Supreme Court: Obligation to redeem stock was not a liability

The U.S. Supreme Court, in a unanimous decision, held that life insurance proceeds a corporation received to satisfy the corporation’s obligation to redeem shares increased its value for estate tax purposes and that the redemption obligation was not a liability that decreased its value for estate tax purposes.

Background

Michael Connelly and his brother, Thomas, owned Crown C Supply, a building materials company in St. Louis. To smooth the transition of ownership upon the death of either brother and ensure that control of the company stayed within the family, the brothers and Crown entered into a stock-purchase agreement.  Under the agreement, if one brother died, the surviving brother had the right to buy his shares, but, if the surviving brother declined, Crown was required to redeem the decedent brother’s shares.

Despite the right of first refusal in the agreement, the brothers always intended that Crown, not the surviving brother, would redeem the decedent brother’s shares.  To fund the redemption, Crown purchased $3.5 million of life insurance on each brother.

After Michael died in 2013, Crown received the life insurance proceeds from its policy on him. Thomas declined to buy Michael’s shares, and Crown, as it had agreed, redeemed his shares.  Rather than secure an outside appraisal of the company’s fair market value (FMV), as the redemption agreement contemplated, Michael’s son and Thomas agreed that the value of Michael’s shares was $3 million, so Crown paid that amount to redeem the shares, leaving Thomas as the sole shareholder of the company.

Thomas was the executor of Michael’s estate, and in 2014 he filed an estate tax return for the estate reporting that Michael’s shares (which were 77. 18% of the outstanding shares at his death) were worth $3 million and, consequently, Crown was worth $3.86 million (approximately $3 million divided by 77.18%). The estate did not treat the life insurance proceeds as an asset of the corporation that increased its value and in turn the value of Michael’s shares.

The IRS audited the estate’s return. It found that the estate had undervalued Michael’s shares by not including the value of the life insurance proceeds. Taking the proceeds into account, it determined Crown was worth $6.86 million. Thus, the IRS found that the estate’s return should have showed a value for Michael’s Crown shares of approximately $5.3 million ($6.86 million × 77.18%). The IRS sent a notice of deficiency to the estate for more than $890,000 in tax.  The estate paid the deficiency and sued for a refund in district court.

The district court granted summary judgment to the IRS (Connelly, No.  4:19-cv-01410-SRC (E.D. Mo. 9/21/21)). It found that the stockpurchase agreement did not affect the valuation of Crown and that its valuation must include the life insurance proceeds used for redemption because they were a significant asset of the company. The district court’s holding relied on the Internal Revenue Code, Treasury regulations, and customary valuation principles. The estate appealed the decision to the Eighth Circuit, which affirmed (Connelly, 70 F.4th 412 (8th Cir.  2023)).

The estate appealed the Eighth Circuit’s decision to the Supreme Court, which agreed to hear the case (Connelly, No.  23-146 (U.S. 12/13/23) (cert. Granted)).

The Supreme Court’s decision

The Supreme Court affirmed the Eighth Circuit’s holding that a corporation’s contractual obligation to redeem shares is not necessarily a liability that reduces a corporation’s value for purposes of federal estate tax.

The parties agreed that when calculating the federal estate tax, the value of a decedent’s shares in a closely held corporation must reflect the corporation’s FMV and that life insurance proceeds payable to a corporation are an asset that increases the corporation’s FMV. That left the Court the “narrow” question of whether Crown’s contractual obligation to redeem Michael’s shares at FMV offset the value of life insurance proceeds committed to funding that redemption.

The Supreme Court found that an obligation to redeem shares at FMV does not offset the value of life insurance proceeds set aside for a share redemption because a share redemption at FMV does not affect any shareholder’s economic interest. Thus, a corporation’s contractual obligation to redeem shares at FMV does not reduce the value of the shares in and of itself.

The Supreme Court further reasoned that because an FMV redemption has no effect on any shareholder’s economic interest, no willing buyer purchasing Michael’s shares would have treated Crown’s obligation to redeem those shares at their FMV as a factor that reduced their value. Consequently, the buyer would be willing to pay $5.3 million for the shares — i.e., the value that could be expected to be received in exchange for the shares under the redemption agreement with Crown. As a result, the Court determined that Crown’s promise to redeem Michael’s shares at FMV did not reduce the value of those shares.

