Anticipation

You may have heard or even read about the U.S. Supreme Court’s recent decision regarding the date of death value[i] of a deceased shareholder’s shares in a closely held corporation that owned a life insurance policy on the decedent’s life, the proceeds of which the corporation used to redeem the decedent’s shares from their estate.[ii]

The significance of the decision for the shareholders of many closely held corporations is belied by the brevity of the Court’s opinion and the relative absence of any “technical” analysis.[iii]

The Court’s opinion was also notable because its conclusion as to the value of the corporation and, thus, of the decedent’s shares, turned on the treatment of what may be described in some contexts as a nonoperating asset – i.e., the life insurance proceeds.[iv]

What’s more, the Court demonstrated the correctness of its decision with a simple mathematical example, which laid bare its significance for the owners of a closely held corporation.

Before delving into the Court’s opinion, it may be helpful if we provided some context and, so, we begin with the basic estate tax valuation concepts that were implicated in the opinion.

Fair Market Value

The value of a property that is includible in a decedent’s gross estate for purposes of the federal estate tax is the property’s fair market value at the time of the decedent’s death.

The fair market value of such a property is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell, and both having reasonable knowledge of relevant facts.[v]

In general, the value of stock in a corporation is the fair market value per share on the date of death.[vi]

Closely Held Corps

The fair market value of a corporation’s stock for which there are neither actual sale prices nor bona fide bid and asked prices is determined by taking into consideration the corporation’s net worth, its prospective earning power and dividend-paying capacity, and other relevant factors.

Some of these “other relevant factors” are: the goodwill of the corporation’s business; the economic outlook in its particular industry; the corporation’s position in the industry and its management; the degree of control of the business represented by the block of stock to be valued; and the values of securities of other corporations that are engaged in the same or similar lines of business and which are listed on a stock exchange. The weight to be accorded such comparisons or any other evidentiary factors considered in the determination of a value depends upon the facts of each case.[vii]

Nonoperating Assets and Liabilities

In addition to the factors described above, consideration is also given to a corporation’s nonoperating assets and liabilities. This may include excess cash or working capital beyond the operational needs of the business; it may also include real estate. Corporate-owned life insurance that is maintained for the buyout of a shareholder’s stock should also fall into this category.

Such nonoperating assets are not taken into account in the determination of the corporation’s going concern value.[viii] Thus, their value, the income they generate, and their associated expenses should not be considered for this purpose.[ix]

That said, these nonoperating assets are still assets of the corporation, and their value must somehow be accounted for in establishing the fair market value of the corporation.

“Extrinsic” Factors

In addition to the foregoing “intrinsic” factors, one may also consider an option or a contract to purchase the shares owned by a decedent at the time of their death. The effect, if any, that is given to the price set forth in such an option or contract in determining the value of a decedent’s shares in a corporation for estate tax purposes will depend upon the circumstances of the particular case.

For example, little weight will be accorded a price contained in an option or contract under which a surviving shareholder may purchase whatever shares of stock the decedent may own at the time of their death if the decedent was free to dispose of the shares at any price they chose during their lifetime – such agreements do not establish the market for the shares. Even if the decedent were not free to dispose of the underlying stock at other than the option or contract price, such price is disregarded in determining the value of the stock unless it is determined under the circumstances of the particular case that the agreement represents a bona fide business arrangement.[x]

Liquidity

Regardless of how the fair market value of a deceased shareholder’s shares of stock in a corporation is determined, the fact remains that the decedent’s estate – if the decedent’s beneficiaries will continue to own such shares – may be hard-pressed to generate sufficient liquidity with which to pay the estate taxes attributable to the shares.

To address this economic need, a shareholder of a closely held corporation will often establish an irrevocable trust that acquires a life insurance policy on the life of the shareholder. Upon the shareholder’s death, the trust will collect the insurance proceeds and then use them to purchase the decedent’s shares from the decedent’s estate.

In this case – which is basically a purchase and sale between the trust and the estate – the insurance proceeds replace the value of the stock in the hands of the estate. The estate ends up with enough cash to satisfy its estate tax liability, while the trust agreement provides for the disposition of the acquired shares in accordance with the decedent’s wishes. No economic value is added to the estate.

