Bulletins

By: Evelyn A. Haralampu, Partner, Burns Levinson LLP

In Connelly v. United States (No. 24-146 U.S., June 6, 2024), the U.S. Supreme Court recently examined the issue of determining the fair market value of a decedent’s shares in a closely-held corporation on the date of his death for purposes of estate taxation. The federal estate tax is based on the fair market value of a decedent’s assets upon death, including any interest in a closely-held business. Any agreement obligating a closely-held entity to redeem a shareholder’s interest as of the shareholder’s death must be for fair market value, otherwise, the IRS can ignore the shareholder agreement and assess estate tax on the shares based on its own determination of fair market value. This is what happened when the IRS revalued Michael Connelly’s interest in a family business and assessed significantly more estate taxes.

Michael and Thomas Connelly were brothers and the sole shareholders of a construction business, Crown. Crown owned insurance on each brother’s life to fund the repurchase of the shares of the first to die. When Michael died, Crown redeemed his 77.18% stock for $3 million, an amount on which Thomas and Michael’s son had agreed was the value of Michael shares, but which was unsupported by any independent appraisal. Michael’s estate paid estate tax on the $3 million valuation. An outside accounting firm subsequently valued Crown as worth $3.86 million on Michael’s death, having offset the redemption obligation by the $3 million of insurance used to redeem Michael’s interest. The accounting firm relied on Estate of Blount v. Commissioner for authority to net the insurance proceeds against Crown’s redemption obligation when valuing shares for estate tax purposes.

Differences in Valuation

What makes this case difficult to understand is the difference between valuing a corporation as a commercial matter and the Court’s method of valuing it for estate tax purposes.

An arm’s-length sale price of Crown to a third party at book value on Michael’s death would have netted the redemption obligation against the value of the assets, yielding a value of the corporation of $3.86 million. However, if Crown were valued at $3.86 million at the time of a fair market value redemption, then, under the Court’s analysis, Michael’s estate would have received a little under $3 million (77.18% of $3.86 Million), and Thomas’s shares would have been worth a little under $1 million (22.82% of $3.86 Million). The pre- and post- redemption price per share would have remained the same, and the post-redemption value of Crown would have been under $1 million. However, that analysis does not take into account the insurance asset that the corporation held to provide the liquidity for the redemption, and contradicts the estate’s claim that the value of Crown was $3.86 million both before and after the redemption, treating the $3 million redemption obligation and $3 million of insurance proceeds as a wash.

In assessing additional taxes, the IRS added the $3 million value of the corporation’s life insurance proceeds to the $3.86 million of other corporate assets and calculated that Michael’s 77.18% share was worth $5.3 million (77.18% of $6.86 million), not $3 million. It took the position that the redemption obligation did not reduce the corporation’s value at the time of Michael’s death.

The Eleventh Circuit Court of Appeals had taken a different approach in Estate of Blount v. Commissioner, 428 F. 3d 1338 (11^th Cir. 2005), a case with similar facts, holding that the corporate obligation to purchase a decedent shareholder’s interest offsets the value of the insurance used to pay for the redemption. The Eleventh Circuit cited a similar analysis of the Nineth Circuit in Estate of Cartwright v. Commissioner, 183 F. 3d 1034  (9^th Cir. 1999).The Eleventh Circuit observed that in setting a purchase price of the entity, a willing arm’s-length buyer would consider the redemption obligation as offsetting the value of the insurance.

The Eighth Circuit Court of Appeals, reviewing Connelly v. U.S. believed, however, that if the value of the corporation was $3.86 both before and after the redemption, then there must have been a disproportionate shift of the value of the corporation to Thomas immediately after the redemption, because his shares would have been worth four times what Michael’s shares were worth at redemption. The U.S. Supreme Court agreed, rejecting the netting of the value of the insurance against the redemption obligation, and took the value of the corporation as $6.86 million, not $3.86 million. 

Generally, the per share price of the stock before and after a redemption remains the same if the redemption is at fair market value, and the business remains the same economically as before the redemption. If the per share value immediately after a redemption is higher than that immediately before, then the remaining shareholders may have received a windfall. If the per share value immediately after a redemption is less than that immediately before, then the redeeming shareholders may have received a windfall. However, the Court noted (in its Footnote 2) that redemptions sometimes decrease a company’s value as when the redemption price requires a sale of the company’s operating assets needed to continue the business. In other words, the Court only rejected the estate’s position that all redemption obligations reduce a corporation’s net value.

Planning Considerations

Using corporate-owned life insurance to buy-back stock on the death of a shareholder, therefore, comes at the cost of including the value of that insurance in setting the redemption price of a deceased shareholder.

If the brothers wanted to avoid increasing the value of the corporation by the life insurance proceeds at the time of Michael’s death, the Court stated that they should have had a cross-purchase agreement. With such an agreement, each brother purchases a life insurance policy on the other brother. That way, the value of the life insurance stays out of the corporation altogether, and there is sufficient liquidity for a brother to purchase stock from the decedent’s estate, keeping the business in the family. However, the purchase price of the decedent’s shares would still have to be set at fair market value of the entity on the decedent’s date of death for purposes of paying estate tax.