Connelly v. Internal Revenue Service is a landmark SCOTUS decision that will impact business owners, partners, shareholders, members, and professional practitioners from a business perspective, succession planning, as well as from a personal estate planning point of view.

The core issue of the case focused on the corporate contractual requirement or obligation to redeem shares and how that liability affects (positively or negatively) the valuation of that company from the perspective of federal taxation.

In an unusual 9-0 unanimous decision, the Supreme Court established much clearer insight into the valuation of specific business assets and holdings and their impact on federal estate taxation. If a company is liable to redeem the shares of any partner, member, shareholder, investor, or professional under a “triggering event” (the death of the owner or investor, divorce, bankruptcy, etc.), is that requirement considered a liability that decreases the valuation of that entity? How does the decision in Connelly affect the tax planning, estate planning, and succession planning of business owners nationwide?

Is there a mandatory company buy-back or redemption of specific shares presently backed by life insurance coverage? If so, calling your business and personal tax and estate planning attorney is a prudent priority. It may be necessary to update your individual estate plan and corporate succession plans to ensure proper valuation in the event of a mandatory company share or ownership interest redemption.

In Connelly v. Internal Revenue Service, two brothers (Thomas and Michael Connelly) owned a building and supply company. The brothers shared the intention to protect the company and keep it within the family in the event either brother became incapacitated or lost their life. In this specific case, the first option to purchase the shares in question fell to the surviving brother. If that individual declined to purchase the shares, the business itself had implemented a mandatory redemption requirement.

The business acquired life insurance for each individual for $3 million, and upon Michael’s passing, the company purchased his shares for that value. Michael’s estate filed federal tax returns establishing the valuation of the company at $3.86 million, which did not reflect the impact of the $3 million in insurance proceeds). Michael’s estate owned just over 77% of the company, resulting in a net interest for the estate of $3 million.

The IRS disputed this conclusion, stating the $3 million figure did not include the valuation of the life insurance proceeds, and re-established the valuation at $6,86 million. This resulted in a substantially increased federal income tax than the amount reflected in the original tax return for the estate.

How would a privately held business providing life insurance for its owners be valued for estate tax purposes? Was the amount of the life insurance for the purpose of mandatory share redemption a liability to the business (reducing its valuation) or an asset that increased the company’s valuation?

SCOTUS’ 9-0 decision in the Connelly matter confirmed lower Court decisions that redemption based upon life insurance doesn’t reduce the valuation as a liability and that value must be included in any resulting valuation.

What are your next steps if you own an interest in a privately held business? It is important to immediately consult with your tax and estate planning attorney(s) to determine the impact on your personal and business interests and tax exposures. What is the best strategy to protect your interests if a triggering event occurs, and how should those protections be structured to reduce the impact of state and federal taxation?

Your tax attorney should review existing corporate documents and bylaws, including the operating agreement of an LLC or the shareholder's agreement of a corporate entity. It may be necessary to consult with a business valuation expert to discuss the impact of alternative strategies on the company's valuation.

How is your personal estate plan structured? How is your business ownership interest protected during a significant life event or death? How are the valuations of ownership interests established? Is there a redemption agreement in your business, and is that agreement backed by life insurance? How much time has passed since the current business succession plan was drafted and implemented? Does your privately held company have a business succession plan at all?

Connelly v. Internal Revenue Service represents a major change to many existing estate and succession plans. It is important to contact your tax and estate planning attorney(s) to review existing planning in light of this game-changing decision.