Buyout

Where the shareholders have agreed amongst themselves that no member of a deceased shareholder’s family should be permitted to retain ownership of the decedent’s shares,[xi] the surviving shareholders have to determine whether they, the corporation, or some combination thereof, will purchase the decedent’s shares.

They also have to decide how to fund the purchase of those shares.

Once again, life insurance on the life of a shareholder may provide the corporation or the surviving shareholders, as the case may be, with the wherewithal to acquire the decedent’s shares without unduly burdening the corporation’s business or their personal finances.

Estate Tax and Life Insurance

Before you conclude, on the basis of the foregoing, that life insurance is some sort of panacea for the shareholders of a closely held corporation, it would behoove you to have at least a passing acquaintance with some of the estate tax considerations arising from the ownership of a life insurance policy on the life of a shareholder.

The Code provides rules for the inclusion in a decedent’s gross estate of the proceeds of insurance[xii] on the decedent’s life that are either (i) receivable by or for the benefit of the estate, or (ii) receivable by other beneficiaries.[xiii]

Payable to the Estate

The Code requires the inclusion in a decedent’s gross estate of the proceeds of life insurance on the decedent’s life that are receivable by the executor or payable to the decedent’s estate.

It makes no difference whether or not the decedent’s estate is named as the beneficiary under the terms of the policy. For example, if under the terms of a life insurance policy the proceeds are receivable by another beneficiary but are subject to an obligation, legally binding upon such other beneficiary, to pay taxes, debts, or other charges enforceable against the insured decedent’s estate, then the amount of such proceeds required for the payment in full (to the extent of the beneficiary’s obligation) of such taxes, debts, or other charges is includable in the decedent’s gross estate for purposes of the estate tax.

Incidents of Ownership

The Code also requires the inclusion in the decedent’s gross estate of the proceeds of insurance on the decedent’s life that are not receivable by or for the benefit of their estate if the decedent possessed at the date of their death any of the incidents of ownership in the policy, exercisable either alone or in conjunction with any other person.

If the decedent did not possess any incidents of ownership at the time of death, no part of the life insurance proceeds would be includible in their gross estate.

The term “incidents of ownership” is not limited in its meaning to ownership of the policy in the technical or legal sense. Generally speaking, the term refers to the right of the insured or their estate to the economic benefits of the policy. Thus, it includes example, the power to change the beneficiary, to surrender or cancel the policy, to assign the policy, to revoke an assignment, to pledge the policy for a loan, or to obtain from the insurer a loan against the surrender value of the policy, et.

A decedent is considered to have an “incident of ownership” in an insurance policy on their life held in trust[xiv] if, under the terms of the policy, the decedent (either alone or in conjunction with another person or persons) has the power (as trustee or otherwise) to change the beneficial ownership in the policy or its proceeds, or the time or manner of enjoyment thereof, even though the decedent has no beneficial interest in the trust.[xv]

Corporate-Owned Policy[xvi]

If the economic benefits of a life insurance policy on a decedent’s life are reserved to a corporation of which the decedent is the sole or controlling shareholder, the corporation’s incidents of ownership in the policy will not be attributed to the decedent through their stock ownership to the extent the proceeds of the policy are payable to the corporation; consequently, the proceeds so payable are not includible in the decedent’s gross estate.

Any proceeds of a corporate-owned policy payable to a third party for a valid business purpose, such as in satisfaction of a business debt of the corporation, so that the net worth of the corporation is increased by the amount of such proceeds, is deemed to be payable to the corporation. Thus, no incidents of ownership will be attributed to the decedent and the proceeds themselves will not be included in the decedent’s gross estate.

Notwithstanding the foregoing exclusion from the gross estate, the insurance proceeds to or for the benefit of the corporation may still be considered in determining the fair market value of the corporation and of the decedent’s shares.[xvii]

Not Payable to the Corp

If any part of the proceeds of the policy are not payable to or for the benefit of the corporation, and thus are not taken into account in valuing the decedent’s stock holdings in the corporation, any incidents of ownership held by the corporation as to that part of the proceeds will be attributed to the decedent through their stock ownership where the decedent is the sole or controlling shareholder.

