The Supreme Court recently decided a rare case involving an estate tax issue.  The Connelly case centered around the valuation of a deceased shareholder’s interest in a closely held business for estate tax purposes, an issue which seemed settled based on a 2005 Eleventh Circuit Court decision.  In the present case, all parties agreed that the life insurance proceeds were to be included in the value of the company for estate tax purposes.  The issue presented to the Supreme Court was whether or not the company’s obligation to redeem the deceased shareholder’s shares provided an offset against the value of the life insurance proceeds.  The Supreme Court held that there was no offset against the insurance value for the obligation to redeem the deceased shareholders’ shares.  The Court’s unanimous 9-0 decision in this case will have significant implications for estate tax planning involving closely held businesses and the treatment of life insurance proceeds in such circumstances.

Background

Michael Connelly and Thomas Connelly were brothers and the only shareholders of Crown C Supply, Inc. (“Crown”), a closely held roofing and siding business.  Michael owned approximately 77% of the shares and Thomas owned 23%.  The brothers entered into a stock purchase agreement which provided that upon the death of either brother, the surviving brother had the right to purchase the deceased brother’s shares.  If the surviving brother declined to purchase the shares, then Crown would purchase the shares at a price determined by one of two possible methods in the stock purchase agreement.  The first option was to agree on the price per share and sign a new Certificate of Agreed Value on an annual basis.  If that was not done, then the price would be determined by at least two appraisals of the fair market value of the company.  The company owned life insurance policies on each brother in the amount of $3.5 million.  It is unclear why the amount of life insurance purchased for each brother was the same when the ownership was unequal.

Michael died in 2013 and the company received the life insurance proceeds from his policy.  Crown purchased the shares for $3 million, which price was derived from an agreement between Thomas and Michael’s son, Michael Connelly Jr.[1]  The remaining $500,000 went to the company to fund operations.  They did not obtain any appraisals at Michael’s death.  Thomas, as Executor for Michael’s estate, filed an estate tax return stating that the shares were worth $3 million (based on the purchase price).  This calculation valued the entire company at a total price of $3.89 million.  The estate tax of $300,000 was paid and the estate was later audited.

The IRS determined that the estate should have included the value of the life insurance proceeds in determining the fair market value of Crown, and that doing so would have increased the value of the company to $6.86 million[2].  As a result, there was a deficiency in the estate tax paid of $1M.  The estate paid the additional tax and proceeded to sue the IRS for a refund.[3]

District Court Analysis

In the district court suit, the court addressed two questions:

1)    Was the stock purchase agreement effective to determine the price for estate tax purposes under Section 2703 of the Internal Revenue Code?

2)    Do life insurance proceeds need to be included in calculating the value of a company?

In addressing the first question, the district court stated the requirements of Section 2703 (which governs how stock purchase or similar agreements should be considered in determining value for transfer tax purposes).[4] The district court found that the agreement: (i) must be a bona fide business arrangement, (ii) must not be a device to transfer property to the family for less than full and adequate consideration and (iii) must be similar to other agreements negotiated at arm’s length between unrelated parties.

Further, the court stated that existing case law and Section 2703 regulations require (i) a fixed and determinable offering price (ii) that the agreement must be binding during lifetime and after death, and (iii) there must be a bona fide business reason.

The district court determined that although the stock purchase agreement was a bona fide business arrangement, it was a device to transfer property to the family for less than full and adequate consideration because they ignored the appraisal requirement and decided on the $3 million price for Michael’s shares.  The court also found that the estate was not able to provide evidence of similar arm’s-length agreements as provided in the third prong of the 2703 test.  The district court also found that there was no fixed and determinable offering price, and that the agreement was not binding after death (based on the parties’ actions following Michael’s death).  Therefore, the district court concluded that the stock purchase agreement was not effective to determine the price for federal estate tax purposes.

On the second question, the estate argued that the life insurance proceeds should not be included in the calculation of fair market value because the redemption obligation offset the addition of the life insurance proceeds.  That argument relied on the Eleventh Circuit Court of Appeal’s decision in Estate of Blount v. Commissioner[5].  The IRS argued that the fair market value must include proceeds used for redemption.

The district court disagreed with the reasoning in the Blount case and stated that a hypothetical willing buyer would not factor a company’s redemption obligation in its assessment of the value of the company, because in purchasing the entire company, the buyer would have all the shares that would be redeemed under the redemption obligation and then the redemption obligation would be to itself.  The district court concluded that the redemption obligation was not a corporate liability for estate tax purposes and that the life insurance proceeds used to redeem the shares must be included in determining the fair market value of the company without any offset related to the company’s redemption obligation.  The district court granted the IRS summary judgment, stating that the stock-purchase agreement did not affect the valuation and that the life insurance proceeds must be used in the calculation because they were a “significant asset of the company.”[6]

Eighth Circuit

The case was appealed to the Eighth Circuit to answer two questions:

1)    Does the stock purchase agreement control how the company should be valued?

