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Supreme Court to consider whether life insurance should be included in the taxable value of estate
December 2023
In brief
What happened?
The US Supreme Court on December 13 agreed to review Connelly v. United States (No. 21-3683), a US Court of Appeals for the Eighth Circuit decision, which held that life insurance proceeds must be included as an asset of a corporation when determining the equity value of a decedent’s shares for estate tax purposes.
Why is it relevant?
The Eighth Circuit's decision in Connelly created a split between the circuits, as the Eleventh Circuit in Blount held that life insurance proceeds paid pursuant to an obligation to redeem shares do not increase the value of the company’s stock.
Actions to consider:
Business owners with similar stock-purchase agreements will want to see how the Supreme Court rules in resolving the split between the Eighth and Eleventh Circuits and how this may affect their intended business succession plans.
In detail
Background
Brothers Michael and Thomas Connelly were the sole shareholders of Crown C Corporation. To keep control of Crown within the family upon their deaths, the brothers and Crown entered into a stock-purchase agreement. If the shares were not redeemed by the surviving brother, then Crown would be obligated to redeem the shares. Pursuant to this agreement, Crown obtained a life-insurance policy on each brother so that it could use the proceeds from the policy to fund any future stock redemption.
In 2013, Michael (the majority shareholder, owning 77.18% of the company) died. Upon his death, Crown received life insurance proceeds of $3.5 million. Of this amount, $3 million was used to redeem Michael’s shares and the remaining $500,000 was applied to fund company operations. The $3 million redemption price paid for Michael’s shares effectively valued Crown in its entirety at $3.89 million (based on Michael’s 77.18% ownership).
As the executor of Michael’s estate, Thomas valued Michael’s shares at $3 million for federal estate tax purposes. This value was consistent with the redemption price paid by Crown to redeem Michael’s shares (in accordance with the “post-death agreement” between the Connellys). Notably, Thomas did not treat the life-insurance proceeds received by Crown upon Michael’s death as an asset of the corporation, which would have increased the equity value of the shares.
The IRS audited Michael’s estate tax return and concluded that the estate had undervalued his shares of Crown. According to the IRS, the $3 million redemption price paid by Crown to redeem Michael’s shares was not indicative of the corporation’s true fair market value. Specifically, the IRS argued that Crown was worth approximately $6.86 million (roughly $3 million more than the $3.89 million value reported by the estate) because the $3 million life-insurance proceeds were an asset of the corporation that increased its net worth. As a result, the IRS sent a notice of deficiency to the estate for $1 million in additional tax liability. Michael’s estate paid the deficiency and sued for a refund.
NOTE: In Estate of Blount v. Commissioner (428 F.3d 1338 (2005)), the Eleventh Circuit Court of Appeals determined that the proceeds of a life insurance policy owned by a corporation did not increase the value of the company’s stock because the proceeds were offset by the corporation’s obligation to redeem the decedent’s shares. Using the willing buyer-willing seller argument, the court believed that a “reasonably competent business person” would not ignore the outstanding liability stemming from the obligation to redeem the decedent’s shares. In other words, the asset created by the life insurance proceeds was directly offset by a corresponding liability to redeem shares, which in aggregate produced no impact on the company’s value
Eighth Circuit decision
In contrast to the ruling in Blount, the court held that the life insurance proceeds received by Crown must be taken into account when determining the company’s value at the time of Michael’s death, even though the proceeds were used to redeem his shares. Referencing the willing-buyer, willing-seller argument, the court reasoned that a prospective buyer would pay up to $6.86 million for Crown’s stock, inclusive of the $3 million life-insurance proceeds. Conversely, a willing-seller would not accept $3.86 million for the stock knowing that the company was due to receive $3 million in life insurance proceeds, “even if those proceeds were intended to redeem a portion of the seller’s own shares.”
The court also specifically rejected the holding in Blount that life insurance proceeds do not increase a company’s value when they are offset by a corresponding liability (i.e., the obligation to redeem shares). According to the court, the obligation to redeem shares “is not a liability in the ordinary business sense.” Thus, relying on the language of Regulation 20.2031-2(f)(2), the court ultimately determined that the life insurance proceeds were an asset that increased shareholder’s equity, and must be included in the value of the company.
The Supreme Court’s decision to accept review of this decision may resolve the current split between Eighth and Eleventh Circuits as to whether life insurance proceeds paid pursuant to an obligation to redeem shares should increase the value of a company’s stock.
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