A decedent will not be deemed to be the controlling stockholder of a corporation unless, at the time of their death, they owned stock possessing more than 50 percent of the total combined voting power of the corporation.[xviii]

Thus, if the decedent is the controlling shareholder in a corporation, and the corporation owns a life insurance policy on their life, the proceeds of which are payable to the decedent’s spouse, the incidents of ownership held by the corporation will be attributed to the decedent through their stock ownership and the proceeds will be included in their gross estate independently of the shares owned by the decedent at the time of their death.[xix]

If the policy proceeds had, instead, been payable 40 percent to decedent’s spouse and 60 percent to the corporation, only 40 percent of the proceeds would be included in decedent’s gross estate,[xx] while 60 percent may be considered in the valuation of the corporation.

If the insured shareholder did not control the corporation, the incidents of ownership held by the corporation would not be attributed to the decedent and their estate, but may still be considered in the valuation of the corporation.

With the foregoing rules as reference, let’s turn to the Court’s treatment of the life insurance proceeds that were payable to a corporation, on the death of its controlling shareholder, to fund the redemption of the decedent’s shares.

The Matter Before the Court

Bro-1 owned 77.18 percent (385.9 out of 500 shares) and Bro-2 owned the remaining 22.82 percent (114.1 shares) of Corp’s issued and outstanding shares of stock.

The two brothers and Corp entered into an agreement to ensure a smooth transition of ownership, and keep Corp in the family, in the event one of the brothers died. The agreement provided that if either brother died, the surviving brother would have the option to purchase the deceased brother’s shares. If the surviving brother declined to do so, then Corp itself would be contractually required to redeem the shares.

The agreement specified that the redemption price for each share of held by a deceased brother would be based upon an outside appraisal of Corp’s fair market value.

To ensure that Corp would have enough money to redeem the shares if required, Corp obtained $3.5 million in life insurance on each brother.

Buyout

After Bro-1 died, Bro-2 was appointed the executor of Bro-1’s estate.

In his individual capacity, Bro-2 opted not to purchase Bro-1’s shares of Corp. As a result, Corp became obligated to redeem B-1’s shares from Bro-1’s estate.

However, instead of securing an outside appraisal of Corp’s fair market value (as the agreement contemplated), Bro-2 and Bro-1’s son (“Son”) agreed that the value of Bro-1’s shares was $3 million. Corp then used $3 million of the $3.5 million of life-insurance proceeds paid to Corp to redeem Bro-1’s shares, leaving Bro-2 as Corp’s sole shareholder.

As the executor of Bro-1’s estate, Bro-2 filed a federal estate tax return on which Bro-1’s shares of Corp stock were reported with a date of death value of $3 million, in accordance with the agreement between Son and Bro-2.

The IRS audited the return.

Audit

During the audit, Bro-2 obtained a valuation of Corp from an accounting firm, which concluded that life insurance proceeds should be deducted from the value of a corporation when they are “offset by an obligation to pay those proceeds to the estate [of a deceased shareholder] in a stock buyout.” The firm concluded that Corp’s fair market value at Bro-1’s death was $3.86 million. In arriving at this value, the firm excluded the $3 million in insurance proceeds that Corp used to redeem B-1’s shares. Because Bro-1 held a 77.18% ownership interest, the firm calculated the value of Bro-1’s shares as approximately $3 million ($3.86 million x 0.7718).

The IRS disagreed, insisting that Corp’s redemption obligation did not offset the life-insurance proceeds paid to Corp as a result of Bro-1’s death. The IRS counted the $3 million in life-insurance proceeds in determining the value of Corp,[xxi] and concluded that Corp’s fair market value as of Bro-1’s date of death was $6.86 million: the $3.86 million determined by the accounting firm[xxii] plus the $3 million of insurance proceeds paid by Corp to Bro-1’s estate.

On the basis of the foregoing, the IRS calculated the value of Bro-1’s shares as $5.3 million; i.e., $6.86 million x 0.7718. Because of this higher valuation, the IRS determined that the estate owed additional estate tax.

