The United States Supreme Court recently decided Connelly v. United States, No. 23-146, holding that a corporation’s obligation to redeem shares upon the death of a shareholder is not a liability that reduces the corporation’s value for purposes of the federal estate tax. What does this mean for practitioners counseling their business clients? The long-time practice of advising small business clients to purchase life insurance to cover the cost of the shares in a buy/sell agreement upon the death of a shareholder may no longer make financial sense given the federal estate tax implications. From the perspective of the highest court in the land, it simply doesn’t add up. 

The Facts

Michael and Thomas Connelly, brothers and sole shareholders of Crown C Supply, a small building supply corporation, entered into an agreement to ensure that Crown would stay in the family if either brother died.  Under the agreement, the surviving brother would have the option to purchase the deceased brother’s shares.  However, if he declined, Crown would be required to redeem the shares. To ensure that Crown would have the money to purchase the shares if required, the company obtained $3.5 million of life insurance on each brother.

Upon Michael’s death, Thomas elected not to purchase Michael’s shares, triggering Crown’s obligation to do so. The agreed-upon value of Michael’s shares was $3 million, and Crown paid the same amount to Michael’s estate. Thomas, as executor of Michael’s estate, filed a federal tax return for the estate, reporting the value of Michael’s share as $3 million. The IRS audited the estate tax return, and during the audit, the estate obtained a third-party appraisal that valued the shares at $3 million. That figure was based on a valuation of the corporation that offset most of the life insurance proceeds with the cost of redeeming the shares. The IRS disagreed, and took the view that the corporation’s redemption obligation was not a liability that reduced the value of the shares.  As a result, the IRS valued the corporation (and thereby the shares) at nearly double, which increased the amount of estate tax owed.  The estate paid the tax and then sued for a refund. The District Court granted summary judgment to the government, and the Eighth Circuit Court of Appeals affirmed. 

The Opinion

The Supreme Court affirmed the Court of Appeals, holding that Crown’s contractual obligation to redeem the shares did not diminish the value of those shares.  The Court simplified the case as a whole stating, “[t]he question here is whether Crown’s contractual obligation to redeem Michael’s shares at fair market value offsets the value of life insurance proceeds committed to funding that redemption.  The answer is no.”  Why? Because a fair market value redemption does not affect any shareholder’s economic interest.  The Court explained that no willing buyer purchasing the deceased brother’s shares would have treated the corporation’s redemption obligation as a factor that reduced the value of those shares.  Rather, life insurance proceeds payable to a corporation are an asset that increase the corporation’s fair market value. 

Thomas argued that the redemption obligation was a liability, but the Court found that cannot be reconciled with the basic mechanics of a stock redemption.  He argued Crown was only worth $3.86 million before the redemption (so Michael’s shares were worth $3 million), but he also argued that Crown was worth $3.86 million after the stock sale.  The Court stated, “Both cannot be right: A corporation that pay out $3 million to redeem shares should be worth less than before the redemption.”

The challenges in this case involve the difference between valuing a corporation in a commercial transaction and valuing it for estate tax purposes.  The federal estate tax is based on the fair market value of a decedent’s assets upon death, including any interest in a closely-held business. An agreement obligating a closely-held company to purchase a shareholder’s interest upon their death must be for fair market value. In other words, parties to a buy/sell agreement cannot simply set the purchase price, disregarding the future fair market value.  And if they do, the IRS can simply ignore the shareholder agreement and assess estate taxes on the shares based on its calculated fair market value.  As for the value of the corporation itself, the life insurance proceeds earmarked for the future redemption must be included in the total value of the company.   

The Effect

The use of corporate-owned life insurance plans is based on the premise that insurance proceeds received by a corporation upon a shareholder’s death will have no effect on the value of the deceased shareholder’s estate tax liability.  The Connelly decision changes this, potentially leaving the estates and families of shareholders in the position of paying estate taxes on assets that their loved ones will never receive.  Using corporate-owned life insurance to buy back stock on the death of a shareholder thus comes at the cost – shareholders must include the value of the insurance when setting the redemption price for the shares of the decedent. 

So, how can lawyers balance this equation? The Court in Connelly suggested that the brothers should have used a cross-purchase agreement, meaning each brother purchases a life insurance policy on the other, taking the value of the life insurance out of the corporation. The insurance proceeds would provide the surviving brother the means to purchase the stock from the deceased brother’s estate, allowing them to keep the business in the family. However, keep in mind that the purchase price of the shares would still be set by the fair market value of the entity for purposes of the estate tax. Commentators also suggest that moving policy ownership outside of a corporation may give rise to income tax concerns under transfer-for-value rules. And, some shareholders may not have peace of mind knowing they are relying on another shareholder, albeit often a family member, to pay the necessary insurance premiums. 

At this point, there is no apparent solution to this problem. However, lawyers should review and perhaps develop additional strategies for the use of corporate-owned life insurance by consulting with the client’s tax and financial advisors on a case-by-case basis.