In brief
The US Supreme Court recently issued a significant decision, impacting many closely-held businesses with buy-sell agreements funded by life insurance policies, Connelly v. United States, 144 S. Ct. 1406 (2024). In a 9-0 decision, the Court held that life insurance proceeds received by a closely-held corporation increased the value of the owner’s estate for federal estate tax purposes.
Background
The Supreme Court granted certiorari in order to resolve a circuit split that had recently emerged between the 8th and 11th Circuits. In 2005, the 11th Circuit Court of Appeals overruled a lower Tax Court decision, and held that the value of life insurance proceeds should be offset by the obligation to redeem the shares of the deceased shareholder. Est. of Blount v. Comm’r, 428 F.3d 1338 (11th Cir. 2005). Whereas, more recently in Connelly, the 8th Circuit disagreed with the 11th Circuit’s reasoning and held that the value of the life insurance policy was includable in fair market value of the corporation for estate tax purposes, without any offset for the related stock purchase agreement.[i] The sole issue on appeal before the Supreme Court was whether the stock purchase agreement should offset the value of the life insurance proceeds. The Supreme Court upheld the 8th Circuit on this issue.
Corporate owned life insurance policies meant to fund buy-sell agreements in closely held corporations are relatively common. Before Connelly, such corporate-owned life insurance arrangements could often be tax efficient for income and estate tax purposes, based partly on the authority of Blount. While Blount was a taxpayer favorable decision, and constituted high level appellate authority on this point, the 11th Circuit’s reasoning in this decision had been subject to criticism by legal scholars and commentators, some of whom filed amicus briefs with the Supreme Court urging them to correct what they saw as error in the Blount Court’s reasoning.[ii] Moreover, the IRS contested this issue in other circuits, which ultimately gave rise to the Connelly decision.
The Connelly case involved a corporation owned by two brothers. The brothers had an agreement that upon the death of one of them, the other could opt to purchase his deceased brother’s shares. If the surviving brother chose not to purchase the shares, then the company was required to redeem the shares. The company had obtained $3.5 million life insurance policies on each brother. When one brother, Michael Connelly, died his brother opted not to purchase the shares, triggering the corporation’s obligation to redeem Michael’s shares. Following a brief negotiation with Michael’s estate (represented by Michael’s son), the Corporation (represented by the surviving brother, Thomas) repurchased the shares for $3 million.[iii]
For estate tax purposes, Michael’s ownership interest in the corporation needed to be valued at the time of his death. Michael’s estate argued that the asset represented by $3.M of life insurance proceeds should be offset by the liability of the corporation’s $3 million share redemption obligation. The IRS argued the life insurance asset should not be offset by this liability.
The Supreme Court, referencing a law review article, as well as the District Court’s decision in Connelly and the Tax Court’s decision in Blount, reasoned that a stock redemption obligation is fundamentally different than a common corporate liability, such as salaries or rent. Rather, a corporation does not diminish its value when it purchases its own shares at fair market value. The redeemed shareholder is paid cash for its outstanding stock, and the value of the equity held by the remaining shareholders is unimpacted. This reasoning can be illustrated by an example used by the Tax Court in the Blount decision:
Assume corporation X has 100 shares outstanding and two shareholders, A and B, each holding 50 shares. X’s sole asset is $1 million in cash. X has entered into an agreement obligating it to purchase B’s shares at his death for $500,000. If, at B’s death, X’s $500,000 redemption obligation is treated as a liability of X for purposes of valuing B’s shares, then X’s value becomes $500,000 ($1 million cash less a $500,000 redemption obligation). It would follow that the value of B’s shares (and A’s shares) is $250,000 (i.e., one half of the corporation’s $500,000 value35) upon B’s death. Yet if B’s shares are then redeemed for $500,000, A’s shares are then worth $500,000—that is, A’s 50 shares constitute 100–percent ownership of a corporation with $500,000 in cash.
It cannot be correct either that B’s one-half interest in $1 million in cash is worth only $250,000 or that A’s one-half interest in the remainder shifts from a value of $250,000 preredemption to a value of $500,000 postredemption.[iv]
Thus, dispensing with the notion that a stock redemption would reduce the corporation’s value, the Supreme Court reached what it thought was a “straightforward conclusion” that, at the time of Michael Connelly’s death, the insurance proceeds were an asset of the corporation and should therefore be included in its valuation.
Implications and questions to consider
- The 2024 federal estate tax threshold is $13.61 million per individual, and will remain at that level, adjusted for inflation, in 2025. This threshold is scheduled to sunset on December 31, 2025, and will revert to an estimated $6-7 million per individual unless U.S. government takes action. Closely held businesses (whether partnerships, LLCs or corporations) should review their buy-sell agreements, particularly if life insurance is involved and owners may be subject to estate taxes.
- Closely held businesses are, by their nature, difficult to value, and present many nuanced issues for tax and estate planning purposes. Further, the IRS is likely to scrutinize any valuations due to the often closely related parties and the lack of arm’s length pricing. Thus, the question of whether the valuation established in buy-sell agreements is supportable by an objective methodology that can hold up to scrutiny by taxing authorities should be kept front of mind while structuring buy-sell arrangements.[v]
- Restructuring could be an option. For example, life insurance policies could be transferred to another legal entity. However, be aware of the “transfer for value” rules under Code section 101(a)(2) which could cause the proceeds from transferred contracts to lose their exemption from tax, among other considerations.
Get in touch
Closely held businesses with shareholders who may be subject to estate taxes have many complex issues to consider. Downs Rachlin Martin with its deep expertise in advising closely held businesses on succession planning, tax structuring, and estate matters, is uniquely situated to assist in navigating these complexities and developing tailored solutions that preserve wealth and ensure a smooth transition across generations.
Ryan P. Flatley, Of Counsel
Conor B. McKenzie, Of Counsel
