Argued in the Supreme Court of the United States on March 27, 2024.
Decided June 6, 2024.
Connelly v. United States involved determining the fair market value of a closely-held corporation for purposes of estate taxation. A corporation, owned by two brothers, was obligated to buy back the shares of the first to die, using proceeds of corporate-owned life insurance. In determining the fair market value of the corporation at the time of the shareholder’s death, the issue was whether or not to include the value of the corporate-owned life insurance proceeds used to buy back the stock.
The IRS argued that the insurance proceeds used to redeem the decedent’s stock increased the value of the corporation, even though the corporation had a contractual obligation to redeem the decedent’s shares. Therefore, the decedent’s estate should value the corporation to include the insurance. The estate argued that the corporation’s redemption obligation offset the value of the insurance, and thus did not increase the value of the corporation. The taxpayer further argued that a willing buyer would have considered the redemption obligation as offsetting the value of the insurance, to arrive at a fair market value of the corporation.
The Court noted the split among the circuits. The Nineth and Eleventh Circuits held for the taxpayers in similar cases, while the Eighth Circuit held for the government.
In a unanimous decision, the U.S. Supreme Court held for the government, that the insurance proceeds increased the value of the corporation for estate tax purposes at the time of decedent’s death, despite the corporation’s contractual redemption obligation.
Brothers, Michael and Thomas Connelly, were the sole shareholders of a construction business, Crown. Crown owned insurance on each brother’s life to fund the repurchase of the shares of the first to die. When Michael died, Crown redeemed his stock for $3 Million, an amount on which Thomas and Michael’s son had agreed was the value of Michael shares, but unsupported by any independent appraisal. Estate tax was paid on the $3 Million valuation. An outside accounting firm subsequently valued Crown as worth $3.86 Million on Michael’s death, offsetting the $3 Million of insurance used to redeem Michael’s shares, by the redemption obligation. The accounting firm relied on Estate of Blount v. Commissioner for authority to net the insurance proceeds against Crown’s redemption obligation when valuing shares for estate tax purposes.
In assessing additional taxes, the IRS added the $3 Million value of the corporation’s life insurance proceeds to the $3.86 Million of other corporate assets and calculated that Michael’s 77.18% share was worth $5.3 Million (77.18% of $6.86 million), not $ 3 Million. It took the position that the redemption obligation did not reduce the corporation’s value at the time of Michael’s death. The estate paid the assessment and sued for a refund arguing that the corporation’s redemption obligation offset the insurance proceeds used to redeem Michael’s shares.
The issue before the U.S. Supreme Court was whether Crown’s obligation to redeem Michael’s shares was a liability that decreased the value of the corporation and its shares for purposes of valuing the redeemed shares for estate taxes.
Split Among the Circuits
Both the federal district court below and the Eighth Circuit Court of Appeals held for the IRS, that the Crown redemption obligation is not a liability that reduces the fair market value of the corporation for estate tax purposes upon redemption of the decedent’s shares. By ignoring the insurance asset, Michael’s shares were undervalued on redemption. Accordingly, the Eighth Circuit Court set aside the redemption agreement between Crown and Michael for not setting a redemption price at a fair market value.
Affirming the lower courts, the Court noted that a hypothetical willing seller of Crown holding all 500 shares would not accept a sale price of only $3.86 million knowing that the corporation 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. To accept $3.86 million would be ignoring, instead of taking into account, the life insurance proceeds.
The Eleventh Circuit Court of Appeals had taken a different approach in
Estate of Blount v. Commissioner holding that the corporate obligation to purchase a decedent shareholder’s interest offsets the value of the insurance used to pay for the redemption. The Eleventh Circuit cited a similar analysis of the Ninth Circuit in Estate of Cartwright v. Commissioner. The Eleventh Circuit observed that in setting a purchase price of the entity, a willing arm’s-length buyer would consider the redemption obligation as offsetting the value of the insurance.
SCOTUS Oral Arguments
In the oral arguments before the U.S. Supreme Court, the estate argued that a third-party buyer of the corporation would not benefit from the $3 Million of the insurance proceeds because that amount was owed to Michael’s estate in the required redemption. Therefore, the value of the corporation before and after the redemption was $3.86 Million, excluding the redemption amount, not $6.86 Million.
