Business succession planning involving corporate owned life insurance in closely held corporations may warrant changes after a recent Supreme Court decision. In Connelly v. United States, the Court ruled that insurance proceeds paid to a business after an owner’s death are included in the company’s value for estate tax purposes despite a stock redemption obligation of the company.

Michael and Thomas Connelly owned a building supply company in St. Louis, Missouri. To keep the company in the family upon either’s death, the brothers agreed to allow the surviving sibling to purchase his shares. In the event this option was declined, the company would be required to redeem the stock. To fund the potential redemption, the company took out $3.5 million of life insurance on each sibling.

Upon Michael’s passing, Thomas opted out of purchasing his brother’s shares, requiring the company to step in. Michael’s shares were internally valued at $3 million, and the company paid that amount to his estate for the shares. Michael’s estate also used the $3 million valuation upon filing an estate tax return. Upon IRS audit, an external valuation also excluded the life insurance proceeds from the company’s value in a commonly used conclusion that they were offset by the obligation to purchase company shares. The IRS disagreed, arguing that the redemption obligation did not offset the life insurance proceeds, therefore increasing the company’s value and adding nearly $900,000 in additional estate tax. Michael’s estate paid the tax assessed and took the issue to court.

In a unanimous opinion, the Supreme Court overturned a federal appeals case that excludes such proceeds from the valuation, arguing they increase the company’s fair market value and the obligation to redeem shares is not an offsetting liability. In calculating the estate tax, the Supreme Court explains that the point is to assess how much the decedent’s shares are worth at time of death, before the insurance proceeds are spent.

Additionally, the redemption at fair market value does not impact any shareholder’s economic interest, as the following example in the ruling illustrates:

• Company X holds one asset of $10 million in cash and is owned by A and B, who own 80 and 20 shares respectively. Each share is worth $100,000 ($10 million/100 shares). A’s shares total $8 million (80 shares x $100,000) and B’s shares are worth $2 million (20 shares x $100,000).
• Company X redeems B’s shares at FMV of $2 million and the company is now worth its $8 million in cash leftover. Post-redemption, there are now 80 shares outstanding and A’s shares are still worth $100,000 each ($8 million/80 shares).

A hypothetical buyer, the Court argues, would treat the proceeds as an asset, not offset by the redemption requirement due to a lack in economic effect.

The Court concedes that their decision will make succession planning for closely held corporations more difficult but implies that other strategies may achieve favorable results. For example, a cross-purchase agreement, where owners purchase each other’s shares at death using life insurance policies taken out on one another, would accomplish succession planning goals and keep the insurance proceeds out of the company’s valuation for estate tax purposes.

While many currently escape the estate tax thanks to the more-than-doubled exemption as part of the Tax Cuts and Jobs Act (TCJA), the threshold is set to revert back to an estimated $7 million after 2025 if not addressed in future tax legislation. Regularly revisiting succession plans, buy-sell agreements, and valuations are wise considerations for business owners.

Published: 08/08/2024

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