Although U.S. Supreme Court rulings in the trust and estate field are infrequent, this summer there was a trilogy of decisions. Let us review them chronologically and explore their potential impact.

Our First Feature: Estate of Michael P. Connelly, Sr. v. United States, 602 US__ (2024)

Issued June 6, 2024, the case had two focus areas: IRC Section 2703 and entity valuation. Only the latter was being reviewed by the Supreme Court, but both deserve mentioning.

Relevant facts: Brothers Michael and Thomas Connelly, in business together, established a cross purchase/default redemption buy-sell agreement at a price set annually by shareholders or via appraisals. Neither was routinely done; in fact, neither was ever done. The company purchased $3.5 million of life insurance on each brother to fund the redemption. Michael died owning a little more than 77% of the company, which was redeemed for $3 million (based on a value of $3.89 million set by agreement of the executor of Michael’s estate and Thomas, which notably excluded most of the life insurance death benefit). The company purchased the shares for $3 million and used the remaining $500,000 of death benefit for working capital.

Issue one:  Does the value under the buy sell bind the IRS?

Under IRC Section 2703, it is possible to establish the methodology of valuation pursuant to a buy-sell or restrictive share agreement. The history of 2703 illuminates its applicability and safe harbors.

Valuation of a family-owned or closely held business interest can be challenging, because there is often a limited market of willing buyers. To create an orderly, controlled and desired succession of an interest, owners typically enter contracted restrictions and arrangements embedded in a buy-sell or restrictive share agreement. These provisions can be imposed for good faith business purposes and can provide a reasonable basis for discounting value. On the other hand, tax-aware owners have a natural incentive to self-impose artificial, value-depressing business entity restrictions to minimize their gift or estate tax liability.

IRC Sections 2703 and 2704(b) seek to find balance between respecting legitimate discounts and disregarding artificial, tax-driven business arrangements. Section 2703 gives the IRS, when valuing such property, broad authority to disregard “any option, agreement, or other right to acquire or use” the property, as well as “any restriction on the right to sell or use such property.” The IRS must respect those agreements and restrictions only if they qualify for a safe harbor. The two safe harbors attempt to delineate (and thus respect) legitimate agreements and restrictions. Section 2704(b) follows a similar scheme.

Regulatory Safe Harbor: Since the target of IRC 2703 is to ignore artificial valuation discounts in intra-family transfers, the regulations expressly create a safe harbor. Any restriction or option will be deemed to fulfill the safe harbor automatically if “more than 50% of the value of the property that is subject to the right or restriction is owned… by individuals who are not members of the transferor’s family.” Regulation 25.2703-1(b)(3). This makes sense because if a business or asset is not family-controlled, then it is deemed to comply with the safe harbor. However, this deemed compliance with the statute is only effective if the third-party owners are also subject to the restriction “to the same extent as the transferor.”

Statutory Safe Harbor: The Tax Code also provides an exception to the extremely broad sweep of IRC 2703 even if there are only family members involved in the transfer. The provisions of IRC 2703(a) that cause restrictive business agreements to be ignored by the IRS will not apply if the following requirements are met [IRC 2703(b):]

1. the agreement is a bona fide business arrangement [IRC 2703(b)(1)];
2. the agreement is not a device to transfer the property to a member of the donor or decedent’s family for less than full and adequate consideration [IRC 2703(b)(2)]; and
3. the terms of the agreement are comparable to similar arms’ length transactions [IRC 2703(b)(3)].

The Court of Appeals laid to rest the taxpayer’s argument that the buy-sell provision enabled the shareholders simply to declare the value as they did. They ruled that the stock-purchase agreement neither fixed a price nor prescribed a formula for arriving at a value, but merely laid out two mechanisms by which the brothers might agree on a price. So, it was an agreement to agree and neither safe harbor was met. Connelly, 70 F.4th 412 (8th Cir. 2023).

Issue two: Valuation of a company that owns life insurance on a shareholder that dies.

The Connelly Estate did not increase the value of the company by the $3 million of death benefit used to redeem Michael’s shares. Instead, relying on precedent in other Federal judicial circuits, they offset the value of the insurance proceeds by the liability of the mandatory redemption.

The Court of Appeals agreed with the IRS, creating a split of authority among the circuits:

In 2005, the 11^th Circuit (Alabama, Florida, and Georgia) held insurance was offset by the contractual liability to redeem the shares, zeroing it out. Estate of Blount, 428 F.3d 1338 (11^th Cir. 2005).

