In Connelly v. United States, the Supreme Court unanimously held that a corporation's contractual obligation to redeem shares is not necessarily a liability that reduces a corporation's value for purposes of the federal estate tax.1
Background
Michael and Thomas Connelly were the sole shareholders in a closely-held business (Crown). To ensure Crown remained in the family if Michael or Thomas died, the brothers entered into a share redemption agreement. Pursuant to the agreement, the surviving brother would have the option to purchase the decedent's shares in Crown. If either brother declined to exercise the option, Crown would be contractually required to redeem the decedent's shares. To ensure Crown would have sufficient liquidity for the redemption (if one was required), it purchased life-insurance on each brother. When Michael died, Thomas declined to exercise his option to purchase Michael's shares (77.18% interest), and Crown used the life-insurance proceeds to redeem the shares from Michael's estate for $3 million (the value agreed upon by Michael's son and Thomas). Thomas, the executor of Michael's estate, then filed a federal estate tax return, reporting the fair market value of Michael's shares as $3 million.
When the IRS audited the federal estate tax return, Thomas got a valuation from an outside accounting firm, which valued Crown at $3.86 million at the time of Michael's death. The valuation excluded the $3 million in life-insurance proceeds earmarked to redeem Michael's shares. The valuation assumed that the value of those proceeds ($3 million) was offset by Crown's obligation to redeem Michael's shares, which were worth $3 million ($3.86 million x 77.18%).2
The IRS disagreed. The IRS insisted that Crown's redemption obligation did not offset the life-insurance proceeds, and therefore, argued that Crown's fair market value at the time of Michael's death was $6.86 million ($3.86 million + $3 million in life-insurance proceeds earmarked for redemption). As a result, the IRS assessed a tax deficiency against the estate. The estate paid the deficiency and then sued the government for a refund. The district court granted summary judgment for the government, holding that the estate was not entitled to a refund because, under appropriate valuation principles, the obligation to redeem shares is not a liability that offsets life-insurance proceeds. The Eighth Circuit affirmed and the estate appealed.
In an opinion by Justice Thomas, the Supreme Court unanimously held that held that a corporation's contractual obligation to redeem shares is not necessarily a liability that reduces a corporation's value for purposes of the federal estate tax, and that Crown's contractual obligation to redeem Michael's shares at fair market value did not offset the value of life-insurance proceeds earmarked to redeem Michael's shares.3 The Court explained that for purposes of determining the federal estate tax, "a decedent's shares in a closely held corporation must reflect the corporation's fair market value" and that "life-insurance proceeds payable to a corporation will increase the corporation's fair market value."
The Court reasoned that because a fair-market-value redemption does not impact the economic interest of any shareholder, an arm's-length buyer of Michael's shares would not treat Crown's obligation to redeem those shares at fair market value as reducing the value of those shares. The Court explained that, on the date of Michael's death, Crown's fair market value was $6.86 million ($3 million in life-insurance proceeds earmarked for redemption, plus $3.86 million of other assets). Therefore, the Court reasoned, an arm's-length buyer would pay up to $5.3 million for Michael's shares ($6.86 million x 77.18%)—the amount the buyer could anticipate receiving when Crown redeemed those shares at fair market value.
The Court highlighted the logical incongruency that the estate's argument necessarily implied with respect to stock redemptions—i.e., that Crown was worth $3.86 million before the redemption (such that Michael's shares were worth $3 million), and that Crown was worth $3.86 million after the redemption of Michael's shares.
The Court also rejected the estate's policy argument that a holding in favor of the government will make business succession planning more difficult, explaining that Crown would have needed to buy a much larger insurance policy to redeem Michael's shares. The Court reasoned that this was simply a consequence of the way the brother's structured their share redemption agreement. The Court pointed out that the brothers could have utilized a cross-purchase agreement, which would have achieved the same objective (keeping Crown in the family), while avoiding the risk of the insurance proceeds increasing the value of Michael's shares.
Looking Forward
The Court's decision in Connelly—that the value of life-insurance proceeds payable to a corporation is an asset that must be included when valuing the corporation's shares for estate tax purposes and is not offset by a corporation's contractual obligation to redeem the shareholders—resolves a long-standing split. The Ninth Circuit and the Eleventh Circuit have held that life-insurance proceeds payable to a corporation are not included when valuing the corporation's shares (i.e., proceeds are offset by a contractual obligation to redeem).4 In contrast, the Eighth Circuit and the Tax Court have held that such proceeds must be included when valuing the corporation's shares.
Practitioners note that taxpayers will need to utilize other strategies, such as cross-purchase buy-sell agreements or arrangements where the life-insurance is held in a trust.5While some practitioners believe that a lot of closely-held corporations will need to have their buy-sell plans reviewed in light of the Connelly decision, others practitioners say the decision was "obvious" and believe that the adverse results to the taxpayers in Connelly could have been easily avoided with a more appropriate buy-sell arrangement.6While many practitioners were well aware of existing uncertainties prior to the Connelly decision, owners of closely-held corporations would nonetheless be well-advised to have their business succession plans reviewed in light of the decision.
Foootnotes
1. Connelly v. United States, No. 23-146 (June 6, 2024).
2. In arriving at this valuation, the accounting firm had followed the holding in Estate of Blount v. Commissioner, 428 F. 3d 1338 (11th Cir. 2005),that life-insurance proceeds should be "deducted . . . from the value" of a corporation when they are"offset by an obligation to pay those proceeds to the estatein a stock buyout." Id., at 1345.
3. Crown in fact received $3.5 million in life-insurance proceeds, but only $3 million was earmarked for the redemption of Michael's shares. While the Court's opinion expressly states that "life-insurance proceeds payable to a corporation are an asset that increases the corporation's fair market value", only $3 million (the portion of the proceeds actually earmarked for redemption) was included in valuing Crown's shares for estate tax purposes.
4. See Estate of Cartwright v. Commissioner, 183 F.3d 1034 (9th Cir. 1999); Estate of Blount v. Commissioner, T.C. Memo. 2004-116, aff'd in part and rev'd in part, 428 F.3d 1338 (11th Cir. 2005); Connelly v. United States, 70 F.4th 412 (8th Cir. 2023).
5. Bloomberg Law, High Court Estate Tax Ruling Forces Succession Planning Revamps, John Woolley, Erin Schilling (June 7, 2024).
6. Id.
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