Supreme Court Ruling Impacts Estate Tax Valuation of Life Insurance Proceeds
On June 6, 2024, the United States Supreme Court released its opinion in Connelly v. United States, a decision with significant implications for how life insurance policies are valued in the context of estate tax calculations. The ruling, which favors the Internal Revenue Service (IRS), clarifies that a company’s contractual obligation to redeem a deceased shareholder’s shares does not automatically offset the increased value of the company resulting from life insurance proceeds paid to the company.
In essence, the Supreme Court affirmed the Eighth Circuit’s original holding. This means that the value of a company, and thus the value of an individual’s shares in that company, will reflect the increase in value stemming from life insurance payouts, regardless of existing redemption agreements. As a result, this decision can lead to higher federal estate taxes for the deceased shareholder’s estate.
The Connelly Case: Key Facts
The case centered on the valuation of life insurance proceeds received by Crown C Supply (Crown). Brothers Michael and Thomas Connelly, the sole shareholders, each had a life insurance policy with Crown as the beneficiary. To safeguard their interests in the closely held business, they made an agreement that the surviving brother had the option to purchase the other’s shares upon death. If the surviving brother declined this option, Crown would then redeem the deceased brother’s shares.
Following Michael’s death, Crown received a $3 million life insurance payout. The estate of Michael Connelly, managed by Thomas, filed an estate tax return which argued that no increase in Crown’s valuation should occur for estate tax purposes because of the offsetting redemption agreement.
The IRS disagreed, taking the position that the $3 million payout should be included in Crown’s valuation, even considering the obligation to redeem the shares.
The Supreme Court’s Decision
The Supreme Court sided with the IRS, asserting that a company’s promise to buy back shares is not necessarily a liability that reduces the company’s value for federal estate tax purposes. The Court assessed the situation through the eyes of a hypothetical buyer of Michael’s shares, concluding that this buyer “would not 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 was keen to point out that the appropriate valuation for estate tax purposes is the point in time of death and that at that specific moment, Crown demonstrated a $3 million increase in value due to the life insurance payout.
Implications and Guidance
The Supreme Court’s ruling highlights the importance of properly structuring business succession plans. Closely held corporations should re-evaluate key person life insurance policies and corresponding redemption agreements. Alternative structuring methods, such as a cross-purchase agreement, may lead to more tax-efficient results.
Contact Peyton H. Lacoste or Laura Walker Plunkett of Baker Donelson’s Tax Group with questions regarding this important opinion.