In 1999, the 9^th Circuit (Alaska, Arizona, California, Hawaii, Idaho, Montana, Nevada, Oregon, and Washington) similarly ruled permitting an offset in a parallel case. Estate of Cartwright, 183 F 2d 1035 (purchase of a deceased’s stock in a law firm).

In 2023, a Court in the 8^th Circuit (Arkansas, Iowa, Minnesota, Missouri, Nebraska, North Dakota, and South Dakota) rejected that argument and held no offsetting liability. Connelly, supra.

The U.S. Supreme Court often grants certiorari when there is a split among the Circuits, and it did so in Connelly. 601 U. S. ___ (2023). The Court affirmed the 8^th Circuit holding and held 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 there is no categorical offset of the life insurance proceeds committed to funding the corporation’s contractual obligation to redeem shares.  In a footnote, the Court clarified that it did not hold that a redemption obligation can never decrease a corporation’s value, only that the taxpayer’s claim that all such obligations do so was not true.

Takeaway: Both the holding on the Section 2703 issue and on the life insurance valuation issues are calls to action for business owners. First, they should review their buy-sell agreements to determine if they should be updated (or establish one if none exists). Next, if insurance is going to be used to help fund the purchase of a deceased shareholder’s shares, review ownership. It is simple to have policies owned by the other shareholder when there are only two, but cross purchase requires many policies when there are multiple shareholders. This is because each shareholder would need to own a policy on every other shareholder, so if there are five shareholders, twenty policies will be needed. This is why redemption is often the chosen method, since you only need one policy per shareholder. But now, post Connelly, having the company own the policies may prove problematic for valuation purposes.

For example, imagine two individuals each contribute $5 million to a new entity. The entity buys $5 million of life insurance on them. But when one dies, the value of the deceased’s shares is not $5 million but $7.5 million, leaving a cash shortfall ($10 million of cash plus $5 million of death benefit means a $15 million valuation, so a 50% owner’s shares are worth $7.5 million). One solution may be to create a captive LLC owned proportionately by all shareholders. The LLC purchases life insurance on each owner. When a shareholder dies, the other LLC members redeem the interest, and the LLC uses the death benefit to purchase the deceased’s shares.

2. Our Second Feature: Loper Bright Enterprises v. Raimondo, 144 S. Ct. 2244 (2024)

This June 28, 2024, ruling is widely reported on as obviating the Chevron deference, which deferred to agencies’ interpretations (rules and regulations) when a statute is ambiguous and the regulation reasonable. Chevron U.S.A. Inc. v National Resources Defense Council, 467 U.S. 837 (1984).

Loper involved the 1976 Magnuson-Stevens Fishery Conservation and Management Act, which specifies three types of fisheries that must pay the cost of government representatives serving as observers, without addressing Atlantic herring fishermen. 16 U. S. C. § 1801 et seq. In 2015, the governing agency adopted a regulation requiring that Atlantic herring fishermen pay for observers if the agency determines an observer is required but declines to assign a government-paid one.

This added a fourth category to an explicit list in the “law” that did not include it — Atlantic herring fisheries. And the cost is material, as the typical daily cost of $720 per observer represented about 20% of daily herring fishing boat revenue.

The Court focused the result of Chevron on judicial jurisprudence, but if there were no “benefit of the doubt” to any agency, it could have resolved the case through statutory construction. To determine if adding a fourth category by regulation to a statute that only listed three requires statutory interpretation. One tool of statutory construction is canons. Three common Latin canons provide syntactical presumptions. Ejusdem generis limits a general word appearing at the end of a list by preceding specific words. Generalia specialibus non derogant resolves a conflict between a general and a specific provision in favor of the latter.

The third is applicable here. It is expressio unius est exclusio alterius, meaning “the expression of one thing is the exclusion of the other.” The import of this canon is that when interpreting legislation, a presumption may be made that an express reference to one matter excludes other matters. Thus, when a statute explicitly sets forth certain terms, the statute may be interpreted as not applying to terms that have been excluded from it. A case from Virginia highlights this. The court used this canon to determine that a statute that prohibits “any horse, mule, cattle, hog, sheep, or goat” from running upon lands enclosed by a fence does not apply to turkeys because the statute did not explicitly proscribe turkeys. Tate v. Ogg, 195 S.E. 496 (Va. 1938).

In Loper, fishermen challenged the regulation adding Atlantic herring fisheries to the three named in the statute. Since the 1984 case, Chevron has stood for the proposition that a duly passed agency regulation was (rebuttably) presumed a proper interpretation of the relevant statute and that a court would only impose a different interpretation when it found the regulation unreasonable. Loper declared this was no longer the rule.

