U.S. Supreme Court Holds: Life Insurance For Deceased Shareholder Shares Adds To Company Value For Estate Tax

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Owners of closely held businesses may need to reassess their business succession plan after the U.S. Supreme Court ruling in Connelly v. United States.
United States Corporate/Commercial Law
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Owners of closely held businesses may need to reassess their business succession plan after the U.S. Supreme Court ruling in Connelly v. United States. The Court in Connelly held that the valuation of stock in a closely held company in the estate of a deceased shareholder was required, for federal estate tax purposes, to include the value of life insurance obtained by the company on the life of the deceased shareholder, despite the company's obligation to use the life insurance to redeem the deceased shareholder's interest. Notably, the company obtained life insurance pursuant to a buy-sell agreement.

Michael and Thomas Connelly were brothers and shareholders of Crown C Supply Company (Crown). The Connelly brothers had entered into a buy-sell agreement with the company to ensure the business stayed in the family when they died. Upon the death of one of the shareholders, the other brother would have an option to purchase the deceased brother's shares. If the surviving brother declined to purchase the deceased brother's shares, Crown was required to purchase the shares. The share price would be determined either by a Certificate of Agreed Value executed annually by agreement of the parties or through two or more written appraisals. The agreement also authorized Crown to purchase life insurance on the lives of the shareholders, the proceeds of which could be used to effectuate the purchase transaction. Michael obtained $3.5 million of insurance on his life and assigned the policies or benefits to Crown, and Crown acquired policies on Thomas's life directly. Michael and Thomas did not appraise the business at the time they signed the buy-sell agreement and did not execute a Certificate of Agreed Value every year.

At the time of his death in 2013, Michael owned a majority interest in Crown. Thomas declined to purchase Michael's shares pursuant to the buy-sell agreement. Crown then used $3 million from the $3.5 million in life insurance proceeds from the policy on Michael's life to purchase the shares from Michael's estate. As executor of Michael's estate, Thomas filed an estate tax return reporting the value of Michael's Crown stock as $3 million, a valuation that was agreed upon by Thomas and Michael's son but was not supported by a qualified appraisal. The estate tax return was audited by the Internal Revenue Service (IRS). During the audit, Thomas submitted to the IRS a valuation report valuing Michael's shares in Crown at $3.86 million. This valuation included in the value of the company the $500,000 of the life insurance proceeds that were not used for the redemption of Michael's shares, but excluded the remaining $3 million that was used to purchase of stock from Michael's estate. The basis for this calculation was the holding in Estate of Blount v. Commissioner that insurance proceeds were properly deducted from the value of a corporation when they were "offset by an obligation to pay those proceeds to the estate in a stock buyout."1

The IRS determined that the entire $3.5 million of life insurance proceeds had to be included in the value of Crown, despite the fact that Crown was obligated to use $3 million of those proceeds to redeem Michael's interest. Therefore, the IRS determined that the value of the business as of Michael's date of death was $6.86 million, Michael's shares were worth $5 million, and the estate owed an additional $889,914 in estate tax.

Buy-sell agreements are often used to ensure that the shares of closely held businesses do not end up in the hands of outside investors in the event of the shareholder's death (or other occurrences such as a divorce). These agreements commonly include redemption agreements that require the company to redeem the outstanding shares of a deceased shareholder based on an agreed-upon price or method of valuation. In such cases, life insurance is often used to provide the necessary liquidity.

Buy-sell agreements, however, are generally disregarded for estate tax purposes and will only conclusively establish the value of the shares if they meet certain requirements. In this case, the circuit court found that the Connelly buy-sell agreement was a bona fide business arrangement, but did not conclusively establish the value of the shares because no professional valuation was done at the time of the execution, and the agreement did not set a fixed and determinable price for the shares.2

The Supreme Court's analysis of the buy-sell agreement in this case was limited to its review of whether the obligation to redeem the decedent's shares constituted a liability that reduced the value of Crown for estate tax purposes. The Supreme Court held that the obligation contained in the buy-sell agreement was not a liability that operated to decrease the net value of Crown by the amount of the life insurance used to purchase the shares. The Court's conclusion was largely based on the analysis that a corporation's contractual obligation to redeem shares at fair market value (where no life insurance is used) does not reduce the value of the shares. The Court concluded that a "willing buyer" for Michael's shares would expect to receive in the redemption the fair market value of those shares (taking into account the $3.5 million of life insurance proceeds).

Key Takeaways

The decision in Connelly creates uncertainty for closely held businesses that have entered into buy-sell agreements funded by life insurance owned by the company as part of their succession planning. In such instances, the remedy may be worse than the disease for companies hoping their careful planning would result in business continuity without risking cash flow. Redemption of shares with life insurance can become exponentially more expensive for closely held businesses whose shareholders have estates in excess of the estate tax exemption.

In light of the Connelly ruling, here are some practical tips for owners of closely held businesses:

1. Review existing buy-sell agreements

Shareholders of closely held businesses should review their existing agreements to determine whether they would meet the requirements for the share price to be controlling for estate tax purposes. This includes ensuring that the agreements contain an agreed-upon share price or a formula to arrive at the share price.

2. Compliance with valuation requirements

An appraisal of the business is recommended at the time of execution of the buy-sell agreement. In addition, if periodic valuations or certificates of agreed value are required, the company should establish procedures to ensure these requirements are met.

3. Consider using other arrangements

In a redemption agreement such as the one in the Connelly case, the company obtained and owned the insurance policies. Other ways to structure restrictive agreements and ownership of the life insurance policies may be more favorable, depending on the objective. It is important to keep in mind that each option has its own tax implications, which must be closely analyzed prior to implementation.

Cross-Purchase Agreement

In a cross-purchase agreement, each shareholder owns a life insurance policy on each of the other shareholders, the proceeds of which are used to purchase the deceased shareholder's interest from their estate.

Buy-Sell Using a Trust or Escrow Agent

Life insurance on each shareholder is held by a trust or paid to an escrow agent, rather than the shareholders themselves being required to maintain them. Upon the death of the shareholder, the trustee or escrow agent distributes the stock of the deceased shareholder to the remaining shareholders for the purchase of the deceased shareholder's interest. Alternatively, the trust could purchase the decedent's interest in the company and hold the interest for the benefit of the decedent's intended beneficiaries.

Special Purpose LLC

An LLC owned by the shareholders can be used to hold the life insurance policies. Upon the death of one of the shareholders, the LLC would receive the proceeds and distribute them to the remaining partners to purchase the decedent's shares.

Footnotes

1. Connelly reverses the prior ruling in Blount that life insurance proceeds were offset dollar-for-dollar by the company's obligation to satisfy the contract with the estate.

2. Connelly v. United States, Dep't of Treasury, IRS, 70 F.4th 412, 417 (8th Cir. 2023) (finding the agreement did not set a price or a formula to arrive at a price and that "the brothers and Crown ignored the agreement's pricing mechanisms").

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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