On June 6, 2024 the Supreme Court unanimously ruled that life insurance proceeds should be included in the fair market valuation of a corporation for federal estate tax purposes. In Connelly v. United States, the Supreme Court further concluded that a corporation’s obligation to redeem a deceased shareholder’s interests does not offset the value of such life insurance proceeds. The Connelly decision effectively overturns prior rulings that a corporation’s obligation to redeem shares offsets any increase in value to the corporation from life insurance proceeds. The Connelly decision will have significant impacts on closely held businesses, especially if they plan to keep businesses familial upon the death of an owner.
Case Summary
In Connelly, Michael and Thomas Connelly were the sole shareholders of a closely held corporation. In order to keep the business in the family, the brothers entered into a buy-sell agreement. Pursuant to the buy-sell agreement, if either brother died, the other would have the option to purchase the deceased brother’s shares and if the surviving brother did not exercise their option, the corporation was required to redeem the shares. To account for this cost, the corporation obtained $3.5 million in life insurance proceeds on both brothers. When Michael passed away, Thomas rejected his option to purchase Michael’s shares and the corporation used $3 million of life insurance proceeds to redeem Michael’s shares.
On the estate’s federal tax return, an outside firm determined the fair market value of the corporation was $3.86 million, making Michael’s interest approximately $3 million for estate tax purposes. The outside firm’s valuation did not include the $3 million in life insurance proceeds in the corporation’s fair market valuation. The Internal Revenue Service (IRS) disagreed with the outside firm’s valuation and insisted that the $3 million in life insurance proceeds be included, increasing the fair market valuation of the corporation to $6.86 million. The corporation’s increased fair market value raised the value of Michael’s interests from approximately $3 million to $5.6 million. Based on the IRS’ fair market valuation, the estate owed an additional $889,914 in taxes. Thomas sued on behalf of Michael’s estate and the District Court granted summary judgement in favor of the IRS, with the Eighth Circuit affirming the judgment on appeal. The Supreme Court then granted cert.
The issue in front of the Supreme Court was whether a corporation’s contractual obligation to redeem shares offsets the corporation’s life insurance proceeds. The Supreme Court found that the IRS’ valuation was accurate and that a share redemption at fair market value does not affect the shareholder’s economic interest and does not reduce the value of those shares. Further, the Supreme Court concluded that “redemption obligations are not necessarily liabilities that reduce a corporation’s value for purposes of the federal estate tax.”
Connelly Decision Impacts on Closely Held Businesses
The Connelly decision confirms that the IRS can tax life insurance proceeds as a corporate asset, regardless if the proceeds must be used to redeem corporate shares. The Connelly decision may also affect the size of an estate, influencing whether the estate is taxable or not. Further, the Connelly decision applies to other types of business entities, not just to corporations. The decision also applies to buy-sell agreements between non-related owners.
Next Steps for Businesses
Closely held businesses should consider this decision when planning to ensure a business remains within the family’s control upon a shareholder’s death. There are options to address this and mitigate the valuation and tax implications. For example, businesses can consider alternative agreements for the death of a shareholder, including cross-purchase agreements. Cross-purchase agreements allow a shareholder to buy a deceased shareholder’s shares and exclude the corporation’s involvement. This also serves as a good reminder to review any existing buy-sell agreements with the appropriate counsel, to ensure that the business is set up to manage any potential obligations. By being proactive and seeking appropriate legal, estate, and business counseling, businesses can ensure smooth ownership transitions and maximize value.
