On June 6, 2024, the United States Supreme Court held in Connelly v. United States that life-insurance proceeds earmarked by a corporation for redemption of a deceased shareholder’s stock must be included when valuing the corporation for estate-tax purposes.  This is a major blow for closely held business succession planning and denies estates a potentially significant tax benefit.

Background

Brothers Michael and Thomas Connelly owned Crown C Supply (the “Company”), a small but successful building supply company.  The two brothers were the only shareholders, with Michael owning roughly 77% of the business and Thomas owning the remaining 23%. 

The Stock-Redemption Agreement

In 2001, Michael and Thomas entered into an agreement designed to keep the Company in the family should one of them die.  Under the agreement, upon either’s death the surviving brother would have the option to purchase the deceased brother’s shares; should the surviving brother decline to purchase those shares, the Company would then be required to redeem the shares at fair market value.  In order to fund the possible redemption, the Company was required to take out a $3.5 million life-insurance policy on each brother. 

Michael died in 2013 and the Company received $3.5 million in life-insurance proceeds.  Thomas elected not to purchase Michael’s shares, and in so doing triggered the Company’s obligation to redeem the shares at fair market value.  

Valuation Disputes

After determining that Michael’s Company interest was worth $3 million (77% of the Company’s $3.86 million value excepting the insurance proceeds), the Company paid that amount to Michael’s estate (the “Estate”) in exchange for his shares.  Thomas, acting as executor of the Estate, then filed a federal estate tax return using the agreed-upon value of $3 million for Michael’s shares. When the Internal Revenue Service (the “IRS” or the “Service”) audited the return, Thomas hired an outside accounting firm which confirmed his initial valuation.  In calculating the Company’s value, the firm excluded the $3 million used to redeem Michael’s shares on the theory that those amounts were offset by the Company’s redemption obligation.  Accordingly, the firm concluded that the Company’s fair market value at Michael’s death was $3.86 million and that Michael’s shares were worth $3 million.

The IRS disagreed, reasoning that the Company’s fair market value should have included the life-insurance proceeds used to purchase Michael’s shares.  According to the Service, the Company was not, as Thomas had reported, worth $3.86 million, but was instead worth $6.86 million; and Michael’s shares were not worth $3 million (77% of $3.86 million), but were instead worth $5.3 million (77% of $6.86 million).  Based on this higher valuation, the IRS assessed an additional $889,914 in estate taxes.

Procedural History

The Estate paid the additional tax and sued for a refund in the District Court.  The District Court granted summary judgment in favor of the Service, holding that, to accurately value Michael’s shares, the additional $3 million in life-insurance proceeds should be included in the value of the Company.  Unsatisfied with the court’s reasoning, the Estate appealed to the Eighth Circuit and lost.  In March 2024, the Estate appealed to the United States Supreme Court. 

On Appeal to the Supreme Court

The central question before the Court was whether, in calculating a decedent’s estate tax, a corporation’s obligation to redeem the decedent’s shares constitutes a liability that decreases the corporation’s value.  Put another way, the Court had to decide whether life-insurance proceeds earmarked for redemption of a decedent’s shares are included when calculating the value of those shares for estate-tax purposes.

The Court ultimately ruled against the Estate, concluding that the Company’s redemption obligation was not a liability and that, consequently, the full value of Michael’s life-insurance proceeds were includable in the value of the Company for estate-tax purposes. 

The Estate’s Argument

In its brief, the Estate proposed that a contractual obligation to redeem shares is a liability that offsets the value of life-insurance proceeds used to fulfill that obligation, and that an arm’s length buyer would treat the proceeds and corresponding redemption obligation as canceling each other out.  Because Michael’s insurance proceeds would leave the Company as soon as they were received in order to fulfill the redemption, a buyer could not actually capture the proceeds’ full value and would thus not consider them a net asset when deciding whether to purchase Michael’s shares.  Accordingly, the Estate felt that the value of Michael’s shares should reflect Michael’s ownership interest in the Company after the redemption—not before.  Additionally, the Estate asserted that an affirmation of the Eighth Circuit’s decision would hinder succession planning for closely held corporations which frequently rely on agreements like the one at issue.