Refund Claim

Bro-1’s estate paid the asserted tax deficiency[xxiii] and filed a refund claim to recover the additional tax paid, which the IRS denied. Bro-2, acting as executor, subsequently sued the U.S. for a refund, arguing that the $3 million in life-insurance proceeds used to redeem Bro-1’s shares should not have been counted when calculating the value of those shares.

The District Court[xxiv] granted summary judgment to the government, concluding that Bro-1’s estate was not entitled to a refund because the $3 million in life-insurance proceeds must be counted to accurately value Bro-1’s shares. It explained that, under “customary valuation principles,” Corp’s obligation to redeem Bro-1’s shares was not a liability that offset the life-insurance proceeds and reduced the corporation’s fair market value.

Cert Granted

The Court of Appeals[xxv] affirmed the lower court’s opinion on the same basis.

The Supreme Court granted certiorari[xxvi] to address whether life-insurance proceeds that will be used to redeem a deceased shareholder’s shares must be included when calculating the value of those shares for purposes of determining the decedent’s federal estate tax.

The Court’s Opinion[xxvii]

When calculating a decedent’s federal estate tax, the Court began, the value of the decedent’s shares in a closely held corporation must reflect the corporation’s fair market value. Any life-insurance proceeds payable to the corporation upon the decedent’s death, the Court continued, are an asset that increases the corporation’s fair market value.

The only issue in the present matter, the Court stated, was whether Corp’s contractual obligation to redeem Bro-1’s shares at fair market value offset the value of the life-insurance proceeds committed to funding that redemption.

Corp Liability?

Bro-2 argued that a contractual obligation to redeem shares is a liability that offsets the value of life-insurance proceeds used to fulfill that obligation. He contended that anyone purchasing “a subset of the corporation’s shares would treat the two as canceling each other out.”

By contrast, the government argued that Corp’s obligation to pay for Bro-1’s shares did not reduce the value of those shares. The government asserted that “no real-world buyer or seller would have viewed the redemption obligation as an offsetting liability.”

A Simple Example

An obligation to redeem shares at fair market value, the Court stated, 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 illustrated this point with the following, deceptively simple, example:

• Corporation’s only asset is $10 million in cash
• It has two shareholders, A and B, who own 80 and 20 shares respectively.
• Each individual share is worth $100,000 ($10 million ÷ 100 shares).
• Thus, A’s shares are worth $8 million (80 shares x $100,000) and B’s shares are worth $2 million (20 shares x $100,000).
• To redeem B’s shares at fair market value, the corporation would thus have to pay B $2 million.
• After the redemption, A would be the sole shareholder in a corporation worth $8 million and with 80 outstanding shares.
• A’s shares would still be worth $100,000 each ($8 million ÷ 80 shares).
• Economically, the redemption would have no impact on either shareholder.
• The value of the shareholders’ interests after the redemption—A’s 80 shares and B’s $2 million in cash—would be equal to the value of their respective interests in the corporation before the redemption.
• Thus, a corporation’s contractual obligation to redeem shares at fair market value does not reduce the value of those shares in and of itself.

Because a fair-market-value redemption has no effect, the Court continued, on any shareholder’s economic interest, no willing buyer purchasing Bro-1’s shares would have treated Corp’s obligation to redeem Bro-1’s shares at fair market value as a factor that reduced the value of those shares.

At the time of Bro-1’s death, Corp was worth $6.86 million—$3 million in life-insurance proceeds earmarked for the redemption[xxviii] plus $3.86 million in other assets and income-generating potential. Anyone purchasing Bro-1’s shares, the Court stated, would acquire a 77.18 percent stake in a company worth $6.86 million, along with Corp’s obligation to redeem those shares at fair market value. A buyer would therefore pay up to $5.3 million for Bro-1’s shares ($6.86 million x 0.7718) – i.e., the value the buyer could expect to receive in exchange for Bro-1’s shares when Corp redeemed them at fair market value.

Thus, the Court concluded that Corp’s promise to redeem Bro-1’s shares at fair market value did not reduce the value of those shares.

