[co-author: Hunter Rose Greenberg]
It is typical to have provisions in the governing documents for your company which contemplate the death and buyout of the owners. Most often, those buyout obligations are funded by the purchase of a life insurance policy on the owners that are payable to the company upon an owner’s death. This widely adopted planning strategy has now been flipped on its head following the recent U.S. Supreme Court determination in Connelly v. United States.
The Court in Connelly determined that for federal estate tax purposes the value of a company must include life insurance proceeds and is not offset by the use of those proceeds to fund the buyout of the deceased owner. Depending on the value of the life insurance policy, millions of dollars could now be tacked onto the fair market value of your company, meaning more taxes and less money for your loved ones.
Summary – Connelly v. United States
In Connelly, two brothers owned the entirety of a small corporation. To keep the company within the family, the brothers entered into shareholders’ agreements which contractually obligated the corporation to buy back all shares owned by either brother when they died. In anticipation of covering the buyout costs, the corporation took out a life insurance policy on each brother for $3.5 million. When one of the brothers died, the company redeemed his shares for $3 million.
Upon filing a federal estate tax return, the estate reported the value of the deceased brother’s shares based on a fair market value (“FMV”) of the company at $3.86 million. The IRS disagreed with the reported valuation because the estate excluded the $3 million in life insurance proceeds that the company used to redeem the brother’s shares. Accounting for the additional $3 million, the IRS found the estate owed hundreds of thousands of dollars in additional taxes.
The estate’s valuation
- FMV of company = $3.86 million
- Value of decedent’s shares = ($3.86 mil.) x (% of shares decedent owned)
The IRS’s valuation
- FMV of company = $6.86 million
- Value of decedent’s shares = ($6.86 mil.) x (% of shares decedent owned)
The estate paid the additional amount and then sued the IRS for a refund. The case made its way to the Supreme Court, which resolved “whether life-insurance proceeds that will be used to redeem a decedent’s shares must be included when calculating the value of those shares for purposes of the federal estate tax.”
The Court held that a contractual obligation to redeem shares does not offset the insurance proceeds used to cover the cost of the buyback. Rather, those insurance proceeds are assets that contribute to the FMV of the company. First, the Court reasoned that share redemption does not impact the economic interest of a company’s shareholders. Additionally, the Court emphasized that an estate tax is calculated based upon how much the shares are worth at the time of death, not after. Applying this principle to the instant case, the court found that the value of the company at the time of decedent’s death was $3 million in insurance proceeds + $3.86 million in other assets. Finally, the Court asserted that “the basic mechanics of stock redemption” establish that when a company repurchases shares, the total value of the company decreases while the remaining shareholders’ proportion of ownership in the company increases. It is not possible for a corporation to have the same value both before and after a buyback.
Practical Advice
With the historically high federal estate tax exemption amounts for 2024 ($13.61 million per individual; double for married individuals), this ruling is unlikely to affect the vast majority of business owners. However, these high levels are set to expire at the end of 2025 unless additional legislation is passed. Likewise, the ruling in Connelly may become a real issue faced by more American business owners.
