Connelly clarifies estate treatment of stock redemption

Editor: Mark G. Cook, CPA, CGMA

In Connelly, No. 23-146 (U.S. 6/6/24), the Supreme Court considered the case of brothers Michael and Thomas Connelly, co-owners of Crown C Supply (Crown), a building supply store in St. Louis. The brothers were the sole owners of the corporation, with Michael owning 77.18% and Thomas owning the remaining 22.82%. Michael and Thomas desired a “smooth transition of ownership” if one of them should die. In order to ensure that transition, they entered into an agreement whereby, upon the death of one of the siblings, the other would have the right to purchase the deceased brother’s shares. Under the agreement, if the surviving brother declined to purchase the shares, Crown would be required to redeem the shares.

Michael died in 2013, and Thomas declined to purchase his brother’s shares. Therefore, Crown redeemed Michael’s shares. Thomas, along with Michael’s son, estimated that Michael’s share value at the time of his death was $3 million, and Crown redeemed those shares using $3 million of life insurance proceeds.

Upon filing the estate tax return for Michael’s estate as his executor, Thomas valued Michael’s shares at $3 million, and an IRS examination ensued. During the examination, Thomas obtained a valuation from an outisde accounting firm that relied on Estate of Blount, 428 F.3d 1338 (11th Cir. 2005), in which the Eleventh Circuit held that when determining the fair market value of a corporation, insurance proceeds should be excluded when those proceeds are “offset by an obligation to pay those proceeds to the estate in a stock buyout.” The IRS disagreed with this position and, taking into account the insurance proceeds, determined that Michael’s shares should have been valued at $5.3 million, which resulted in an additional $889,914 estate tax liability.

The estate paid the additional liability, and Thomas, as the estate’s executor, sued for a refund in district court. The district court held that the estate was not entitled to a refund because a “redemption obligation is not an ordinary corporate liability,” and that the “life-insurance proceeds used to redeem Michael’s shares must be included in the fair market value of Crown C and of Michael’s shares” (Connelly, No. 4:19-cv-01410-SRC (E.D. Mo. 9/21/21)). The Eighth Circuit affirmed the decision on the same basis (Connelly, 70 F.4th 412 (8th Cir. 2023)).

The Supreme Court agreed to hear the case to address the “narrow” dispute of “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.”

Supreme Court’s decision

In a unanimous decision, the Court affirmed the Eighth Circuit’s judgment and held that Michael’s shares were not diminished in value based on Crown’s contractual redemption obligation “[b]ecause redemption obligations are not necessarily liabilities that reduce a corporation’s value for purposes of the federal estate tax.”

Thomas argued before the Court that Crown’s redemption obligation to redeem Michael’s shares offset the life insurance proceeds, contending that a potential purchaser of the company’s shares “would treat the two as canceling each other out.” The IRS countered that “no real-world buyer or seller would have viewed the redemption obligation as an offsetting liability.” The Court agreed with the IRS, finding that “[a]n obligation to redeem shares at fair market value does not offset the value of life-insurance proceeds set aside for the redemption because a share redemption at fair market value does not affect any shareholder’s economic interest.”

The Court explained that under the general rules of the estate tax, a decedent’s taxable estate includes the value of “all property” owned by a decedent “at the time of his death,” that the “lodestar” of calculating property value in a decedent’s estate is FMV, and a corporation’s FMV determination must include a company’s net worth “including proceeds of life insurance policies payable to … the company” (quoting Regs. Sec. 20. 2031-2(f), flush text).

Consequently, the Court found that “Crown’s promise to redeem Michael’s shares at fair market value did not reduce the value of those shares” and that Crown’s value at the time of Michael’s death consisted of the “$3 million in life-insurance proceeds earmarked for the redemption plus $3.86 million in other assets and income-generating potential,” for a total value of $6.86 million. A potential buyer of Michael’s shares and 77.18% ownership would be willing to pay up to $5.3 million ($6.86 million × 0.7718), according to the Court, as that represented “the value the buyer could expect to receive in exchange for Michael’s shares when Crown redeemed them at fair market value.”

According to the Court, Thomas’s argument that Crown’s redemption obligation represented an offsetting liability against the company’s value because the life insurance proceeds “would leave the company as soon as they arrived to complete the redemption” could not be “reconciled with the basic mechanics of a stock redemption,” and his understanding of stock redemptions “would turn this ordinary process upside down.” The Court noted that, for estate tax calculation purposes, “the whole point [was] to assess how much Michael’s shares were worth at the time that he died — before Crown spent $3 million on the redemption payment.”

Implications

Based on the Court’s holding, corporate taxpayers should review existing redemption agreements supported with company-owned life insurance. Although this decision involved a closely held family business, taxpayers should assume likely similar treatment for entities with diverse ownership structures that are not necessarily closely held.

Editor Notes

Mark G. Cook, CPA, CGMA, MBA, is the lead tax partner with SingerLewak LLP in Irvine, Calif.

For additional information about these items, contact Cook at mcook@singerlewak.com.

Contributors are members of or associated with SingerLewak LLP.