No Dominion Over the Proceeds

Bro-2, the Court stated, resisted “this straightforward conclusion” and suggested that Corp’s redemption obligation “would make it impossible” for a hypothetical buyer seeking to purchase 77.18 percent of Corp “to capture the full value of the insurance proceeds.” That is so, according to Bro-2, because the insurance proceeds would leave the company as soon as they arrived to complete the redemption. Bro-2 argued that the “buyer would thus not consider proceeds that would be used for redemption as net assets.” According to the Court, Bro-2 viewed the relevant inquiry as what a buyer would pay for shares that made up the same percentage of the corporation that existed after the redemption; i.e., after the decedent’s shares had been redeemed.

The Court, however, explained that, for purposes of calculating the estate tax, the “whole point” is to assess how much Bro-1’s shares were worth at the time that he died,[xxix] before Corp spent $3 million on the redemption payment. A hypothetical buyer would, therefore, treat the life-insurance proceeds that would be used to redeem Bro-1’s shares as a net asset.

“Cashing Out”

Moreover, the Court continued, Bro-2’s argument that the redemption obligation was a liability could not be reconciled with the basic mechanics of a stock redemption. The Court explained that when a shareholder redeems their shares, they are “essentially ‘cashing out’” their shares of ownership in the corporation and its assets. The redemption necessarily reduces a corporation’s total value and, because there are fewer outstanding shares after the redemption, the remaining shareholders are left with a larger proportional ownership interest in the less-valuable corporation.

In Bro-2’s view, however, Corp’s redemption of Bro-1’s shares left Bro-2 with a larger ownership stake in a corporation with the same value as before the redemption. Bro-2 argued that Corp was worth only $3.86 million before the redemption, and thus that Bro-1’s shares were worth approximately $3 million ($3.86 million x 0.7718). But Bro-2 also argued that Corp was worth $3.86 million after Bro-1’s shares were redeemed. According to the Court, that could not be right: A corporation that pays out $3 million to redeem shares should be worth less than before the redemption.

A Wrench in the Works?

Finally, Bro-2 asserted that affirming the decision below would make succession planning more difficult for closely held corporations. Bro-2 reasoned that if life-insurance proceeds earmarked for a share redemption were treated as a net asset for estate-tax purposes, then Corp “would have needed an insurance policy worth far more than $3 million in order to redeem [Bro-1′]s shares at fair market value.”

Although the Court agreed with this statement, it explained that the outcome was “simply a consequence of how the [brothers] chose to structure their agreement.” The Court stated that the two brothers could have used a cross-purchase agreement, in which shareholders agree to purchase each other’s shares at death and purchase life-insurance policies on each other to fund the agreement. A cross-purchase agreement would have allowed Bro-2 to purchase Bro-1’s shares and keep Corp in the family, while avoiding the risk that the insurance proceeds would increase the value of Bro-1’s shares because the proceeds would have gone directly to Bro-2, not to Corp.[xxx]

Decision

The Court held that Corp’s contractual obligation to redeem Bro-1’s shares did not diminish the value of those shares. Because redemption obligations are not necessarily liabilities that reduce a corporation’s value for purposes of the federal estate tax, the Court affirmed the judgment of the Court of Appeals.

However, the Court also cautioned that it was not holding that a redemption obligation could never decrease a corporation’s value. A redemption obligation could, for instance, require a corporation to liquidate operating assets to pay for the shares, thereby decreasing its future earning capacity.[xxxi]

In the present matter, the Court stated, it simply rejected Bro-2’s position that all redemption obligations reduce a corporation’s net value.

Observations and Questions

The shareholders of most closely held corporations have to consider the possibility that one of them may die while still owning shares of stock in the corporation.

In most circumstances involving a non-family-owned business, the surviving shareholders will want to remove the deceased shareholder’s successors (family members) from the business,[xxxii] and those successors will want to be bought out.[xxxiii]

Estate’s Liquidity and Value of Corp

From the estate’s perspective, it will be important to generate liquidity with which to pay the estate taxes attributable to the inclusion of the decedent’s shares in their gross estate,[xxxiv] especially if the corporation represents the most valuable asset in the estate.[xxxv]

The beneficiaries of the estate will want to receive a fair price for the shares.