We know that tax law can be a behavior modification tool. If Congress wants to support philanthropy, it establishes an income tax deduction. If Congress wants to prohibit early access to retirement accounts, it establishes a penalty for early withdrawals. But regulations have the perceived potential for abuse of Chevron deference by enabling the benefit of the doubt in empowering an agency to use regulations as a political football. The concern is that a new administration could appoint federal agency leaders who pass new rules and regulations defining and applying existing laws in a manner aligned with their political platform. Loper seeks to eliminate such a potential by declaring that the meaning of a law is fixed at the time of passage.

In a sense, the Court determined that deferring to agencies was allowing the usurpation of the role of the judiciary. So, by way of Loper, the Supreme Court perhaps inflated the role of courts and deflated the use of agency rules and regulations as a political football.

Takeaway:  While the Court was careful to protect existing regulations, it put into play the legitimacy of those “in the works” and those to be finalized in the future. Consider these potential outcomes:

1. The Administrative Procedures Act (APA), more on that below, requires not only a “notice and comment” period, but it also requires the agency to address all comments in the preamble to the final regulations. Agencies will be well advised to carefully prepare thorough analysis of comments, lengthening the preambles, and preparing a summary of the analysis undertaken in response to them.
2. The post-Loper state of review can be summarized in two ways:If there is statutory authority for regulations, this is a delegation by Congress and the regulations will pass muster if neither arbitrary or capricious.  If not, then the authority is under IRC 7805 and the likely review will be as set forth in Skidmore v. Swift & Co, a 1944 Supreme Court case that found that an agency’s rulings, opinions and interpretations are not binding on a court but reflect a body of experience and informed judgment that can be looked to by a court and litigants for guidance.
3. Alternatively, when the APA earned “force and effect” of law via regulations may be more than needed, an agency may look to a nimbler rule making approach. For example, the Treasury on behalf of the IRS may employ other announcements, such as through Revenue Rulings, Private Letter Rulings, Notices, and Chief Counsel Advisories.As an example, note the significant response by the planning community to the release of CCA 202352018 – here, Treasury was able to send a meaningful message to planners about the potential of a gift tax being assessed should a grantor trust be modified to insert a tax reimbursement provision – all without the effort of a published regulation.

3. Our Third Feature: Corner Post, Inc. v. Board of Governors of the Federal Reserve System, 603 U.S.__ (2024).

This case was decided on July 1, 2024, and despite having the least amount of published commentary among these three cases, it may have the biggest impact in years to come. First, for a regulation to have the force and effect of law, it must comply with the APA). This act was initially put into place as a buffer to the regulatory activity taking place during the New Deal era.

In an article published in 2015 on the history of the APA, Roni Elias noted that initially the Republicans relied on the judiciary to thwart Federal government administrative activism, citing that in the first two years of President Franklin Roosevelt’s first term, courts issued over 1,600 injunctions against New Deal legislation. Elias, The Legislative History of the Administrative Procedure Act, Fordham Environmental Law Review, Vol. 27, Number 2, Article 2, page 209 (2015).

The typical approach to challenge a regulation is to challenge compliance with the APA. If proven correct, the regulation will be overturned. But the APA has a six-year statute of limitations, meaning if a lawsuit is not initiated within that time frame, it will be dismissed as untimely.

The history of Corner Post is that in 2021 two North Dakota trade associations sued challenging a 2011 regulation of the Federal Reserve Board setting the maximum fees that large banks can charge merchants for a debit-card transaction.

In response, the Federal Reserve Board filed a motion to dismiss saying that the six-year statute of limitations had expired. The argument was that the regulation was promulgated in 2011, and the case was filed ten years later. Instead of forcing the court to decide on that point, the trade associations added a third plaintiff, Corner Post, Inc., which first opened in 2018. The argument is that the regulation, while adopted more than six years before in 2011, did not impact this plaintiff until three years before in 2018.

In other words, the issue became whether the six-year statute of limitations was triggered the date the regulation was adopted or the date the plaintiff was impacted. To the surprise of some, the Supreme Court ruled that it was the latter.

Takeaway:  The determination that the time clock for the statute of limitations under the APA does not begin to run until the plaintiff is impacted results in a degree of uncertainty regarding the validity of regulations. For example, for tax regulations no matter when promulgated, a new business could be started in 2034 which will have until 2040 to file a lawsuit challenging them.

And scene!  Our viewing of this summer Supreme Trilogy is finis, but the impact to our clients may last for decades to come. I find this somewhat unsettling, but maybe I just ate too much popcorn.

The author takes sole responsibility for the views expressed herein and these views do not necessarily reflect the views of the author’s employer or any other organization, group or individual.