2)    Does the fair market value of the company include the life insurance proceeds used for redemption?

To answer the first question, the Eighth Circuit did its own analysis of Section 2703 of the tax code. It determined that Section 2703(b) sets out the factors for whether a corporate agreement can determine the price of shares for estate tax purposes.  Under Section 2703(b), there must be (i) a bona fide business arrangement, (ii) the agreement cannot be a device to transfer property to family members for less than full and adequate consideration and (iii) the agreement must be similar to other agreements negotiated at arm’s-length.  The court stated that existing case law and Section 2703 regulations require a fixed and determinable offering price, a binding agreement during lifetime and after death, and a bona fide business reason.[7]  The Eighth Circuit found that in this case, there was no set price in the stock purchase agreement but that it only laid out two ways for the brothers to agree on a price—the Certificate of Agreed Value or appraisals as described above.  Neither of these options was used, but the Circuit Court argued that even if they had been used, “neither price mechanism constituted a fixed or determinable price for valuation purposes.”[8]  This is because the first approach—a certificate of agreed value—was only an “agreement to agree” and the second approach—appraisals of the fair market value—did not constitute a determinable price because the agreement did not provide a formula or calculation by which an appraiser could determine the price.

To answer the second question, the court laid out factors for determining how the value of shares of a closely held company is found.  The court stated that under Section 2031, the value of “nonoperating assets” including life insurance proceeds should be considered.  The court looked at the connection between Section 2031 (defining the gross estate) and Section 2042 (discussing life insurance proceeds that go to beneficiaries other than the decedent’s estate) to further understand what it means to “take into account” the nonoperating assets.  The court stated that Section 2042 requires that life insurance proceeds received by other beneficiaries under policies in which the decedent possessed any “incidents of ownership” be included in the decedent’s gross estate.  In this case, however, the Company purchased the policy.  The court pointed out that Treasury Regulation 20.2042-1(c)(6) states that a decedent does not possess the incidents of ownership in a policy simply by being a controlling shareholder in a corporation that owns and benefits from the policy.  The court concluded that Section 2042 neither requires nor excludes the proceeds from being included in the decedent’s gross estate in this case.

The Eighth Circuit then went on to agree with and expand on the district court’s rejection of the arguments in the Blount case.  The Eighth Circuit stated that the Blount premise that the life insurance proceeds had been offset by a redemption obligation is flawed, because an obligation to redeem shares is not a liability, but only a reduction to corporate surplus.  The court reasoned that a “willing buyer” could extinguish the stock purchase agreement or redeem the shares from himself, and that the buyer controls the life insurance proceeds.  The hypothetical buyer would pay up to $6.86 million having taken the life insurance proceeds into account.  A “willing seller” would not accept only $3.86 million knowing that the company was about to receive $3 million in life insurance proceeds [Note: in this case the company is redeeming shares from Michael’s estate].  The court concluded that the life insurance proceeds were an asset that increased the shareholder’s equity, and the fair market value must reflect this.

Supreme Court Review

There is a significant difference in the approach between the Eighth Circuit and the Eleventh Circuit on the issue of whether the insurance proceeds were offset by the company’s obligation in the stock purchase agreement to use the proceeds to redeem the shares.  The Eleventh Circuit says yes, the life insurance proceeds were offset by the company’s obligation and therefore the value of the proceeds should not be added to the company’s valuation.  The Eighth Circuit does not recognize such an offset.  This disagreement set the stage for the Supreme Court to weigh in.

The following question was presented in the petitioner’s brief: “Whether the proceeds of a life insurance policy taken out by a closely held corporation on a shareholder in order to facilitate the redemption of the shareholder’s stock should be considered a net corporate asset when calculating the value of the shareholder’s shares for purposes of the federal estate tax[9].”

The following arguments are stated in the petitioner’s brief:

• The willing-buyer/willing-seller test accounts for all relevant facts concerning the relevant property.
• The willing buyer and willing seller valuing a closely held corporation would disregard life insurance proceeds used by the corporation to fulfill an offsetting obligation to redeem the insured’s stock.
• The proper valuation of a block of corporate shares does not include value available only to a purchaser of the entire company because it is inconsistent with the willing buyer/willing seller test to assume that a willing buyer of some stock would ultimately purchase and control additional stock.
• Increasing the value of an estate’s stock based on corporate insurance proceeds designated for a stock redemption would create negative consequences.

