Eight Circuit: Value of Taxable Estate Includes Insurance Proceeds Used to Redeem Shares

(Parker Tax Publishing June 2023)

The Eighth Circuit affirmed a district court holding that the value of a closely held company's stock included in a decedent's estate had to be increased by the amount of insurance proceeds the company received in order to fund the redemption of the decedent's shares pursuant to a stock purchase agreement. The Eighth Circuit rejected the reasoning of Estate of Blount v. Comm'r, 428 F.3d 1338 (11th Cir. 2005), a case with similar facts where the Eleventh Circuit concluded that insurance proceeds should not be included in an estate when valuing the decedent's stock in a family-owned business for estate tax purposes. Connelly v. U.S., 2023 PTC 154 (8th Cir. 2023).

Background

Brothers Michael and Thomas Connelly were the sole shareholders of Crown C corporation, a building-materials company in St. Louis. Michael owned 77.18 percent of the 500 shares outstanding (385.9 shares); Thomas owned 22.82 percent (114.1 shares). To provide for a smooth transition of ownership upon either's death, the brothers and Crown together entered into a stock purchase agreement. If one brother died, the surviving brother had the right to buy his shares. If the surviving brother declined, Crown itself had to redeem the shares. In this way, control of the company would stay within the family. The brothers always intended that Crown, not the surviving brother, would redeem the other's shares.

The stock purchase agreement provided two mechanisms for determining the price at which Crown would redeem the shares. The principal mechanism required the brothers to execute a new Certificate of Agreed Value at the end of every tax year, which set the price per share by "mutual agreement." If they failed to do so, the brothers were supposed to obtain two or more appraisals of fair market value. The brothers never executed a Certificate of Agreed Value or obtained appraisals as required by the stock-purchase agreement. To fund the redemption according to the stock purchase agreement, Crown purchased $3.5 million of life insurance on each brother.

After Michael died in 2013, Crown received the life insurance proceeds and redeemed his shares for $3 million. The actual redemption transaction was part of a larger, post-death agreement between Thomas and Michael's son, Michael Connelly, Jr., resolving several estate-administration matters. No appraisals were obtained. Instead, the Connellys declared that they had resolved the issue by mutual agreement and agreed that the value of the Michael's stock was $3 million.

Thomas is the executor for Michael's estate. In 2014, the estate filed a tax return reporting that Michael's shares were worth $3 million. To value the shares, Thomas relied solely on the redemption payment, rather than treating the life insurance proceeds as an asset that increased the corporation's value and hence the value of Michael's shares. All told, this resulted in an estate tax of about $300,000, which was paid.

The IRS audited the estate's return. It concluded that the estate had undervalued Michael's shares by simply relying on the $3 million redemption payment instead of determining the fair market value of Crown, which should include the value of the life insurance proceeds. Taking the proceeds into account, the IRS determined that Crown was worth $3 million more than the estate had determined -- about $6.86 million. As a result, the IRS sent a notice of deficiency to the estate for $1 million in additional tax liability. The estate paid the deficiency and sued for a refund in a district court.

Under Code Sec. 2703(a), the value of any property for tax purposes is generally determined without regard to any option, agreement, or other right to acquire the property at a price less than the fair market value, or to any other restriction on the right to sell or use such property. Under Code Sec. 2703(b), to affect valuation, such an agreement must (1) be a bona fide business arrangement, (2) not be a device to transfer property to members of the decedent's family for less than full and adequate consideration, and (3) have terms that are comparable to other similar arrangements entered into in arm's length transactions. Reg. Sec. 20.2031-2(h), the regulation the clarifies how to value stock subject to a buy-sell agreement, refers to the "price" in such agreements and "the effect, if any, that is given to the price in determining the value of the securities for estate tax purposes." The regulation also states that "little weight will be accorded a price" in an agreement where the decedent was "free to dispose of" the securities at any price during his lifetime. Courts thus recognize that an agreement must contain a fixed or determinable price if it is to be considered for valuation purposes.

Code Sec. 2031(b) provides that for closely-held corporations, the share value is determined by taking into consideration, in addition to all other factors, the value of stock or securities of corporations engaged in the same or a similar line of business which are listed on an exchange (i.e., the fair market value analysis). Under customary valuation principles, the fair market value of a company depends on its net worth, prospective earning power, capacity to pay dividends, and other relevant factors like the good will of the business, and the economic outlook in the particular industry. But in valuing a closely-held company, Reg. Sec. 20.2031-2(f)(2) provides that, in valuing a closely held corporation, consideration must also be given to nonoperating assets, "including proceeds of life insurance policies payable to or for the benefit of the company."

