Abstract

On June 6, 2024, Justice Thomas authored the opinion for a unanimous Supreme Court (the “Court”) decision in Connelly v. United States. The Court held that life insurance proceeds paid on the death of a shareholder and received by a corporation must be included in the corporation’s federal estate tax value, and a corporation’s obligation to redeem a deceased owner’s shares did not constitute a liability that would reduce this value.

Clients affected – Not to be included in the internal version

Companies, including C corporations, S corporations, partnerships and their equity owners that have engaged in (or are considering engaging in) planning to use life insurance proceeds to redeem a decedent’s equity.

Applicability dates – Not to be included in the internal version

The case was decided on June 6, 2024. Clients who have engaged in “Buy-Sell Agreement” planning similar to the approach in Connelly can no longer rely on Estate of Blount v. Commissioner (an 11th Circuit decision from 2005) for the proposition that life insurance proceeds included in a company's assets at the time of valuation are allowed to be offset by a redemption obligation, effectively excluding them from the company's value.

Overview

By way of background, Michael and Thomas Connelly were the only shareholders of Crown C Supply (“Crown”), a building supply corporation based in St. Louis, Missouri. Michael owned 77.18% of Crown’s outstanding shares; Thomas owned the balance, 22.82% of the shares. The two brothers had developed an agreement to ensure that Crown would remain in the family at such time as either of them died. More specifically, the agreement stipulated that Crown would redeem a deceased owner’s shares if the surviving owner did not exercise his option to purchase such shares. In connection with this agreement, Crown procured $3.5 million of life insurance on each of the owners to fund any potential redemption.

Michael died in 2013 and Thomas did not exercise his option to purchase Michael’s shares. Crown, pursuant to its contractual obligation, used a portion of the life insurance proceeds to redeem such shares at an agreed value of $3 million. Thomas, as executor of Michael’s estate, filed a federal estate tax return which valued Michael’s shares at $3 million (pursuant to the agreed value). During an audit of the federal estate tax return, Thomas retained an accounting firm that valued Crown at $3.86 million and excluded the $3 million in insurance proceeds used to redeem the applicable shares. The IRS argued that the life insurance proceeds were includable for purposes of valuing Michael’s ownership in Crown and maintained that the corresponding redemption obligation did not offset the increase in value. Consistent with this approach, the IRS concluded Crown’s value was $6.86 million, Michael’s ownership interest value was $5.3 million ($6.86 million x 77.18%), and that the estate owed $889,914 in additional tax due

to the applicable increase in value. Thomas, acting as executor, paid the deficiency and then filed suit for a refund, arguing that the life insurance proceeds used in connection with the redemption should not be included for purposes of valuing the corporation. Both the District Court and the Eighth Circuit Court of Appeals ruled against Thomas and rejected his claim for a refund.

Section 2703 of the Internal Revenue Code requires that buy-sell agreements meet specific criteria to set the estate tax value of a closely held business interest. To the extent that an agreement does not meet all the requirements, as the lower courts found in Connelly, value will be determined without reference to the agreement. The value of a decedent’s property at death should reflect its fair market value, which is the price at which the property would change hands between a willing buyer and willing seller.

In the context of valuing a corporation, the Court noted that one must consider many factors, including accounting for assets received by the corporation, such as life insurance proceeds, which become a corporate asset that increases its fair market value. Consistent with this reasoning, the Court found that the estate tax value of the shares at Michael’s death should be determined by looking at this specific moment in time, prior to any redemption. The central issue in question was whether the life insurance proceeds used to redeem Michael’s shares should be considered as a net asset of Crown or if the corresponding redemption obligation offset this value.

In affirming the Eighth Circuit Court of Appeals decision, the Court concluded that Crown’s obligation to redeem Michael’s shares at fair market value did not reduce the value of those shares for estate tax purposes – the redemption merely exchanged one form of asset for another, leaving the overall economic interest unchanged – and stated, “… no willing buyer purchasing Michael’s shares would have treated Crown’s obligation to redeem Michael’s shares at fair market value as a factor that reduced the value of those shares.” To illustrate this point, and from a hypothetical buyer’s perspective, purchasing Michael’s shares would mean receiving 77.18% in a corporation valued at $6.86 million, with the understanding that such shares would be redeemed at fair market value. This hypothetical buyer would therefore be willing to pay up to $5.3 million for Michael’s shares, which is the value the buyer would expect to receive in connection with the corporate redemption at fair market value.

Observations

This victory for the government will undoubtedly create issues for business owners who rely on life insurance proceeds as a funding mechanism to satisfy redemption obligations in connection with business succession plans. Where life insurance proceeds increase the value of a corporation, it may force many business owners to rethink how they will fund a potential redemption (e.g., using a sinking fund or promissory note). Conversely, some individuals may decide to overhaul their provisions and consider alternative structures, including, for example, a traditional cross-purchase agreement. At the very least, business owners with buy-sell agreements in place should consider meeting with their advisors to review their current valuation and funding provisions and ensure that their business documents will meet their intended planning objectives.

How Citrin Cooperman can help

For more information, please contact Dan Carlson, Catherine Taylor, Mary Delman, or another member of Citrin Cooperman’s Trust and Estates Practice.