Supreme Court: Insurance proceeds increase corporation’s estate tax value

The U.S. Supreme Court, in a unanimous decision, held Thursday that life insurance proceeds a corporation received to fund a share redemption agreement increased the corporation’s estate tax value, and the corporation’s obligation to redeem the shares was not a liability that decreased the corporation’s value (Connelly, No. 23-146 (U.S. 6/6/24)).

The decision affirms an Eighth Circuit holding in favor of the IRS in the case, which involved two brothers, Michael and Thomas Connelly, and their small building supply corporation, Crown C Supply.

The Court said, “The central question is whether the corporation’s obligation to redeem Michael’s shares was a liability that decreased the value of those shares” (slip op. at 1). The Court held that the answer is, “No.”

Thus, after the death of a shareholder, the value of that person’s shares must reflect the corporation’s fair market value, including insurance proceeds meant to fund a share redemption, the Court said.

Background

The Connellys, who were sole shareholders in Crown, wanted the corporation to stay in the family when either brother died, so they agreed that when one of the brothers died, the surviving brother would have an option to purchase the deceased brother’s shares. Crown C would be obligated to buy the shares if the surviving brother declined the option, which Thomas Connelly did when his brother died in 2013.

As part of the agreement, and to ensure Crown would have the money to buy the shares, the company had obtained $3.5 million in life insurance on each brother.

Michael’s estate filed a federal tax return listing the value of Michael Connelly’s shares at $3 million, the amount Crown paid to redeem the shares. The IRS, on audit, disagreed, saying Crown’s redemption obligation did not offset the life insurance proceeds. It set Crown’s total value at $6.86 million, based on the $3 million and a $3.86 valuation of Crown based on the redemption amount paid and Michael’s ownership percentage in Crown.

The IRS ruled the estate owed $889,914 in additional taxes, which the estate paid. Thomas Connelly then sued for a refund. A district court and the Eighth Circuit upheld the IRS’s decision (Connelly, No. 4:19-cv-01410-SRC (E.D. Mo. 9/21/21), aff’d, 70 F.4th 412 (8th Cir. 2023)).

Supreme Court’s opinion

In its opinion, the Court said, “An 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” (slip op. at 5–6). Therefore, the Court concluded, no hypothetical purchaser of Michael’s shares would have treated the company’s obligation to redeem those shares as a factor that reduced the value of those shares.

The estate argued that the life insurance proceeds used to redeem the estate’s Crown shares did not increase Crown’s net worth because of Crown’s contractual obligation to redeem the estate’s shares. Therefore, the estate argued, the estate tax valuation of the estate’s shares was equal to the estate’s interest in Crown prior to receipt of the life insurance proceeds. The Court rejected this idea, finding that “for calculating the estate tax, 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).

Thomas Connelly argued that affirming the Eighth Circuit’s decision would make succession planning more difficult for closely held corporations. However, the Supreme Court concluded this result “is simply a consequence of how the Connelly brothers chose to structure their agreement” (slip op. at 8).

— To comment on this article or to suggest an idea for another article, contact Martha Waggoner at Martha.Waggoner@aicpa-cima.com.