In Estate of Blount, the Eleventh Circuit also considered whether life insurance proceeds used to redeem stock under a stock-purchase agreement for a closely held corporation should be included in the fair market value of the company. The Eleventh Circuit referenced the requirement in Reg. Sec. 20.2031-2(f)(2) that proceeds be "taken into account," but concluded that the life insurance proceeds had been accounted for by the redemption obligation, which a willing buyer would consider. The court viewed the life insurance proceeds as an "asset" directly offset by the "liability" to redeem shares, yielding zero effect on the company's value.

The estate claimed that the redemption transaction, made in furtherance of the stock purchase agreement, determined the value of Crown for estate tax purposes, so there was no need to conduct a fair market value analysis. Alternatively, the estate argued that Crown's fair market value should not include the life insurance proceeds used to redeem Michael's shares because, although the proceeds were an asset, they were immediately offset by a liability - the redemption obligation. In other words, the proceeds added nothing to Crown's value. By contrast, the IRS argued that the stock purchase agreement should be disregarded and that any calculation of Crown's fair market value must account for the proceeds used for redemption.

In Connelly v. U.S., 2021 PTC 302 (E.D. Mn. 2021), the district court granted summary judgment to the IRS. The court first concluded that the stock purchase agreement did not affect the valuation. The court then determined that a proper valuation of Crown must include the life insurance proceeds used for redemption. In doing so, the district court declined to follow Estate of Blount v. Commissioner, 428 F.3d 1338 (11th Cir. 2005), relying instead on the Code, regulations, and customary valuation principles. The estate appealed to the Eighth Circuit.

Analysis

The Eighth Circuit affirmed the district court's grant of summary judgment to the IRS. The court found that the stock purchase agreement should be disregarded and that a fair-market-value analysis of Crown had to include the life insurance proceeds used for the redemption.

In the view of the Eighth Circuit, the stock purchase agreement lacked a fixed or determinable price to which the court could look in valuing Michael's shares. The court found that the agreement merely laid out two mechanisms by which the brothers might agree on a price: by mutual agreement or using an appraisal process. Even though this second mechanism seemed to carry more objectivity, the court said that there was nothing in the agreement, aside from minor limitations on valuation factors, that fixed or prescribed a formula or measure for determining the price that the appraisers would reach. Thus, the court found that neither mechanism constituted a fixed or determinable price for valuation purposes. The court did not think the $3 million that Crown actually paid for Michael's shares constituted a fixed price. For one, the court pointed out that the $3 million price was chose after Michael's death. Second, the court said that the $3 million price came not from the mechanisms in the stock purchase agreement but rather from an amicable agreement between Thomas and Michael.

Next, the court determined that in determining the fair market value of Crown, the life insurance proceeds had to be accounted for as an asset that increased shareholders' equity. In the court's view, the Eleventh's Circuit's decision in Estate of Blount rested on a flawed premise. An obligation to redeem shares, the court said, is not a liability in the ordinary business sense. The court reasoned that in order for a willing buyer at the time of Michael's death to own Crown outright, the buyer would control the life insurance proceeds and therefore would pay up to $6.86 million for Crown, "taking into account" the life insurance proceeds and then either extinguishing the agreement or redeeming the shares. On the flip side, a hypothetical willing seller of Crown would not accept $3.86 million knowing that the company was about to receive $3 million in life insurance proceeds.

According to the court, the illogic of the estate's position was demonstrated by considering the windfall to Thomas. If the court valued Crown without taking into account the life insurance proceeds intended for redemption, then upon Michael's death each share was worth $7,720 before redemption. After redemption, Michael's interest is extinguished, but Thomas still has 114.1 shares giving him full control of Crown's $3.86 million value. Those shares are now worth about $33,800 each. Overnight and without any material change to the company, Thomas's shares would have quadrupled in value. The court noted that this result contradicted the estate's position that the proceeds were offset dollar-by-dollar by a "liability" - an offset would leave the value of Thomas's shares undisturbed. The court concluded that the brother's arrangement had nothing to do with corporate liabilities. The proceeds were, in the court's view, simply an asset that increased shareholders' equity, and a fair market value of Michael's shares had to account for that reality.

For a discussion of valuing closely held stock, see Parker Tax ¶225,410.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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