The IRS’s Response

The IRS, however, insisted that the Company’s obligation to redeem Michael’s shares did not reduce the value of those shares.  According to the Service, “no real-world buyer or seller would have viewed the redemption obligation as an offsetting liability.”  The Company’s value had nearly doubled—from $3.86 million to $6.86 million—prior to the redemption when it received the insurance proceeds, and according to the Service that increase in Company value should have been reflected in Michael’s estate tax assessment.

The Court’s Decision

Writing for a unanimous Court, Justice Clarence Thomas sided with the IRS and held that the Company’s obligation to redeem Michael’s shares did not constitute a liability that offset the value of the life-insurance proceeds used to fulfill the redemption.  Accordingly, the $3 million in life-insurance proceeds were includable in the value of the Company for purposes of calculating the value of Michael’s shares.  In reaching its conclusion, the Court emphasized several noteworthy points.

First, the Court observed that a fair-market-value redemption obligation does not offset the value of life-insurance proceeds set aside for the redemption because it has no effect on any shareholder’s economic interest.  The Court explained that when a company redeems one of its shareholders, it pays that shareholder the value of his or her interest, nothing more. Remaining shareholders are subsequently left with a larger proportional ownership interest (since the redeemed owner’s interest has been extinguished) in a less valuable corporation, but the monetary value of their individual shares remains the same.  Applying this principle to the instant case, the Court concluded that no willing buyer purchasing Michael’s shares would have treated the Company’s obligation to redeem them as a liability that reduced their value.

The Court was similarly unconvinced by the Estate’s argument that an arm’s-length buyer would not consider proceeds earmarked for a redemption as net assets.  The Court emphasized that the entire point of valuing Michael’s shares for estate-tax purposes was to assess how much the shares were worth at Michael’s death—before the Company spent $3 million on the redemption payment.  Without much explanation, the Court pointed to Internal Revenue Code Section 2033 (defining the gross estate to “include the value of all property to the extent of the interest therein of the decedent at the time of his death”) and Treas. Reg. § 20.2031-1(b) (the “value of every item of property includible in a decedent’s gross estate . . . is its fair market value at the time of the decedent’s death”) and concluded that a hypothetical buyer would treat the life-insurance proceeds as a net asset because, at the time of Michael’s death, they had not yet been used to redeem his shares and therefore existed as a Company asset.

The Court then noted that treating the redemption as a liability would refute the basic mechanics of a stock redemption.  A redemption, the Court explained, is essentially a cash-out payment to an exiting shareholder and therefore reduces a corporation’s total value.  By valuing Michael’s shares at $3 million, the Estate’s position required the Company to have been worth $3.86 million before and after the redemption.  Since a redemption necessarily involves a reduction in Company value, the Court rejected the Estate’s position as an economic impossibility.

Finally, the Court dismissed the Estate’s concerns that a decision in favor of the Service would jeopardize succession planning for closely held corporations.  The Court admitted that including earmarked life-insurance proceeds in estate tax valuations would require small businesses like the Connellys’ to take out much larger life-insurance policies on the lives of their owners in order to redeem their shares; but the Court felt that this was simply a consequence of how the brothers had chosen to structure their agreement.   For instance, the brothers could have instead used a cross-purchase agreement—one in which shareholders agree to purchase each other’s shares at death and purchase life insurance policies on each other to fund the agreement—to plan for succession.  Doing so, according to the Court, would have allowed Thomas to purchase Michael’s shares while avoiding the risk that proceeds would increase the value of Michael’s shares.

Importantly, the Court noted that its holding in Connelly does not preclude the possibility that a properly structured redemption obligation might decrease a corporation’s value (for instance, if such an obligation required a corporation to liquidate operating assets to pay for shares, thereby decreasing its future earning capacity), so there may still be opportunities for creative structuring that would avoid the result in Connelly.

Takeaway

Owners of closely held businesses should be wary of the Court’s decision in Connelly.  By holding that life-insurance proceeds payable to a company to redeem a deceased shareholder are includable in the company’s value for estate tax purposes, the Court largely abrogated a tool frequently used to avoid estate taxes.  Going forward, business owners would be wise to re-examine their existing estate plans to ensure that they do not contain foot faults, and individuals contemplating similar plans should consider alternative options to ensure that their intended tax benefits are respected.

Sam Sturgis is an associate at Gunster, where he works as a member of the firm’s Tax and Private Wealth Services practice groups.