In contrast, IRS argued that the corporation’s redemption obligation is not a debt that reduces its value, but, rather, reflects a division between two shareholders of a $6.86 Million corporate pie (including the insurance proceeds). The IRS, arguing it is not bound by the shareholders’ undervaluation of closely held shares for purposes of the estate tax, rejected the estate’s assertion that Michael’s 77% interest was worth $3 Million in a redemption, and that Thomas’s 23% interest was worth $3.86 Million after the redemption.
SCOTUS Decision and Analysis
The Court observed that the value of a shareholder’s economic interest is unaffected by a redemption of shares at their fair market value. Whether a shareholder holds shares or cash equal to the fair market value of those shares, the value of each asset is the same. After the redemption, however, the value of the entity is reduced by the assets used to redeem stock.
To illustrate the concept, the Court gave an example of a corporation worth $10 Million, having 100 outstanding shares. The corporation is owned by 20% and 80% shareholders. If the 20% interest is redeemed for $2 Million, the remaining value of the corporation is $8 Million, because the corporation would pay $2 Million of its cash assets to redeem the $2 Million value of the 20% shareholder. Prior to the redemption, each of the 100 shares would be worth $100,000 ($10 Million divided by 100 shares); and after the redemption of 20 shares, each remaining outstanding share would still be worth $100,000 ($8 Million divided by 80 shares). A fair market value redemption does not change the value of the shares immediately before and after the redemption.
Therefore, a hypothetical buyer of Michael’s interest would not expect that Crown’s fair market redemption obligation would reduce the value of Michael’s shares as compared to Thomas’s, but would consider the insurance when valuing Michael’s interest at $5.3 Million of the total value of the corporation, (i.e. 77.18% of $6.86 Million). For estate tax purposes, Michael’s corporate interest is valued on his death, not after the redemption when the insurance assets have been consumed. Thus, the price per share immediately before and after the redemption remains the same.
Commentary on Connelly v. U.S.
The federal estate tax is based on the fair market value of a decedent’s assets upon death. Any agreement obligating a closely-held entity to redeem a shareholder’s interest as of the date of the shareholder’s death must be for fair market value, otherwise the agreement is ignored and the fair market value of the interest at death is determined.
Generally, the per share price of the stock before and after a redemption remains the same if the redemption is at fair market value. If the per share value immediately after a redemption is higher than that immediately before, then the remaining shareholders may have received a windfall. If the per share value immediately after a redemption is less than that immediately before, then the redeeming shareholders may have received a windfall.
What makes this case difficult to understand is the difference between a commercial determination of the fair market value of Crown versus the valuation for estate tax purposes. An arm’s-length sale price of Crown to a third party at book value on Michael’s death would have netted the redemption obligation against the value of the assets, yielding a value of $3.86 Million. However, if Crown were valued at $3.86 Million at the time of a fair market value redemption, then Michael’s estate would have received a little under $3 Million (77.18% of $3.86 Million), and Thomas’s shares would have been worth a little under $1 Million (22.82% of $3.86 Million). The pre- and post- redemption price per share would have remained the same, and the post-redemption value of Crown would have been under $1 Million. However, that analysis does not take into account the insurance asset that the corporation held to provide the liquidity for the redemption, and contradicts the estate’s claim that the value of Crown was $3.86 Million both before and after the redemption. If the value of the corporation was $3.86 both before and after the redemption, then a disproportionate shift of the value of the equity was made to Thomas.
Thus, the Court rejected netting the value of the insurance against the redemption obligation, and took the value of the corporation as $6.86 Million, not $3.86 Million. Because the redemption agreement resulted in the disproportionate transfer of assets to Thomas the Court rejected the agreement, and treated the insurance as an asset for purposes of determining Crown’s value as of the date of Michael’s death.
Planning Considerations
Using corporate-owned life insurance to buy-back stock on the death of a shareholder, therefore, comes at the cost of including the value of that insurance in setting the redemption price of a deceased shareholder.
If the brothers wanted to avoid increasing the value of the corporation by the life insurance proceeds at the time of Michael’s death, the Court stated that they should have had a cross-purchase agreement. With such an agreement, each brother purchases a life insurance policy on the other brother. That way, the value of the life insurance stays out of the corporation altogether, and there is sufficient liquidity for a brother to purchase stock from the decedent’s estate, keeping the corporation in the family. However, the purchase price of the decedent’s shares would still have to be set at fair market value of the entity on the decedent’s date of death for purposes of paying estate tax.
