part of these life insurance death benefits subject to estate taxation, as explained below.
Importantly, no one in Ohio pays an estate tax unless the total of that person’s gifts during life and inheritances upon/after-death exceed $12.92 million, technically called the “gift and estate tax exemption amount.”
However, that lifetime and post-lifetime exemption amount will decrease to about $6.2 million in 2026.
It can be hard for many people to fathom dying after 2025 with over $6.2 million in assets. But the pace of inflation coupled with exponential increases in real estate values makes it reasonable to conclude that many more Ohio farmers and small business owners may face estate tax beginning in 2026.
The question is whether life insurance benefits that a small business pays to a deceased business owner’s family counts toward that exemption amount.
According to earlier opinions from two federal appeals courts, life insurance benefits received by a small business that corresponded with an immediate redemption obligation to the deceased owner’s family was not considered an asset of the small business.
However, in June 2023, a different court of appeals ruled that $3.5 million of life insurance paid to a small business (that had a redemption agreement in place to pay the benefits to the deceased owner’s heirs) simply added $3.5 million to the value of the small business.
In that case, the deceased owner owned 71% of the business. So, the court ruling added 71% of the $3.5 million in life insurance proceeds ($2.485 million) to the total of the deceased owner’s estate.
A split in opinions by the federal courts of appeal who have made rulings increases the likelihood that the U.S. Supreme Court will hear the June 2023 case, which has been appealed.
In the meantime, it is safest tax-wise for all life insurance that will be used in the context of buying out deceased small business owners’ interests not be owned by and/or payable to the small business, even if the small business is paying the premiums. Of course, this will likely increase the need for more and more precise documentation (independent from the insurance policy itself) to try to “write around” this new, unfortunate June ruling, unless or until the Supreme Court addresses the issue.
Lee R. Schroeder is an Ohio licensed attorney at Schroeder Law LLC in Putnam County. He limits his practice to business, real estate, estate planning and agriculture issues in northwest Ohio. He can be reached at [email protected] or at 419-659-2058. This article is not intended to serve as legal advice, and specific advice should be sought from the licensed attorney of your choice based upon the specific facts and circumstances that you face.
