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July 1, 2024 / Newsletters, Publications

Supreme Court Decision Changes Estate Tax Impact of Corporate-Owned Life Insurance Policies

by Amy L. Lawrence

Closely-held businesses may want to reconsider business succession planning after the recent U.S. Supreme Court decision in Connelly v. United States, finding that the value of a closely-held company (for purposes of the estate of a deceased shareholder) must include life insurance proceeds received by the company on the life of the deceased shareholder, despite the company being required, under a buy-sell agreement, to use the life insurance proceeds to redeem the deceased shareholder’s interest.

Case Summary

Michael and Thomas Connelly were brothers and the sole shareholders of a building supply corporation. To ensure that the company stayed within the family when one brother died, Michael and Thomas entered into a buy-sell agreement with the company whereby, upon the death of one brother, the other would have the option to purchase the deceased brother’s shares. If he declined, the company would be required to redeem the shares. To ensure that the company would have sufficient funds to redeem the shares, it obtained $3.5 million in life insurance on each brother.

When Michael died in 2013 owning a 77.18% interest in the company, Thomas declined to purchase Michael’s shares, triggering the company’s obligation to do so. The company purchased Michael’s shares for $3 million, a value agreed to by Thomas and Michael’s son but not supported by a qualified appraisal. When Michael’s estate tax return was audited by the IRS, Thomas obtained a valuation from an outside accounting firm that supported the valuation agreed to by Thomas and Michael’s son. This third party valuation excluded the $3 million in insurance proceeds used to redeem Michael’s shares in reliance on a 2005 case with similar facts (the Eleventh Circuit Court of Appeals decision in Estate of Blount) holding that insurance proceeds are properly deducted from the value of a corporation when they are “offset by an obligation to pay those proceeds to the estate in a stock buyout.” The IRS disagreed, finding that the redemption obligation did not offset the life insurance proceeds, and accordingly, assessing the company’s total value at $6.86 million and Michael’s shares at $5.3 million, resulting in an additional $889,914 in estate taxes.

The Supreme Court agreed with the IRS, finding that a corporation’s contractual obligation to redeem shares does not diminish the value of those shares. The Court explained that because a fair market value redemption does not affect any shareholder’s economic interest, no willing buyer purchasing Michael’s shares would have treated the corporation’s redemption obligation as a factor that reduced the value of those shares. The “whole point” of the valuation for estate tax purposes, according to the Court, is to assess how much the shares were worth when Michael died, before the company spent $3 million on the redemption. A hypothetical buyer would have treated the life-insurance proceeds as a net asset of the company, said the Court. Taking the position that the redemption obligation is a liability “cannot be reconciled with the basic mechanics of a stock redemption” because it “cannot be right,” the Court reasoned, that a corporation would be worth the same or more after it pays out $3 million to redeem shares than it was worth before the redemption.

Planning Considerations

The Connelly decision confirms that life insurance proceeds will be subject to estate tax as a corporate asset, even if those proceeds will ultimately be used to redeem a deceased shareholder’s outstanding shares. Owners of closely-held businesses should carefully review and discuss the following with their estate planning counsel in light of the Connelly decision:

  1. Using a Cross-Purchase Agreement
    The Court in Connelly noted that if Michael and Thomas had wanted to avoid increasing the value of the corporation by the life insurance proceeds at the time of Michael’s death, they should have had a cross-purchase agreement, with each brother purchasing a life insurance policy on the other. The proceeds of the life insurance would not have been included in the company’s value, and each brother would still have had liquidity to purchase stock from the decedent’s estate. However, as the Court noted, every arrangement has its drawbacks: a cross-purchase agreement would have required each brother to pay the premiums for the insurance policy on the other brother, creating a risk that one of them would be unable to do so, and it could have had its own tax consequences.Owners of closely-held businesses should consider ways to structure redemptions to avoid ownership of life insurance proceeds by the company. A cross-purchase agreement, where shareholders (or a trust for the shareholder’s benefit) purchase insurance on each other can avoid inflating the company’s value for estate tax purposes; however, it is important to keep in mind that each option has its own tax implications and should be carefully considered and discussed with estate planning counsel.
  2. Review Existing Buy-Sell Agreements
    Buy-sell agreements must contain clear, fixed valuation methods or formulas to determine the price of shares, including binding appraisals conducted by qualified professionals, formula valuations, or annual (or other periodic) agreed values. Existing buy-sell agreements should be reviewed regularly with estate planning counsel to ensure they comply with current laws and accurately reflect the value of the business interests.
  3. Evaluate Life Insurance Policies
    Discuss the impact that existing life insurance policies will have on your estate’s valuation with your estate planning counsel to make sure policies are adequately valued and structured to avoid unexpected tax liabilities.
  4. Ensure Compliance with Valuation Requirements
    A closely-held business should be appraised when a buy-sell agreement is executed. In addition, if periodic valuations or certificates of agreed value are required, the company should establish procedures to ensure these requirements are met.

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