Supreme Court: Estate's Value Includes Insurance Proceeds Used to Redeem Shares

(Parker Tax Publishing June 2024)

The Supreme Court affirmed a decision of the Eighth Circuit and held that a closely held corporation's contractual obligation to redeem shares did not reduce the corporation's value for purposes of the federal estate tax. The court found that, because a fair-market-value redemption has no effect on any shareholder's economic interest, no hypothetical buyer purchasing the decedent's shares would have treated the company's redemption obligation as a factor that reduced the value of those shares. Connelly v. U.S., 2024 PTC 196 (S. Ct. 2024).

Background

Michael and Thomas Connelly were the sole shareholders in Crown C Supply, a small but successful building supply corporation in St. Louis, Missouri. Michael owned 77.18 percent of Crown's outstanding shares and Thomas owned the remaining 22.82 percent. The brothers entered into an agreement to ensure that Crown would stay in the family if either brother died. Under that agreement, the surviving brother would have the option to purchase the deceased brother's shares. If he declined, Crown itself would be required to redeem (i.e., purchase) the shares. To ensure that Crown would have enough money to redeem the shares if required, it obtained $3.5 million in life insurance on each brother. After Michael died in 2013, Thomas elected not to purchase Michael's shares, thus triggering Crown's obligation to do so.

Michael's son and Thomas agreed that the value of Michael's shares was $3 million, and Crown paid the same amount to Michael's estate. As the executor of Michael's estate, Thomas then filed a federal tax return for the estate, which reported the value of Michael's shares as $3 million. The IRS audited the return. During the audit, Thomas obtained a valuation from an outside accounting firm. That firm determined that Crown's fair market value at Michael's death was $3.86 million, an amount that excluded the $3 million in insurance proceeds used to redeem Michael's shares on the theory that their value was offset by the redemption obligation. The firm's analyst took as given the holding in Estate of Blount v. Comm'r, 428 F.3d 1338 (11th Cir. 2005), which concluded that insurance proceeds should be "deduct[ed] ... from the value" of a corporation when they are "offset by an obligation to pay those proceeds to the estate in a stock buyout." The analyst thus excluded the $3 million in insurance proceeds used to redeem Michael's shares, and determined that Crown's fair market value at Michael's death was $3.86 million. Because Michael had held a 77.18 percent ownership interest in Crown, the analyst calculated the value of Michael's shares as approximately $3 million ($3.86 million x 0.7718).

The IRS took a different view. It insisted that Crown's redemption obligation did not offset the life-insurance proceeds, and accordingly, assessed Crown's total value as $6.86 million ($3.86 million + $3 million).The IRS then calculated the value of Michael's shares as $5.3 million ($6.86 million x 0.7718). Based on this higher valuation, the IRS determined that the estate owed an additional $889,914 in taxes. The estate paid the deficiency and Thomas, acting as executor, sued for a refund. In Connelly v. U.S., 2021 PTC 302 (E.D. Mo. 2021), a district court granted summary judgment to the government. The court held that, to accurately value Michael's shares, the $3 million in life-insurance proceeds must be counted in Crown's valuation. Thomas appealed, and in Connelly v. U.S., 2023 PTC 154 (8th Cir. 2023), the Eighth Circuit affirmed on the same basis. The estate appealed the Eighth Circuit's decision to the Supreme Court and was granted certiorari.

Before the Supreme Court, Thomas argued that a contractual obligation to redeem shares is a liability that offsets the value of life-insurance proceeds used to fulfill that obligation. He accordingly contended that any purchasing "a subset of the corporation's shares would treat the two as canceling each other out." Thomas further argued that Crown's redemption obligation "would make it impossible" for a hypothetical buyer seeking to purchase 77.18 percent of Crown "to capture the full value of the insurance proceeds." Thomas reasoned that, because the insurance proceeds would leave the company as soon as they arrived to complete the redemption, the buyer would thus not consider the proceeds as net assets. Finally, Thomas asserted that affirming the Eighth Circuit's decision would make succession planning more difficult for closely-held corporations. He argued that if life-insurance proceeds earmarked for a share redemption are a net asset for estate-tax purposes, then "Crown would have needed an insurance policy worth far more than $3 million in order to redeem Michael's shares at fair market value."

Analysis

The Supreme Court affirmed the Eighth Circuit and held that Crown's contractual obligation to redeem Michael's shares did not diminish the value of those shares.