Thomas argued that a buyer would not consider proceeds that would immediately have to be used to complete the redemption of the shares under the agreement as net assets.  In other words, the Supreme Court stated, Thomas viewed the relevant inquiry as determining what a buyer would pay for shares that make up the same percentage of the less-valuable corporation that exists after the redemption. The Court rejected this notion, finding that for estate tax purposes, “the whole point is to assess how much Michael’s shares were worth at the time that he died — before Crown spent $3 million on the redemption payment” (slip op.  At 7).

In addition, the Supreme Court found that Thomas’s argument that the redemption obligation was a liability could not be reconciled with the basic mechanics of a stock redemption. In a stock redemption, the shareholder cashes out his or her share of ownership in the company, which reduces the corporation’s value and leaves the remaining shareholders with a larger stake in a corporation with a lower value. Following Thomas’s view, the Court pointed out, would leave him with a smaller share of Crown with the same value, even though the corporation had paid out $3 million to him in the redemption. This, the Court concluded, “cannot be right” and was at odds with the elementary understanding of a stock redemption.

Finally, Thomas argued that his position should be adopted because following the lower court’s holdings would make succession planning harder for closely held corporations, stating that if life insurance proceeds intended for a share redemption transaction are a net asset for estate tax purposes, Crown would have been required to purchase a much larger insurance policy to redeem Michael’s shares at FMV. The Court found that this was true but observed that it was simply a result of how the Connellys chose to structure their redemption agreement, which also offered certain benefits over other structuring options available to them.

Choosing another structure, the Supreme Court explained, such as using a cross-purchase agreement, where the brothers purchased the insurance to fund the redemption agreement, might obviate the issue that Michael complained of but would present other drawbacks. By having Crown purchase the life insurance policies, the Connellys gained the benefit of a guarantee that the policies would remain in force and the insurance proceeds would be available to fund the redemption.  The attendant downside was an increase in the value of Michael’s shares. The Court stated, “Thomas’ concerns about the implications of how he and Michael structured their agreement are therefore misplaced” (slip op.  At 9).

Reflections

The Supreme Court, by upholding the Eighth Circuit’s decision in this case, rejects the Eleventh Circuit’s holding in Estate of Blount, 428 F.3d 1338 (11th Cir.  2005), the case on which Michael’s estate relied for the proposition that Crown’s redemption liability should offset the insurance proceeds Crown received. In its opinion in Blount, the Eleventh Circuit stated, “To suggest that a reasonably competent business person, interested in acquiring a company, would ignore a $3 million liability strains credulity and defies any sensible construct of fair market value.”

The Eighth Circuit, however, found that the flaw in the Eleventh Circuit’s holding lay in its premise that the redemption liability was an ordinary liability. According to the Eighth Circuit, the obligation to redeem shares is not a liability in the ordinary business sense, and treating it so “distorts the nature of the ownership interest represented by those shares.”

As the Eighth Circuit explained, to own Crown outright, a willing buyer would have to obtain all its shares. At that point, the willing buyer could extinguish the stock-purchase agreement or have the corporation redeem the shares. This, the court reasoned, would be “just like moving money from one pocket to another.” There would be no liability to be considered because the willing buyer would control the life insurance proceeds. Thus, the willing buyer of Crown would pay up to $6.86 million, having “taken into account” the life insurance proceeds, and extinguish the agreement or redeem the stock as it wished.

On the other hand, a hypothetical willing seller of Crown holding all 500 shares would not accept only $3.86 million, knowing that the company was about to receive $3 million in life insurance proceeds, even if those proceeds were intended to redeem a portion of the seller’s own shares. The Eighth Circuit thus concluded that to accept $3.86 million would be ignoring, instead of taking into account, the anticipated life insurance proceeds.

Connelly, No.  23-146 (U.S. 6/6/24)

Contributor

James A. Beavers, CPA, CGMA, J.D., LL.M., is The Tax Adviser’s tax technical content manager. For more information about this column, contact thetaxadviser@aicpa.org.