From the perspective of the corporation and the surviving shareholders, the buyout must be structured in a way that does not impose an unduly burdensome economic cost on the corporation’s business.[xxxvi]

In each case, the amount payable by the corporation to the estate in exchange for the decedent’s shares should be equal to the date of death fair market value of those shares.[xxxvii]

The challenge of reconciling these various interests will depend, in no small part, upon the means by which the buyout is funded.[xxxviii]

Available Cash

If the corporation has plenty of excess cash,[xxxix] it may be able to redeem the decedent’s shares without difficulty, though the aggregate value of the corporation’s assets – as distinguished from its value as a going concern – will be reduced by the removal of such cash.

Sale of Disposable Asset

If the corporation had a valuable and dispensable nonoperating asset, it may be able to sell such asset to generate the liquidity needed to fund the buyout. Of course, the sale may also generate an unwelcomed corporate-level income tax liability. The aggregate value of the corporation’s assets – as distinguished from its value as a going concern – will be reduced by the removal of such cash.

Loan

Assuming there is nothing to prevent the corporation from doing so, it may borrow the necessary funds from a commercial lender. In that case, the value of the loan proceeds received are offset by the corporation’s obligation to repay the loan, with interest.

The value of the corporation’s business does not change. Its business and other assets remain intact; it does not lose the use of its funds; it does not incur a tax liability. Of course, when the loan proceeds are distributed to the decedent’s estate in exchange for all of its shares, the corporation remains liable for the repayment of the loan plus interest, meaning it will have to divert resources that would otherwise be reinvested in the business or distributed to the shareholders.[xl]

Insurance

But is there another alternative by which the estate of a deceased shareholder may be bought out without reducing the value of the corporation? Stated differently, is there a way to replace the value that the corporation will lose on the redemption of the decedent?

Two words: “Life insurance.”[xli]

As in the case described above, a corporation may acquire life insurance on the lives of one or more of its shareholders. The receipt of the insurance proceeds would not be taxable to the corporation,[xlii] and would provide the corporation with a dedicated sum of cash to be applied toward the redemption of a deceased shareholder’s shares without reducing the value of the corporation, except to the extent of the premiums paid on the policy,[xliii] which will have effectively been borne indirectly but proportionally by each shareholder.

This beneficial outcome for all the parties involved was the source of the dispute addressed by the Court, above. But was the Court’s approach the correct one?

The Regs[xliv]

As we saw earlier, according to the IRS’s regulations, where the economic benefits of a life insurance policy on the decedent’s life are reserved to a corporation of which the decedent was the controlling shareholder (as in the present case),[xlv] the corporation’s incidents of ownership will not be attributed to the decedent through their stock ownership to the extent the proceeds of the policy are payable to the corporation.[xlvi]

However, the regulations also indicate that the insurance proceeds payable to the corporation should be considered in valuing the corporation to the extent they have not been taken into account in determining the corporation’s net worth, prospective earning power and dividend-earning capacity.[xlvii]

Query whether this regulation is an appropriate interpretation of the “hypothetical buyer-hypothetical seller” valuation standard. In most transactions involving the purchase and sale of all the stock of a corporation, the buyer does not want acquire or pay for certain unwanted assets owned by the corporation. Thus, the buyer will require the selling shareholders to remove the corporation’s excess cash and other unwanted (nonoperating) assets prior to the stock transaction.[xlviii]

Incidents

If any part of the proceeds of the policy are not payable to or for the benefit of the corporation, and thus are not taken into account in valuing the corporation and, thereby, the decedent’s stock holdings, any incidents of ownership held by the corporation as to that part of the proceeds will be attributed to the decedent through their stock ownership where the decedent is the controlling shareholder and their share of the proceeds will be included in the decedent’s gross estate as a separate asset, without regard to the value of the corporation.

What Do Shareholders Intend?

When shareholders contemplate the eventual buyout of their respective shares following their deaths, they do not look to life insurance as a means of increasing the value of their shares but as a way of facilitating the buyout of those shares.

Indeed, a shareholder expects their shares to be redeemed for the same amount they would have received on the sale of the corporation to a third party buyer immediately prior to the shareholder’s death.

