In a landmark decision, the U.S. Supreme Court’s decision in Connelly v. United States will require closely-held business owners to reconsider their current buy-sell arrangement in order to avoid additional federal estate tax. Now under the Court’s holding in Connelly, for federal estate tax purposes, the value of life insurance proceeds, held by the company, must now be included in the fair market value of the business. This ruling is likely going to result in additional estate tax obligations for family-owned businesses, small business owners, and closely-held business owners and a need to reconsider the appropriate structure for buy-sell arrangements.

Summary of the Court’s Decision

Michael and Thomas Connelly, two brothers, owned Crown C Supply Corporation, a successful closely-held business. Like many family-owned businesses, the brothers had an agreement (stock-redemption agreement) that would allow the remaining brother to buy-out the interest of the deceased brother. In the alternative, if the remaining brother did not purchase the interest, then the company would be required to purchase the interest of the deceased. In order to fund this obligation, the Company obtained life insurance on the lives of each of the brothers for $3.5 million.

Upon Michael’s death, Thomas chose not to exercise his option to purchase his brother’s interest, and therefore, the Company purchased Michael’s interest for $3.0 million. While the agreement, between the brothers, required a third-party appraisal requirement, the estate of the deceased and Thomas determined the value of the company independently. The value of the company was determined to be $3.86 million. However, the value of the company did not include the value of the life insurance proceeds that were received upon the death of Michael Connelly.

Subsequently, the Internal Revenue Service audited the estate tax return of Michael and determined that there was an underpayment of estate tax and assessed additional tax on the estate. The IRS assessed additional liability upon the estate due to a determination that the value of the company should have been $6.86 million instead of the $3.86 million that the company had previously determined. The IRS alleged that the value of the life insurance proceeds should have been included in the value of the business because it was an asset of the business and did not reduce the value of the redeemed interest.

In arguments before the IRS and the Court, the taxpayer argued that the contractual obligation of the company to purchase the interest of Michael should have offset the value of the life insurance proceeds that were used to fulfill that obligation. The taxpayer indicated that the life insurance proceeds should have resulted in a “wash” since those funds were immediately distributed upon the redemption.

Findings of the Court’s Decision

The Court determined that “a corporation’s contractual obligation to redeem shares is not necessarily a liability that reduces a corporation’s value for purposes of the federal estate tax.” This means that when a company holds the obligation to redeem an owner’s interest upon death, the value of the life insurance proceeds must be included in the value of the business at the time of death. The Court reasoned that the interest holder’s economic interest is not impacted by a redemption.

How Does the Court’s Decision Impact Me?

1. Time to Rethink Your Redemption Arrangement

If a company currently has a redemption arrangement between owners they will need to re-evaluate the impact of such an arrangement from an estate tax-planning perspective.

Generally, a redemption arrangement requires the company to maintain a life-insurance policy on the life of an owner. The company pays the premium on the policy and ensures that the policy is sufficient to cover the cost of the redemption. Upon the death of the owner, the company uses the proceeds of the life insurance policy to redeem the interest of the deceased former owner.

However, due to the Supreme Court’s recent ruling, such an arrangement would result in additional taxation to the estate. Closely-held business owners will need to rethink whether a redemption arrangement makes the most economical sense.

2. Make a Plan for Determining Fair Market Value

Under IRS guidelines and various court rulings, fair market value is defined as the price that a willing buyer and a willing seller, knowing all the necessary facts and circumstances and not being compelled to buy, would be willing to pay. While this definition does not provide any practical or helpful information on how to determine fair market value, it does provide important insight to how the government views fair market value.

Under Connelly, the Court highlighted that a willing buyer would not have been willing to over pay for the value of interest. For example, with a valuation of $6.86 million, a willing buyer would likely have been willing to pay $5.3 million for 77.18% ownership interest, while a willing seller would not have been willing to sell the same interest for $3.0 million.

Therefore, it’s important for closely-held business owners to have a reasonably acceptable method for determining the fair market value for the company. This can include the use of a third-party valuator or generally accepted methodology for determining the fair market value of a closely-held business.

3. Cross-Purchase Arrangements Maybe more Useful

Closely-held business owners may consider using a cross-purchase agreements instead of redemption arrangement.

Under a cross-purchase arrangement, the individual owners purchase independent life insurance policies on the life of the other owners. For example, if there are two owners then each owner would acquire a life insurance policy on the other owner. The owners would pay the premiums of the policy but in exchange, they become the beneficiaries upon death.

While such an arrangement increases the individual cost to the owners, it avoids the tax implications imposed by the Court’s decision and potentially results in a step-up in basis arrangement. In addition, in order to reduce the cost to the owners, the company may consider various ways to compensate the owners for these premiums (including through the use of additional compensation, using capital withdrawals, or similar structures).

The Court’s holding in Connelly will have ripple effects on how family-owned and closely-held businesses structure their succession planning.