On June 6, 2024, the Supreme Court of the United States decided the case of Connelly v. United States, 144 S. Ct. 1406. The recent ruling has introduced significant implications for closely held corporations and their members. This landmark case revolves around a fundamental question: should a corporation’s obligation to redeem a deceased shareholder’s shares be considered a liability and thus reduce the value of the corporation and a deceased shareholder’s interest in the Company?
The case revolves around two brothers who owned a closely held corporation. The share redemption agreement stipulated that upon the death of either brother, the surviving brother could purchase the deceased’s shares. If the surviving brother chose not to, the corporation itself was required to redeem the shares. To fund the redemption, the corporation secured life insurance policies on both brothers. When one brother passed away, and an Estate Tax Return was filed, the IRS disagreed with the Estate’s valuation of the brother’s interest in the corporation. The IRS determined that the corporation and, consequently, the brother’s interest was not reduced by the corporation’s obligation to redeem the shares. The District Court and the Eighth Circuit sided with the IRS, and the U.S. Supreme Court agreed.
Understanding the Holding
The brothers were sole shareholders in the company; Michael owning 77.18% and Thomas owning 22.82%. To ensure that the company would have enough money to redeem the shares if required, the company obtained $3.5 million in life insurance on each brother. Michael died in 2013. Thomas chose not to purchase Michael’s shares; thus, the company was obligated to redeem Michael’s shares valued at an agreed upon $3 million. Thomas, as executor, then filed a federal estate tax return, which reported the value of Michael’s $3 million in shares.
The IRS audited the return, and Thomas obtained a valuation from an accounting firm. The firm considered the holding in Estate of Blount v. Commissioner, 458 F.3d 1338 (CA11 2005), which held that when a corporation is obligated to redeem a deceased shareholder’s shares, the insurance proceeds used for the buyout should be deducted from the value of the corporation. Relying on this holding, the accounting firm excluded the $3 million in insurance proceeds used to redeem Michael’s shares and determined that the corporation’s fair market value at Michael’s death was $3.86 million, with Michael’s 77.18% valued at $3 million.
The IRS disagreed, insisting that the corporation’s obligation did not offset the life insurance proceeds and, therefore, included the $3 million in life insurance, finding that the corporation’s total value was $6.86 million. By this logic, the IRS determined that Michael’s shares were worth $5.3 million, and his estate owed an additional $889,914 in estate taxes.
The Supreme Court agreed with the IRS that the redemption obligation does not offset the life insurance proceeds in the corporation’s total value. The Court supports this decision by comparing the corporation to that of a buyer purchasing Michael’s shares upon his death. The Court reasoned that anyone purchasing Michael’s shares would acquire his entire stake in the business at fair market, including the $3 million in life insurance. The corporation’s promise to redeem Michael’s shares at fair market value does not reduce the value of his shares.
Additionally, for calculating the estate tax, the Court determined that the whole point was to determine how much Michael’s shares were when he died before the company spent the $3 million on the redemption payment. Again, when comparing to the hypothetical buyer, the life insurance proceeds used to redeem Michael’s shares would be treated as a net asset. As such, the life insurance proceeds are included in the total value of the corporation.
What Impact Does This Have on Succession Planning?
First and foremost, the Connelly decision sets out the potential for a substantial increase in estate tax bills for business owners with insurance-funded buy/sell agreements. When life-insurance proceeds are included in the business valuation, the taxable estate increases, potentially creating liquidity issues for estates that are not prepared for an increased tax burden.
Additionally, due to possible increased tax liability and higher business valuations, businesses should place greater emphasis on ensuring their buy/sell agreements are adequately funded. This could mean increasing insurance coverage, or exploring other funding sources such that both purchase price and potential tax obligations will be accounted for.
Moving forward, valuation experts will likely consider new factors when determining the fair market value for businesses with stock redemption agreements. This may open the floodgates to disputes with the IRS and increase litigation.
Businesses may also consider alternatives as a means to minimize the impacts of the Connelly decision. The Court in Connelly recommends the “cross-purchase agreement” approach, in which shareholders, rather than the corporation, agree to purchase a deceased shareholder’s interest, funded by the shareholders’ purchase of life insurance. Further, it may be wise to hold policies outside of the estate through an Irrevocable Life Insurance Trust (ILIT). Lastly, business owners may begin to gift their ownership interests during their lifetime as a means to remove the interests from the estate.
The Connelly decision could lead to increased estate tax liabilities and force the sale of small family businesses to outside parties, or even create conflicts within the corporation due to possible disagreements among members on how to address these tax liabilities.
The Connelly decision highlights the importance of lifetime planning as a means to minimize potential estate tax and succession issues. As the world of succession planning evolves as a result of this decision, businesses and advisors must adopt new strategies to maintain compliance with these changes, and to manage any challenges that may arise.
The experienced attorneys at Cavitch are here to help businesses navigate these new challenges arising out of the Connelly decision. They can assist in exploring ways to reorganize ownership structures and explore other tax advantages in succession planning.