In a landmark decision, on June 6, 2024, the United States Supreme Court decided Connelly v. United States, No. 23-146, upholding the IRS position on how life insurance proceeds and redemption obligations should be treated for federal estate tax purposes.
Background:
Two brothers were the sole shareholders of a closely held corporation.
In order to ensure the corporation would stay in the family if either brother died, they entered into an agreement that gave the surviving brother the option to purchase the deceased brother’s shares. If he declined, the agreement required the corporation itself to redeem the shares. The corporation also took out an insurance policy on each brother to fund the share redemption obligation.
After one brother died, the surviving brother declined to purchase the shares. The corporation received the life insurance proceeds and redeemed the shares, at an agreed-upon price of $3 million.
The surviving brother then filed a federal tax return as executor for his deceased brother’s estate in which he reported the value of those shares at the $3 million redemption price.
The IRS audited the estate tax return. During the audit, the estate obtained a third-party appraisal that valued the shares at $3 million, with that amount being based on a valuation of the corporation that offset most of the life insurance proceeds with the cost of redeeming the shares. The IRS disagreed and took the view that the corporation’s redemption obligation was not a liability that reduced the value of the shares, and as a result, the IRS valued the corporation (and thereby the shares) at $5.3 million, which increased the amount of estate tax owed by an additional $889,914. The estate paid the tax and then sued for a refund. The District Court agreed with the IRS, and the United States Court of Appeals for the Eighth Circuit affirmed.
The Supreme Court affirmed, holding that the corporation’s contractual obligation to redeem the shares did not diminish the value of those shares for estate tax purposes. The Court explained that because a fair-market-value redemption does not affect any shareholder’s economic interest, no willing buyer purchasing the deceased brother’s shares would have treated the corporation’s redemption obligation as a factor that reduced the value of those shares.
The Supreme Court's decision in Connelly v. United States highlights the critical importance of careful estate planning and the potential tax implications of corporate agreements. In light of the Supreme Court’s ruling, owners of closely held businesses should review and possibly reassess their business succession plans to best ensure that the plan will yield the most tax-efficient results possible.
If you have questions regarding this article or need help with business succession planning, please contact Joshua B. Beisker at 585-258-2879 or jbeisker@underbergkessler.com.