Last year the Supreme Court released an important decision in Connelly v. United States that has the potential to impact many business owners.
The case examined how life insurance used in business succession plans affects estate taxes. The Court ruled in favor of the IRS and held that a corporation’s obligation to redeem shares held by a deceased shareholder is not a liability that reduces the corporation’s value for estate tax purposes.
Background of Connelly v. United States
Brothers Michael and Thomas Connelly were the sole shareholders in a closely-held corporation, Crown C Supply (“Crown”). Michael owned 77.18% of the shares, with Thomas owning the remaining shares. The brothers had a buy-sell agreement that gave each brother the right to purchase the other brother’s shares upon their death. The corporation had a contractual obligation to redeem either brother’s shares upon his death if the surviving brother did not buy the shares. To cover the cost of redeeming the shares, the corporation held life insurance policies on each of the brothers.
When Michael passed away in 2013, Thomas elected not to purchase his shares, triggering the corporation’s obligation to redeem the shares. Michael’s estate agreed with the corporation to accept $3 million for the shares and the corporation used the proceeds from a $3.5 million life insurance policy on Michael to pay the estate. Michael’s estate filed a federal estate tax return valuing the company at $3.89 million, with Michael’s shares at $3 million.
Under audit, the IRS argued that the redemption obligation should not reduce the calculation of the company’s value, resulting in a higher value of Michael’s shares, leading to a higher estate tax bill.
The table below compares the estate’s valuation of the company with the IRS’s valuation.
| Estate's Valuation | IRS's Valuation | |
| Base value of the company | $3.36M | $3.36M |
| Life insurance proceeds | $3.50M | $3.50M |
| Offsetting redemption obligation | ($3.00M) | - |
| Total valuation | $3.86M | $6.86M |
| Michael’s estate share (77.18%) | $2.98M | $5.29M |
| Estate tax liability (40%) | $1.19M | $2.12M |
Supreme Court’s Opinion
In a unanimous decision, the Court ruled that the life insurance policy proceeds of $3.5M used to buy out the deceased owner's share of the business were not offset by the redemption obligation.
In the opinion, the Court stated “An obligation to redeem shares at fair market value does not offset the value of life-insurance proceeds set aside for the redemption because a share redemption at fair market value does not affect any shareholder’s economic interest.” The Court further stated that “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.”
What Does This Mean for Businesses Going Forward?
For businesses, especially closely-held entities, the Connelly decision underscores the importance of understanding how life insurance proceeds used for share redemptions are treated for estate tax purposes.
The use of buy-sell agreements is common in business succession planning for closely-held companies. In 2005, the Eleventh Circuit Court of Appeals held in Blount v. Commissioner that the proceeds of life insurance policies owned by a corporation were offset by the corporation’s obligation to redeem the decedent’s shares. For nearly two decades, many attorneys have relied on that ruling when structuring these types of agreements. 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 light of the Connelly decision, attorneys and business owners may wish to revisit existing agreements to avoid falling into the same trap as the Connellys. Consider alternative buy-sell structures that use life insurance policies to purchase shares upon the death of a partner or shareholder that do not require the corporation to hold the insurance policy. The Court’s opinion acknowledges that a cross-purchase agreement in lieu of a redemption agreement would have avoided the additional tax burden.
Finally, this case will have implications for even those business owners who do not have a taxable estate. The inclusion of life insurance proceeds in the valuation of the corporation will result in a larger step-up in basis for the estate, equal to the fair market value reflecting the proceeds. At the same time, the receipt of a lower, contractually-agreed-upon value for the redemption of the shares could generate a capital loss for the estate.
Need Help?
Gross Mendelsohn can help with business valuation and succession, estate planning and tax planning. Contact us online or call 800.899.4623 for help.