Likewise, the surviving shareholders view the life insurance as a means of funding the buyout. They may also see it as a way of avoiding adverse economic consequences for the business of the corporation.[xlix]

In other words, the life insurance proceeds are specifically tied to the corporation’s obligation to redeem the insured shareholder’s stock upon their death– in a sense, like “collateral.” Under this analysis, wouldn’t it make sense that the proceeds are offset by the corporation’s obligation?

Still, one may ask about any “windfall” that may be enjoyed by the surviving shareholders.[l] Is it appropriate, as the Court stated in Connelly, to treat the insurance proceeds paid to the corporation as a corporate asset for purposes of determining the fair market value purchase price for the decedent’s shares, and thereby eliminate the windfall by shifting value to the decedent’s estate?

Alternatively, if the decedent’s purchase price was determined by a fair market appraisal that did not consider the insurance proceeds, how would we account for the “extra” value that remains in the corporation? Would it be appropriate to treat it as a constructive dividend to the remaining shareholders? After all, their percentage interest and the value of their shares increased. Think along the lines of a disproportionate distribution that results in some shareholders receiving cash while others increase their proportionate interest in the corporation.[li]

The Court’s decision in Connelly may not be[lii] the final word on the use of corporate-owned life insurance to redeem a decedent’s shares.

The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.

[i] For purposes of the federal estate tax.

[ii] Connelly v. U.S., 602 U.S. ___ (2024).

[iii] As valuation decisions go.

[iv] That, plus the fact the Court’s opinion was unanimous.

[v] Reg. Sec. 20.2031-1(b). All relevant facts and elements of value as of the date of death must be considered.

[vi] Reg. Sec. 20.2031-2(a).

[vii] Reg. Sec. 20.2031-2(f).

[viii] Reg. Sec. 20.2031-2(f). They are not accounted for in determining prospective earning power, and dividend-earning capacity.

[ix] Those of us in the transactional world encounter non-essential (often personal) expenses paid or incurred by a closely held business (club dues, car expenses, travel, etc.), which a buyer will “add back” to ascertain the actual profits and value of the business.

[x] Reg. Sec. 20.2031-2(h). See also IRC Sec. 2703. For example, the agreement must not be a device to pass the decedent’s shares to the natural objects of the decedent’s bounty for less than an adequate and full consideration in money or money’s worth.

[xi] At least when no such member has been active in the business in some executive or other managerial capacity.

[xii] The amount to be included in the gross estate is the full amount receivable under the policy.

[xiii] IRC Sec. 2042. Proceeds of life insurance which are not includable in the gross estate under IRC Sec. 2042 may, depending upon the facts of the particular case, be includable under some other provision of the Code.

[xiv] An irrevocable life insurance trust, or ILIT.

[xv] Moreover, assuming the decedent created the trust, such a power may result in the inclusion in the decedent’s gross estate under section 2036 or 2038 of other property transferred by the decedent to the trust if, for example, the decedent has the power to surrender the insurance policy and if the income otherwise used to pay premiums on the policy would become currently payable to a beneficiary of the trust in the event that the policy were surrendered.

[xvi] Different rules apply to life insurance owned by a partnership on the life of a partner.

When a partnership owns a life insurance policy on a partner’s life and the proceeds are payable other than to or for the benefit of the partnership, the insured partner possesses incidents of ownership in the policy in conjunction with the other partners, so that the value of the proceeds is includible in the insured partner’s gross estate. Rev. Rul. 83-147.

[xvii] See Reg. Sec. 20.2031-2(f) for a rule providing that the proceeds of certain life insurance policies shall be considered in determining the value of the decedent’s stock.

As we’ll soon see, this is the Court’s position in Connelly.

[xviii] For example, a decedent shall be considered to be the owner of only the stock with respect to which legal title was held, at the time of their death, by the decedent (or their agent or nominee).

[xix] Under IRC Sec. 2042.

[xx] Under IRC Sec. 2042.

[xxi] Query why it did not include the entire $3.5 million paid to Corp under the policy.

[xxii] Yes, the IRS seems to have accepted the estate’s valuation of the business, presumably as a going concern.