On June 6, 2024, the Supreme Court’s unanimously sided with the IRS and affirmed the Eighth Circuit’s ruling.  The opinion properly described the dispute in the case as “narrow,” stating that all parties agree that the value of a decedent’s shares in a closely held corporation must reflect its fair market value, and that life insurance proceeds payable to a corporation are an asset that increases the fair market value.  The dispute in this case is whether the company’s contractual obligation to redeem the decedent’s shares at fair market value offsets the value of the life insurance proceeds allocated to funding the redemption.  On this question, the court said no and rejected the petitioner’s arguments.  Its opinion held that “a corporation’s obligation to redeem shares is not necessarily a liability that reduces a corporation’s value for purposes of the federal estate tax.”[10]  Interestingly, the court stated in a footnote that “We do not hold that a redemption obligation can never decrease a corporation’s value.  A redemption obligation could, for instance, require a corporation to liquidate operating assets to pay for the shares, thereby decreasing its future earning capacity.  We simply reject Thomas’s position that all redemption obligations reduce a corporation’s net value.  Because that is all this case requires, we decide no more.”[11]  The court stated that a fair market value redemption has no effect on any shareholder’s economic interest, and because of this, the court stated that no willing buyer purchasing the decedent’s shares would have treated the company’s obligation to redeem the shares at fair market value as a factor that would reduce the value of those shares.[12]

The court distinguishes the reasoning in Blount by stating that the court in Blount values the corporation (and takes into account the redemption obligation) after the redemption, whereas for purposes of calculating the estate tax, the valuation should be a reflection of the date of death value, i.e., before the redemption.  The court went on to state that if the brothers had used a cross-purchase agreement instead of a stock purchase agreement (despite some significant drawbacks), then Thomas could have purchased Michael’s shares and avoided the risk that the insurance proceeds would have increased the value of the shares.

Conclusion

In this case there was a complete lack of adherence to the stock purchase agreement—this was emphasized by each court that heard this case.  If the brothers had followed the terms of the agreement, obtained an appraisal, etc., the case may have never arisen.  Practitioners must focus on properly drafting buy-sell agreements and should emphasize to their clients the importance of following such agreements.  Current agreements should be reviewed and other arrangements such as cross-purchase agreements considered, although moving from a stock purchase agreement to a cross-purchase agreement could trigger transfer-for-value issues and risks that one or more shareholders would not maintain the life insurance policies.

Going forward, current stock purchase agreements that are funded with company owned life insurance will result in the value of the life insurance proceeds being included in the gross estate.  Despite this, in the current era of high estate tax exemptions (even if the exemption is decreased by half in 2026) there may not be an increase in estate tax liability for estates of most business owners.  However, increasing the value of a business for estate tax purposes will increase its basis as reported on an estate tax return if one is filed—if the sales price is less than the basis, there could be a resulting loss for the estate.

The Connelly decision will impact the way closely held businesses structure their agreements and secure liquidity to address the death of a shareholder.  It is imperative that closely held business owners think about these issues proactively to reduce the likelihood of future complications for their families or other heirs.  Implementing carefully drafted agreements is essential to prevent unexpected or unintended consequences following the death of a shareholder.

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[1] Connelly v. United States, No. 21-3683 (8th Cir. 2023)

[2] The value of $6.86 million was derived from the IRS’s determination that Michael’s 77.18% interest was worth $2,982,000, meaning the entire company (without life insurance proceeds) was valued at $3.86 million, and with life insurance proceeds, was valued at $6.86 million.

[3] 26 U.S.C. § 7422; 28 U.S.C. § 1346(a)(1).

[4] 26 U.S.C. § 2703

[5] Est. of Blount v. Comm’r, 428 F.3d 1338, 1342 (11th Cir. 2005)

[6] Connelly v. United States, 4:19-cv-01410-SRC (E.D. Mo. Sep. 21, 2021)

[7] Est. of Blount v. Comm’r, 428 F.3d 1338, 1342 (11th Cir. 2005)

[8] Connelly v. United States, No. 21-3683 (8th Cir. 2023)

[9] Petitioner’s brief, Connelly v. US (No. 23-146) (2024).

[10] Connelly v. United States, 602 US ___ (6/6/2024) (not yet published).

[11] Id. – Footnote 2.

[12] Id.

Kathi L. Ayers, Vaughan, Fincher & Sotelo, PC

Kathi is a principal in the law firm of Vaughan, Fincher & Sotelo, PC, an organization dedicated to providing estate planning and estate administration services to individuals, families and their businesses in the Washington Metropolitan area.  Kathi received her J.D. from George Mason University School of Law in 2007, and her undergraduate degree in biochemistry from Eastern College in St. Davids, Pennsylvania in 2001.  She is a member of the Bars of Virginia, Maryland and the District of Columbia. Kathi is a member of the inaugural class of the ACTEC Southeast Fellows Institute and is a member of the Legislative Committee of the Virginia Bar Association’s Wills, Trusts and Estates section.  Kathi previously served as a co-chair of the Wills, Trusts and Estates section of the Fairfax County Bar Association and is a member of the Northern Virginia Estate Planning Council.  Kathi has been named as a Rising Star in DC and Virginia Superlawyers and as a “Top Financial Professional” in Washingtonian and Northern Virginia magazines.