U.S. Supreme Court Rules For IRS In Key Succession Planning Case

McLane Middleton, Professional Association


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The U.S. Supreme Court ruled last week that life insurance policy proceeds payable to a company were properly included in valuing the company for federal estate tax purposes, despite that company's...
United States Family and Matrimonial
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Published: McLane.com
June 17, 2024

The U.S. Supreme Court ruled last week that life insurance policy proceeds payable to a company were properly included in valuing the company for federal estate tax purposes, despite that company's contractual obligation to redeem the shares of one of its deceased owners.

In a unanimous decision for the government written by Justice Thomas, the Court concluded that a hypothetical purchaser of shares of a family company would not necessarily consider a contractual redemption obligation to be a corporate liability. In upholding the "snap-shot" rule as the proper construct for valuing a company upon the death of a shareholder, the Supreme Court said that the redemption would take place after the shareholder's death and therefore was not a true corporate liability. The Court explained that the relevant statute required the government to "assess how much [the decedent's] shares were worth at the time he died." In a final footnote, the opinion limited the breadth of the ruling, stating that the Court was not holding that all redemptions would not be considered by a purchaser. Connelly, 602 U.S.____ (2024).

The opinion ignores some key issues raised by the parties and overlooks the reality that Section 2042, the statute governing the valuation of life insurance, creates multiple planning opportunities for avoiding the inclusion of life insurance proceeds on a federal estate tax return and providing cash to heirs. In fact, the decision is a clear example of a tax case where the form of the transaction had substance. Justice Thomas noted that if the two shareholders, Michael and Thomas, had entered into a cross-purchase agreement instead of an agreement backstopped by a corporate redemption, the life insurance proceeds would not have been properly included in the value of the family company.

Using the willing buyer-willing seller framework, the Court considered how a purchaser would evaluate the company and policy proceeds. Justice Thomas used an example to show that the value of the company did not change as a result of the redemption. That observation, he said, was hard to square with the fact that under the estate's analysis the surviving brother's shares were worth $7,720 per share based on the federal estate tax valuation and $33,800 per share post-redemption. Of course, that differential represented the reduction in the number of shares outstanding due to the redemption. But to the government, the allocation of corporate value under the brothers' buy-sell agreement was not binding on it and seemed testamentary in nature. In support of its analysis, the government argued it should be free to determine the true economics of the value of the company upon the majority shareholder's death. The "windfall" received by the surviving brother served to pull back the curtain on the estate settlement as lacking sound financial underpinning.

In Connelly, two brothers, Michael and Thomas owned respectively 77% and 23% of a business supply company. The brothers' failure to follow the dictates of the buy-sell agreement they signed was likely a contributing factor in the IRS' decision to audit Michael's estate tax return. Section 2703(b) provides a safe harbor for recognition of the share price established under a buy-sell agreement for estate tax purposes. To affect valuation under § 2703(b), an agreement must (1) be a bona fide business arrangement; (2) not be a device to transfer property to family members for less than full and adequate consideration; and (3) have terms comparable to similar arm's-length transactions. The estate argued that it had met the requirements of § 2703(b) but consistent with other case law in the last 30 years, each court determined that by not agreeing annually to a share value as required in the agreement and by not having the shares appraised when Michael died, the exception was inapplicable. In essence, the estate reported the value that Thomas had agreed to with Michael's son.

In reviewing the Court's opinion as well as the Eighth Circuit's decision, it is clear that the safe harbor of section 2703(b) is the solution to thorny valuation questions arising upon the death of a key shareholder. Here, it would have allowed the parties to agree to a value that more closely tracked the economics upon the death of the majority shareholder. Arguing 2703(b) after the fact does not work, as a long line of cases under the statute demonstrates.

The decision reverses Estate of Blount v. Commissioner, 428 F.3d 1338 (11th Cir. 2005), an opinion that had established the valuation rule on this issue for decades. The Eleventh Circuit in Blount held that life insurance proceeds paid pursuant to an obligation to redeem shares do not increase the value of the company's stock. It reasoned that the corporation had a binding contractual obligation to redeem the decedent's shares which offset the increase in value of the company due to the receipt of the policy proceeds. Using the willing buyer-willing seller argument, the court believed that a "reasonably competent business person" would not ignore the outstanding liability stemming from the obligation to redeem the decedent's shares. In other words, the asset created by the life insurance proceeds was directly offset by a corresponding liability to redeem shares, which in aggregate produced no impact on the company's value.

Indeed, the appraiser in the Connelly case excluded the policy proceeds from the valuation of the company, Crown C Supply, in reliance upon Blount. Valuation experts will now have to include proceeds of life insurance in the company valuation under Section 2031 even if the company has to immediately pay out the sum pursuant to a redemption obligation.

Another shortcoming of the opinions and argument in the case is its focus on how a sale of the full company would have turned out economically. If Thomas and the estate had opted to sell the company, the government posited, then the purchaser could have extinguished the redemption obligation and would have had the full value of the company as well as the $3.5 million of life insurance proceeds. This is a red herring that courts increasingly explore in estate tax cases. The willing buyer-willing seller analysis is limited to a valuation of what the decedent owned on date of death and the fact that a buyer of the whole company would be in a stronger position is not relevant to the issue in the case. A better analysis would have looked at the value of the company shares, including discounts and including the life insurance proceeds, and then accounted for the liability owed to the estate. It's doubtful that a full offset would have been the only analytical framework used by an appraiser to determine how a purchaser of a majority stake of the company would have valued the company. In not following the dictates of section 2703(b), this option was lost.

This decision affects the succession planning for hundreds of small and mid-size businesses that own life insurance on a shareholder. Given that the policy proceeds will now be included in the value of the entity for purposes of estate administration and settlement, business owners should review the options for structuring stock purchase agreements and succession planning. Attorneys and other advisors should reiterate the importance of compliance with buy-sell agreements to protect business owners' estates under section 2703(b).

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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