On June 6, 2024, the U.S. Supreme Court issued a unanimous decision in Connelly v. United States affecting the valuation of closely held businesses for estate tax purposes. The Court explained that, for purposes of federal estate taxes, when a corporation is obligated to redeem an owner’s shares at death, a corporation’s value is not necessarily reduced by that obligation. The Court’s decision affects succession planning for many owners of closely held businesses. However, as discussed below, there are alternative structuring methods that could allow small business owners to obtain the same benefits.

The Valuation of Crown C Supply

Like many closely held business owners, brothers Michael and Thomas Connelly had entered into various agreements to ensure that their business, Crown C Supply (Crown), would remain within the family upon either of their deaths, including an agreement with Crown, pursuant to which Crown could become obligated to redeem a deceased brother’s shares. To ensure adequate financing for the redemption obligations, Crown purchased $3.5 million in life insurance on each brother.

When Michael died, Thomas filed a tax return that reported the value of Michael’s shares as $3 million, which was supported by the holding of Estate of Blount v. Commission, 428 F. 3d 1338 (CA11 2005). However, the IRS insisted, and the Court agreed, that the value of Michael’s shares needed to reflect the value of Crown’s life insurance policy on Michael without offsetting that asset by Crown’s obligation to use those proceeds to redeem Michael’s shares, which subjected Michael’s estate to an additional almost $900,000 tax liability.

In holding that the value of the Crown shares was not reduced by the redemption liability, the Supreme Court left open the possibility that a redemption agreement could, in some cases, have an impact on the estate tax value of a company.

Planning Considerations for Closely Held Businesses

After Connelly, the increase in estate tax value of a company due to life insurance is unlikely to be completely offset by the company’s redemption obligation. Failing to plan for this possible higher valuation can lead to unhappy surprises:

• A redemption agreement that establishes a value of the company that excludes life insurance can create a phantom tax: if an estate tax applies, the estate will have to report and pay estate tax on company shares based on a higher value than the amount of cash that the family received for those same shares.
• On the other hand, a redemption agreement that establishes a value of the company tied to estate tax value or includes insurance proceeds can create business liquidity problems. The business could have to pay the deceased owner’s estate more than anticipated and perhaps more than the available insurance.

Alternative structures may avoid these potential problems. Possible alternatives include, but are not limited to, cross-purchase agreements between owners, under which the obligation to buy is held by other owners in the business and not directly by the company.

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Business owners are encouraged to review their business succession plans to consider the impact of an estate tax valuation determination like the one in Connelly.