[xxiii] Which, among other things, would have stopped the accrual of interest on the deficiency.

[xxiv] ED Mo. 2021.

[xxv] The Eighth Circuit

[xxvi] 601 U.S. ––––, 144 S.Ct. 536, 217 L.Ed.2d 285 (2023).

[xxvii] Connelly v. U.S., 602 U.S. ___ (2024).

[xxviii] What about the other $500,000 paid under the policy?

[xxix] IRC Sec. 2033 (defining the gross estate to “include the value of all property to the extent of the interest therein of the decedent at the time of his death”); Reg. Sec. 20.2031–1(b) (the “value of every item of property includible in a decedent’s gross estate … is its fair market value at the time of the decedent’s death”.

[xxx] The Court conceded that every arrangement has its own drawbacks. A cross-purchase agreement would have required each brother to pay the premiums for the insurance policy on the other brother, creating a risk that one of them would be unable to do so. And, it would have had its own tax consequences. By opting to have Corp purchase the life-insurance policies and pay the premiums, the brothers guaranteed that the policies would remain in force and that the insurance proceeds would be available to fund the redemption. As we have explained, however, this arrangement also meant that Corp would receive the proceeds and thereby increase the value of Bro-1’s shares.

[xxxi] And perhaps generating a corporate income tax liability.

[xxxii] Few are willing to become business “partners” with people they have not worked with over many years.

[xxxiii] Especially if they have no history with the business.

[xxxiv] Ignore for purposes of this post the ability to pay the estate tax in installments over 15 years pursuant to IRC Sec. 6166 and the ability to be redeemed by the corporation over that same period without being treated as having received a dividend, as provided by IRC Sec. 303.

[xxxv] There’s a reason the shares of a closely held corporation are valued with a discount based upon their non-marketability.

[xxxvi] If the estate were willing to wait for payment – unlikely – the court could redeem its shares in exchange for a promissory note payable, with interest, over a term of years.

[xxxvii] How many times have you encountered a buyout that differs significantly from the value determined by the IRS on audit? Not a good place to be.

[xxxviii] Our focus is on the redemption of the decedent’s shares by the corporation. In most closely held business, the ability to fund a buyout will depend upon the cash flow of the business – indeed, even in the case of a cross-purchase, the shareholders will be relying upon the corporation’s making funds available to them. In the case of a passthrough entity, this outflow of cash from the business may eliminate the basis increase afforded by a cross-purchase.

[xxxix] For example, working capital beyond the reasonable needs of the business.

[xl] The aggregate value of the corporation’s assets – as distinguished from its value as a going concern – will be reduced by the removal of such cash.

[xli] Yep, I’m sort of channeling the well-known scene in The Graduate in which the McGuire character gives Dustin Hoffman’s character (Ben) “one word” of advice: “plastics.”

[xlii] IRC Sec. 101.

[xliii] Because the corporation would be the owner and beneficiary under the policy, the premiums would not be deductible. IRC Sec. 264.

[xliv] Reg. Sec. 20.2042-1(c)(6).

[xlv] What if the deceased shareholder was not the controlling shareholder? It appears that the corporation’s incidents of ownership will not be attributed to the decedent regardless of how the policy proceeds are used, though the proceeds will be considered in determining the value of the corporation.

[xlvi] Any proceeds payable to a third party for a valid business purpose, such as in satisfaction of a business debt of the corporation, so that the net worth of the corporation is increased by the amount of such proceeds, is deemed payable to the corporation for these purposes.

[xlvii] Reg. Sec. 20.2031-2(f).

[xlviii] Even though these unwanted assets will likely find their way into the hands of the selling shareholders prior to the sale, there will be an income tax cost associated with their disposition, whether on the sale of such assets or on their distribution to the shareholders. The point though is that a hypothetical buyer will not pay for these assets.

[xlix] Such as a funding mechanism that depresses the value of the corporation. After all, the same operating assets, the same goodwill and going concern that existed before the death of the deceased shareholder remain immediately after that death. How can they suddenly be worth less?

[l] See the example provided buy the Court, earlier.

[li] IRC Sec. 305(b)(2).

[lii] Should not be.