Keeping it in the family just got more complicated. Our Tax Group studies a Supreme Court decision that left a family with an unexpected estate tax liability related to a share redemption agreement.

• The company took out life insurance policies to secure sufficient funds for redemption of the shares
• The Court ruled that the proceeds from the policy were includable in the estate and not a liability that reduced the company’s value
• Taxpayers should reassess their current arrangements to protect against similar circumstances

A recent Supreme Court case, Connelly v. United States, is expected to have an immediate impact for many taxpayers. In a unanimous decision written by Justice Clarence Thomas, the Court determined that a corporation’s obligation to redeem a deceased shareholder’s shares was not, without more, a liability that reduced the corporation’s value for purposes of the federal estate tax. This decision will add complexity to some commonly used succession planning structures that are designed to ensure closely held businesses are able to remain within the same family or ownership group and will impact whether and to what extent the owners of such businesses are subject to the estate tax.

Connelly concerned a building supply company taxable as a Subchapter C corporation that was owned by two brothers, Michael and Thomas Connelly. Michael held 77.18% of the company’s shares and Thomas held the remaining 22.82%. Michael and Thomas desired to keep the company in their family when either of them died. To do so, they entered into a relatively common contractual arrangement sometimes referred to as a “share redemption agreement.” The agreement provided that if either brother died, the surviving brother had an option to purchase the other’s shares.

The Eighth Circuit decision in the case indicates the brothers never intended to exercise these options. If the surviving brother did not purchase the shares, the company would be obligated to redeem the shares. The company then took out a life insurance policy on each brother to ensure there would be sufficient cash to exercise a redemption. The contract provided two methods for determining the purchase or redemption price of the shares. First, the brothers were to execute a “certificate of agreed value” at the end of every tax year that would set the purchase or redemption price in the event of death during the following year. Second, the brothers could obtain two or more appraisals of the fair market value of the company by averaging their results or obtaining a third appraisal as a tie breaker.

The contractual arrangement came into effect when Michael passed away. Thomas decided not to purchase Michael’s shares directly. Instead, the corporation collected life insurance proceeds under the policy it had taken out on Michael and redeemed his shares. The brothers had not executed any certificates of agreed value setting the price at which the redemption was to occur. Further, Thomas and Michael’s estate did not obtain any appraisals of the company. Instead, they reached a mutual agreement on the valuation. When valuing Michael’s shares, the estate did not include the value of the life insurance proceeds used in the redemption.

The issue before the Supreme Court was whether those proceeds should have been included in the value of Michael’s shares or whether they should be netted against a partially offsetting obligation requiring the company to redeem Michael’s shares. The Supreme Court sought to issue a narrow ruling and held that the life insurance proceeds were includable in the estate and the corporation’s obligation to redeem shares was not, under these circumstances, a liability that reduced its value for purposes of the federal estate tax.

The Supreme Court pointed to 26 C.F.R. Section 20.2031-2(f)(2) as requiring the inclusion of life insurance proceeds payable to a company in evaluating that company’s fair market value for estate tax purposes. The Supreme Court’s analysis of the redemption obligation was based primarily on an examination of what a hypothetical third-party buyer would pay for Michael’s shares at the time that he died. The Supreme Court viewed the timing of this analysis as required by 26 U.S.C. Section 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.” The Supreme Court acknowledges that its decision may make estate planning more difficult and indicates that taxpayers using share redemption agreements will be required to take out much larger insurance policies to redeem a deceased owner at fair market value, but suggests other options such as cross-purchase agreements are available.

The brothers in Connelly v. United States could have structured their agreement as a cross-purchase agreement. Under a cross-purchase agreement, the brothers would have had an obligation rather than an option to purchase one another’s shares when one of them died. Instead of the company taking out life insurance policies on each brother, the brothers would have taken out policies on one another. Cross-purchase agreements are a commonly used estate planning technique and avoid the issue of including life insurance proceeds in share value.

However, they are not without drawbacks or complexity. For instance, if a company has more than two shareholders, the number of insurance policies and required purchase mechanics can become much more complex. This complexity may be navigated using mechanisms such as life insurance pooling trusts, partnership agreements, stock holding trusts, and others. Another potential issue that may not be as easily addressed is that cross-purchase agreements require each shareholder to pay their respective premiums. This introduces some uncertainty to contracts that are intended to assure continuity because shareholders cannot predict or guarantee the financial future of their co-owners even when close family is involved.

Connelly also highlights the importance of taking certain safeguards when preparing estate planning arrangements. The Eighth Circuit decision being appealed in Connelly dealt with two issues. First, the Eighth Circuit determined the brothers’ agreement did not control how their shares should be valued. The Eighth Circuit then looked to the fair market value of the shares. Because only the fair market value was at issue in the Supreme Court, the Court was not required to closely examine 26 U.S.C. Section 2703(b), which provides an exception to the general rule that contractual restrictions are ignored in valuing property for estate and gift tax purposes. An option, agreement, right, or restriction is only given such effect if:

• It is a bona fide business arrangement.
• It is not a device to transfer such property to members of the decedent’s family for less than full and adequate consideration in money or money’s worth.
• Its terms are comparable to similar arrangements entered into by persons in an arm’s-length transaction.

The Eighth Circuit found that the Connellys’ agreement was defective in this regard because it did not set any fixed or determinable price that could be used in valuing the shares and was not binding throughout life and death. In other words, because the Connellys chose to ignore the valuation mechanisms in their own agreement and were free to dispose their shares at different prices while alive, their contractual arrangement was effectively irrelevant in determining the value of the shares for estate tax purposes. While the terms of 26 U.S.C. Section 2703(b) may be overly restrictive in some scenarios, crafting and respecting agreements that meet those terms adds certainty to the use of cross-purchase agreements and may allow for the use of share redemption agreements in certain circumstances.

The decision in Connelly v. United States will have important ramifications. The Connelly brothers were concerned with keeping a successful business in their family. Their arrangements to address these concerns ultimately led to an unexpected estate tax liability. These concerns will be familiar to many taxpayers. For taxpayers who have not planned for these circumstances, the case should serve as an important reminder of the high stakes involved. For those who have, the case may require a reassessment of whether their current arrangements adequately achieve their goals.

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