The Court found that an obligation to redeem shares at fair market value does not offset the value of life-insurance proceeds set aside for the redemption because a share redemption at fair market value does not affect any shareholder's economic interest. The Court provided a hypothetical example to prove the point. Consider a corporation with one asset - $10 million in cash - and two shareholders, A and B, who own 80 and 20 shares respectively. Each individual share is worth $100,000 ($10 million 100 shares). Thus, A's shares are worth $8 million (80 shares x $100,000) and B's shares are worth $2 million (20 shares x $100,000). To redeem B's shares at fair market value, the corporation would have to pay B $2 million. After the redemption, A would be the sole shareholder in a corporation worth $8 million and with 80 outstanding shares. A's shares would still be worth $100,000 each ($8 million 80 shares). Economically, the redemption would have no impact on either shareholder. The value of the shareholders' interests after the redemption - A's 80 shares and B's $2 million in cash - would be equal to the value of their respective interests in the corporation before the redemption. Thus, the Court concluded that a corporation's contractual obligation to redeem shares at fair market value does not reduce the value of those shares in and of itself.

The Court reasoned that, because a fair-market-value redemption has no effect on any shareholder's economic interest, no willing buyer purchasing Michael's shares would have treated Crown's redemption obligation as a factor that reduced the value of those shares. At the time of Michael's death, Crown was worth $6.86 million: $3 million in life-insurance proceeds earmarked for the redemption plus $3.86 million in other assets and income-generating potential. According to the Court, anyone purchasing Michael's shares would acquire a 77.18 percent stake in a company worth $6.86 million, along with Crown's obligation to redeem those shares at fair market value. A buyer would therefore pay up to $5.3 million for Michael's shares ($6.86 million x 0.7718) - i.e., the value the buyer could expect to receive in exchange for Michael's shares when Crown redeemed them at fair market value.

The Court rejected Thomas's argument that a hypothetical buyer would not consider the life-insurance proceeds as a net asset because they would leave the company as soon as they arrived to complete the redemption. The Court noted that under Code Sec. 2033 and Reg. Sec. 20.2031-1(b), the value of Michael's gross estate had to be determined by including the value of all property to the extent of his interest therein at the time of his death. A hypothetical buyer thus would, in the Court's view, treat the life-insurance proceeds that would be used to redeem Michael's shares as a net asset. The Court further found that Thomas's view ran contrary to the basic mechanics of stock redemptions. When a shareholder redeems his shares he is essentially "cashing out" his shares, and that transaction necessarily reduces the corporation's total value. Because there are fewer outstanding shares after the redemption, the remaining shareholders are left with a larger proportional ownership interest in the less-valuable company. The Court said that Thomas's understanding would turn this ordinary process upside down. In Thomas's view, Crown's redemption of Michael's shares left Thomas with a larger ownership stake in a company with the same value as before the redemption. Thomas argued that Crown was worth only $3.86 million before the redemption, and thus that Michael's shares were worth approximately $3 million ($3.86 million x 0.7718). But, he also argued that Crown was worth $3.86 million after Michael's shares were redeemed. According to the Court, that cannot be right: A corporation that pays out $3 million to redeem shares should be worth less than before the redemption. Thomas's argument thus could not, in the Court's view, be reconciled with an elementary understanding of a stock redemption.

The Court also disagreed with Thomas's assertion that affirming the Eighth Circuit's decision will make succession planning more difficult. The Court explained that the result in this case was a consequence of how the Connelly brothers chose to structure their agreement and noted that there were other options. For example, the Court said that they could have used a cross-purchase agreement - an arrangement in which shareholders agree to purchase each other's shares at death and purchase life-insurance policies on each other to fund the agreement. Such an agreement would have allowed Thomas to purchase Michael's shares and keep Crown in the family, while avoiding the risk that the insurance proceeds would increase the value of Michael's shares. The drawback to such an agreement, the Court observed, is that it would have required each brother to pay the premiums for the insurance policy on the other brother, creating a risk that one them would be unable to do so. And, the Court noted that it would have had its own tax consequences. By opting to have Crown purchase the life-insurance policies and pay the premiums, the Connelly brothers guaranteed that the policies would remain in force and that the insurance proceeds would be available to fund the redemption. As the Court explained, however, this arrangement also meant that Crown would receive the proceeds and thereby increase the value of Michael's shares.

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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