Supreme Court Upholds Life Insurance Valuation in Estate Tax Calculation
On June 6, 2024, the U.S. Supreme Court issued its opinion in Connelly v. United States. This decision supports the IRS’s stance that contractual redemption obligations to a deceased shareholder’s estate don’t decrease a company’s value after life insurance proceeds are paid to the company. Consequently, the taxpayer in Connelly was found to owe federal estate tax, reflecting the increased value of his shares after death.
Because redemption obligations will no longer reduce the value of life insurance proceeds, many businesses will need to rethink key person life insurance policies and their corresponding redemption agreements to avoid unfavorable federal estate tax outcomes for their shareholders.
At issue was the valuation of life insurance proceeds payable to the Connelly brothers’ corporation, Crown C Supply (Crown). Brothers Michael and Thomas Connelly, the sole shareholders in Crown, each took out a life insurance policy with Crown as the beneficiary upon death. To protect each of their interests in the closely held company, they contractually agreed that the surviving brother could purchase the other’s shares. If the surviving brother chose not to buy the shares, Crown was obligated to redeem the deceased brother’s shares.
Michael passed away, and Crown received his $3 million life insurance payout, subject to the contractual obligation to redeem Michael’s shares in Crown. Thomas, as the executor of Michael’s estate, filed an estate tax return. He believed that the $3 million life insurance payout, balanced by the offsetting redemption agreement, shouldn’t increase Crown’s valuation, which would increase the value of Michael’s shares and thus his estate tax liability. Historically, this offsetting obligation would have canceled out the policy proceeds for estate tax purposes.
The IRS disagreed, arguing that the $3 million payout should be included in Crown’s valuation when calculating Michael’s estate tax, even considering the share redemption obligation. The Supreme Court agreed with the IRS, ruling that a corporation’s contractual obligation to redeem shares isn’t necessarily a liability that decreases a corporation’s value for federal estate tax purposes.
Considering the perspective of a hypothetical buyer of Michael’s shares, the Court reasoned that “no hypothetical buyer purchasing Michael’s shares would have treated Crown’s obligation to redeem Michael’s shares at fair market value as a factor that reduced the value of those shares.” The Court emphasized that the proper valuation for estate tax should be determined at the time of death. At the time of Michael’s death, Crown, and therefore Michael’s shares, were worth $3 million more than before, due to the immediate availability of the life insurance payout.
The Court felt that valuing Crown after the redemption conflicted with the general rule of estate tax calculation, which is to value the estate, and thus the shares, at the time of death.
The Supreme Court also dismissed the argument that this ruling complicates succession planning for closely held corporations. The Court argued that this result was a consequence of the companies’ structure and suggested alternative methods, like a cross-purchase agreement, which could lead to more advantageous results.
Closely held corporations should carefully consider this opinion when structuring their business succession plans to avoid similar disputes. Other structuring approaches may result in more tax-efficient outcomes.
If you have any questions about this opinion, reach out to Peyton H. Lacoste, Laura Walker Plunkett, or any member of Baker Donelson’s Tax Group.
