In a rare valuation case at the United States Supreme Court, a longstanding dispute between the estate of Michael Connelly and the Internal Revenue Service was resolved in a landmark decision issued June 6, 2024.
Closely held companies may have buy-sell arrangements to govern how a deceased owner’s interest can pass at death, limiting outsiders’ access to shares. In this case, brothers Thomas and Michael Connelly, the sole shareholders of a corporation, entered a buy-sell agreement that gave the surviving brother the option to purchase the deceased brother’s shares. If the surviving brother declined to do so, as happened in this case, the company was required to redeem the shares from the deceased brother’s estate at fair market value determined by an independent appraisal.
Court Rules Life Insurance Proceeds Are Part of Company Valuation
The company purchased $3 million in life insurance policies for each of the two brothers to fund this requirement. An independent appraisal determined the value of the deceased brother’s shares in the corporation to be $2.3 million. However, the IRS valued the deceased brother’s shares at $5.3 million, comprised of the $2.3 million plus an additional $3 million for the life insurance proceeds. This resulted in an additional estate tax liability of $889,914. The deceased brother’s estate sued the IRS claiming the estate was owed a refund. The estate argued that the contractual requirement to redeem the shares should be treated as a debt and offset the life insurance proceeds for purposes of valuing the shares for estate tax purposes. The IRS disagreed with this argument and determined that the contractual requirement to redeem the stock should not be considered in determining the value of the shares for estate tax purposes.
The district court and Eighth Circuit upheld the IRS’s view. In a significant shift in the application of federal estate tax to insurance proceeds received by closely held corporations, the Supreme Court affirmed that a corporation’s contractual obligation to redeem shares at fair market value does not reduce the corporation’s value for estate tax purposes.
Alternatives to Avoid Increasing Company Value
The Court’s ruling creates the need for new strategies addressing the use of corporate-owned life insurance to fund wealth transfers at death. Alternatives that can keep life insurance proceeds outside a company’s operating assets or otherwise prevent a company’s increase in value after the death of an owner include:
- Cross-purchase agreements in which business owners or their trusts purchase life insurance on each other. The surviving owner or owners will use the proceeds to purchase the deceased owner’s interest. If a company-owned policy is already in place, transfer of the policy to individual owners can have tax consequences if it is not carefully structured.
- Capital contributions and loans from individual owners to fund the company’s purchase of a deceased owner’s stock.
- Revised redemption agreements requiring the company to liquidate assets to purchase a deceased owner’s interest.
- Other alternatives include setting up a special purpose life insurance LLC to hold company-purchased life insurance. Extra care needs to be taken in construction of the LLC agreement to ensure the LLC interest does not increase the value of the decedent’s estate.
You should discuss these strategies with your advisor, as each comes with its own advantages and disadvantages depending on your unique situation.
The decision in Connelly provides an excellent opportunity to review your company’s redemption agreements and life insurance policies, current market values and tax regulations, and more. Learn more about Aldrich’s Private Wealth Tax group to help ensure your business succession plan aligns with your overall tax and estate planning goals.
