In Connolly v. U.S., 602 U.S. ____, 144 S.Ct. 1406 (decided June 6, 2024), the U.S. Supreme Court considered whether and how a key person insurance policy owned by a corporation and used to redeem an owner’s shares affected a decedent’s estate tax liability. In the case, two brothers, Michael and Thomas, owned all the stock of a corporation. To keep the business within the family, an agreement between Thomas and Michael provided that, if either died, the surviving brother would have the option to purchase the deceased brother’s shares and, if the surviving brother declined to do so, then the corporation itself would be contractually required to redeem the shares. The agreement specified that the redemption price for each share would be based upon an outside appraisal of the corporation’s fair market value.
To ensure that the corporation would have enough cash to redeem the shares if required, the corporation obtained a $3.5 million life insurance policy on each brother. When Michael died in 2013, the surviving brother (Thomas) declined to purchase Michael’s shares, triggering the corporation’s obligation to redeem Michael’s shares. Thomas, also acting as Executor of Michael’s Estate, agreed with Michael’s son to forego an appraisal and accept $3 million as the fair market value for Michael’s shares, which was paid through the corporation’s life insurance proceeds on Michael’s life.
Thomas filed an estate tax return for Michael, reporting the value of Michael’s interest in the corporation as $3 million, the price paid to the Estate for Michael’s shares. The Internal Revenue Service audited the estate tax return, during which time Thomas obtained a valuation Michael’s shares from an outside accountant. The accountant had relied on the case Estate of Blount v. Commissioner, 428 F.3d 1338 (11th Cir. 2005), which reversed the Tax Court’s finding that insurance proceeds of $3.1 million should be added to the value of the decedent’s stock in a corporation. Thus, the accountant did not include the life insurance proceeds or value in the valuation of the Estate’s shares because of the company’s redemption obligation.
The IRS auditor disagreed with the Estate’s position, and apparently the Estate of Blount holding, instead insisting that the corporation’s redemption obligation did not offset the life-insurance proceeds. The IRS added the $3 million in life insurance proceeds to the Estate’s value and assessed almost $900,000 in additional Estate taxes arising from Michael’s share of the additional value. Thomas, on behalf of the Estate, paid the taxes and sued in District Court for a refund. The case made its way up to the U.S. Supreme Court. See 2021 WL 4281288 (E.D. Mo., Sept. 21, 2021); 70 F.4th 412 (8th Cir. 2023).
Calling the dispute “narrow,” the United States Supreme Court noted that both parties agreed that, when calculating the federal estate tax, the value of a decedent’s shares in a closely held corporation must reflect the corporation’s fair market value, and life insurance proceeds payable to a corporation are an asset that increases the corporation’s fair market value. Thus, the Supreme Court considered only whether the corporation’s contractual obligation to redeem the decedent’s shares at fair market value offset the value of the life insurance proceeds committed to funding the redemption.
The Court first considered whether a fair market value redemption had any effect on a shareholder’s economic interest, or in other words, whether a redemption obligation for a corporation with only cash assets would affect the redemption price. In short, the answer is no: “[e]conomically, the redemption would have no impact on either shareholder.” As a direct result, the Court found that a buyer paying fair market value for shares would thus not reduce that value because of a corporation’s redemption obligation, because that was the amount the buyer could expect to receive in exchange for the shares when the corporation later redeemed them at fair market value.
Moreover, the Court explained that the stock should be valued at the time the decedent died – before the corporation made the redemption payment – not after. The redemption obligation was not a liability of the company, because it did not change the company’s overall value for the remaining shareholders. Instead, the Estate was merely cashing in its shares, and the surviving owner (Thomas) now owned 100% of the company, but at the same value as his interest before the redemption of Michael’s interest.
The Supreme Court’s ultimate holding – that redemption obligations are not necessarily liabilities that reduce a corporation’s value for purposes of the federal estate tax – may require businesses and their owners to re-think about end-of-life planning for both. Since many small businesses utilize buy-sell agreements with an insurance component, owners may desire to reconsider the structure of the agreement, whether the company is obligated to redeem he shares, and if so, how the company will pay for the redemption. Attorneys at Gensburg Calandriello & Kanter, P.C. are at the forefront of estate planning and asset protection, and can assist in providing a tailored approach to meet the needs of individuals and the businesses they care about.
Sandra Mertens
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