• June 10, 2024

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A longstanding dispute between the Estate of Michael Connelly and the Internal Revenue Service was finally resolved by the Supreme Court on June 6, 2024 in a rare valuation case requiring a decision from the highest court in the land.

The dispute centered on the fair market value of the estate’s 77% equity interest in a corporation that operated a building supply business. Two brothers owned the business, Thomas and Michael Connelly. The brothers entered into a buy-sell agreement years ago that gave the surviving brother the option to purchase the deceased brother’s shares. If the surviving brother declined to do so, which occurred here, then the company was required to redeem the stock of the estate of the first brother to die, with the purchase price being fair market value pursuant to an independent appraisal. For funding purposes, the company purchased life insurance policies on each of the two brothers.

By the time the case reached the Supreme Court, it was clear that the proceeds of the life insurance policy on the deceased brother was to be included as a corporate asset for estate tax valuation purposes. This is required pursuant to 26 CFR § 20.2031-2(f)(2), which states that when determining fair market value of closely held stock, consideration shall also be given to nonoperating assets, including proceeds of life insurance policies payable to or for the benefit of the company, to the extent such nonoperating assets have not been taken into account in the determination of net worth, prospective earning power and dividend-earning capacity.

Given clarity on this matter and other issues having been stipulated, the only issue to be resolved was whether the corporation’s requirement under the buy-sell agreement to redeem the Estate’s stock was a corporate liability/debt. Does such obligation offset the value of life-insurance proceeds committed to funding that redemption? The Estate argued that the contractual requirement to redeem stock was akin to debt and should offset the life insurance proceeds for purposes of valuing the stock for estate tax purposes. The government disagreed.

The Supreme Court agreed with the government and affirmed the prior rulings of the Circuit Court and the Tax Court. The Supreme Court held that because a redemption at fair market value has no effect on any shareholder’s economic interest, no hypothetical buyer purchasing the Estate’s shares would have treated the company’s obligation to redeem such shares at fair market value as a factor that reduced the value of those shares. The Court ran through various scenarios illustrating that doing anything different would create irreconcilable discrepancies, including valuing the deceased brother’s shares at a lower per share amount than the surviving brother’s shares, which is precisely in contrast to the fairness sought in the buy-sell agreement. Unlike bank debt, which clearly reduces corporate net worth, a redemption transaction at fair market value effectively divides value between redeeming and non-redeeming owners rather than reduces it in the aggregate. The economic interests, whether reflected in shares or cash, of redeeming and non-redeeming shareholders should have the same value before and after the redemption, an outcome aligned with the government’s position.

Clients with similar situations should take note of this decision and how corporate-owned life insurance impacts valuation for estate tax purposes. While is it common for ownership groups to use corporate-owned life insurance to fund potential obligations under buy-sell agreements, the estate tax implications may be misunderstood and alternative arrangements, including cross-purchase agreements or setting up a LLC to hold the life insurance, ought to be considered. A copy of the Court’s decision can be found at www.supremecourt.gov/opinions/23pdf/23-146_i42j.pdf.