Supreme Court Unanimously Rules in Favor of the IRS in Connelly

In a decision released on June 6, 2024, the Supreme Court held that a contractual obligation to redeem shares is not necessarily a liability that reduces the corporation’s value for purposes of the federal estate tax. The decision was 9-0, with Justice Thomas delivering the opinion of the Court. 

Background of Connelly vs. United States

The Connellys, Thomas and Michael, were the sole shareholders in a closely held corporation. Michael owned approximately 75% of the shares of the corporation, with Thomas owning the remaining shares. The brothers had a buy-sell agreement, which gave each brother the right to purchase the other brother’s shares upon their death. The corporation had a contractual obligation to redeem either brother’s shares at fair market value upon his death if the surviving brother did not buy the shares. The agreement specified that the redemption price would be based on an appraisal of the corporation’s fair market value. In order to cover the cost of redeeming shares, the corporation held life insurance policies on the brothers to cover the potential costs of redeeming shares. 

When Michael died in 2013, Thomas did not purchase his shares, triggering the corporation’s obligation to redeem the shares using most of the proceeds from a $3.5 million life insurance policy on Michael. The estate valued the company at slightly under $4 million, and Michael’s shares at $3 million, for purposes of the federal estate tax. No independent appraisal of the corporation’s fair market value was done. The IRS adjusted the estate tax return to include the value of the life insurance proceeds in the overall valuation of the company, increasing the value of the company to just under $7 million and Michael’s shares to approximately $5.3 million. Thomas argued the corporation’s contractual obligation to redeem Michael’s shares was a liability that offset the value of the life insurance proceeds.

Reasoning of the Decision

The issue before the Court was whether life-insurance proceeds earmarked to redeem a decedent’s shares of a closely held corporation must be included in the corporation’s valuation for purposes of the federal estate tax. The Court concluded in a short opinion that the life insurance proceeds in this situation must be included. In its reasoning, the Court focused on the fact that a redemption of shares at fair market value would not reduce the value of the shares or a shareholder’s economic interest. Additionally, the Court reasoned that a “hypothetical buyer” would consider the life insurance proceeds to be a net asset overall.  Ultimately, the opinion states a contractual obligation to redeem shares is “not necessarily a liability that reduces a corporation's value” for federal estate tax purposes.

Implications of the Decision

Use of buy-sell agreements is not uncommon in business succession planning for closely held companies. In 2005, the Eleventh Circuit Court of Appeals held in Blount v. Commissioner that the proceeds of life insurance policies owned by a corporation were offset by the corporation’s obligation to redeem the decedent’s shares. For nearly two decades, many taxpayers have relied on that ruling when structuring these types of agreements. In light of this decision, business owners may wish to revisit existing agreements to avoid falling into the same trap as the Connellys. 

Additionally, they may wish to look into other ways to use life insurance policies to purchase shares upon the death of a partner or shareholder that do not require the corporation to hold the insurance policy. The opinion itself mentions the use of cross-purchase agreements as a potential alternative to the agreement such as the one used by the Connellys.
 
Finally, this case will have implications for even those business owners who do not have a taxable estate. The inclusion of life insurance proceeds in the valuation of the corporation will result in a larger step-up in basis for the estate, equal to the fair market value reflecting the proceeds. At the same time, the receipt of a lower, contractually-agreed-upon value for the redemption of the shares could generate a capital loss for the estate.
 
The decision in Connelly highlights the intricacies of estate and tax planning, especially with a closely held corporation. One small detail being overlooked or misunderstood can result in the unwinding of an entire estate plan. By engaging trusted professionals for business, tax, and estate planning, an individual can build a business succession plan that also minimizes tax liabilities.