Value of Taxable Estate Includes Insurance Proceeds Used to Redeem Shares

(Parker Tax Publishing October 2021)

A district court held 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 district court declined to follow the holding in Estate of Blount v. Comm'r, 428 F.3d 1338 (11th Cir. 2005), where the Eleventh Circuit concluded, in a case with similar facts, 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., 2021 PTC 302 (E.D. Mo. 2021).

Background

Brothers Michael and Thomas Connelly were the only shareholders in Crown C Supply, Inc., a closely held family business that sold roofing and siding materials in the St. Louis area. Before his death, Michael was the President, CEO, and majority shareholder. The Connelly brothers together owned all of Crown C's 500 shares, with Michael owning 385.90 shares (77.18 percent) and Thomas owning 114.10 shares (22.82 percent).

In 2001, the Connelly brothers and Crown C signed a stock purchase agreement intended to maintain family ownership and control over the company and to satisfy their estate-planning objectives. The agreement provided that upon one brother's death, the surviving brother had the right to buy the decedent's shares, but Crown C itself was required to redeem the deceased brother's shares if the surviving brother chose not to buy such shares. When the brothers signed the stock agreement, they always intended that Crown C, not the surviving brother, would redeem the deceased brother's shares. To fund its redemption obligation, Crown C bought $3.5 million in life insurance policies on both Connelly brothers. Upon Michael's death on October 1, 2013, Crown C received $3.5 million in life insurance proceeds and used the proceeds to buy Michael's shares from his estate. Crown C and the estate did not obtain appraisals for the value of Michael's shares under the stock agreement. Instead, they entered into a sale and purchase agreement for the price of $3 million.

Thomas, as executor of Michael's estate, filed an estate tax return valuing Michael's Crown C shares at $3 million as of October 1, 2013, and included that amount in the taxable estate. The IRS audited the estate, challenging the $3 million value of Michael's Crown C shares and assessing a $1 million estate tax deficiency. The IRS determined that the fair market value of the Crown C shares should have included the $3 million in life insurance proceeds used to redeem the shares, resulting in a higher value for Michael's Crown C shares than the amount reported on the estate's return. The estate paid the $1 million deficiency and filed suit in a district court seeking a refund.

Under Code Sec. 2001, an estate tax is levied on a decedent's taxable estate if the estate's value exceeds a certain amount. Code Sec. 2031(a) provides that the value of the taxable estate is the fair market value of the decedent's property at the date of death. Generally, under Code Sec. 2703(a), the fair market value of property for estate tax purposes is determined without regard to a buy-sell agreement unless the agreement meets the requirements provided in Code Sec. 2703(b). Under Code Sec. 2703(b), a buy-sell agreement determines the value of a decedent's property if: (1) it is a bona fide business arrangement; (2) it is not a device to transfer property to members of the decedent's family for less than full and adequate consideration in money or money's worth; and (3) its terms are comparable to similar arrangements entered into by persons in an arm's length transaction.

In Estate of Blount v. Comm'r, T.C. Memo. 2004-116, a case with facts similar to this one, the Tax Court held that life insurance proceeds used to redeem shares of a family-owned business had to be included in the value of the company and the shareholders' shares. However, the Eleventh Circuit (428 F.3d 1338 (11th Cir. 2005)) reversed, reasoning that the stock purchase agreement created a contractual liability for the company, offsetting the life-insurance proceeds. The Eleventh Circuit reasoned that inclusion of insurance proceeds in the valuation of corporate stock when the proceeds are used for a redemption obligation was precluded by Reg. Sec. 20.2031-2(f)(2), which provides a list of relevant factors to be considered in determining the fair market value of a closely-held company. The regulation states that, in addition to the listed factors, consideration must also be given to nonoperating assets, including proceeds of life insurance policies payable to the company, "to the extent such nonoperating assets have not been taken into account in the determination of net worth." In Estate of Blount, the Eleventh Circuit determined that under Reg. Sec. 20.2031-2(f)(2), the presence of an offsetting liability means that the life insurance proceeds have already been "taken into account" in determining the company's net worth. The Eleventh Circuit also relied heavily on the Ninth Circuit's ruling in U.S. v. Estate of Cartwright, 183 F.3d 1034 (9th Cir. 1999), which excluded insurance proceeds from the fair market value of a company when the proceeds were offset by an obligation to pay the proceeds to a shareholder's estate.

Michael's estate argued that the stock agreement determined the value of Crown C for estate tax purposes under Code Sec. 2703(b). Alternatively, it contended that under the Eleventh Circuit's holding in Estate of Blount, Crown C's fair market value did not include the $3 million of the life insurance proceeds because the stock agreement created an offsetting $3 million obligation for Crown C to redeem Michael's shares. The IRS argued in a motion for summary judgment that the stock agreement failed to meet the requirements under Code Sec. 2703(b) and therefore did not control the valuation of the shares. The IRS further asserted that the life insurance proceeds increased Crown C's fair market value by $3 million under customary valuation principles. The IRS urged the court to reject the Eleventh Circuit's holding in Estate of Blount and instead apply the Tax Court's reasoning. Allowing the redemption obligation to offset the insurance proceeds, the IRS contended, would undervalue Crown C and violate well-established equity valuation principles because the resultant share price would create a windfall for a potential buyer that a willing seller would not accept.

Analysis

The district court granted summary judgment for the IRS and held that the $3 million in life insurance proceeds used to redeem Michael's shares had to be included in the fair market value of Crown C and of Michael's shares. The court found that the stock purchase agreement failed to meet the requirements in Code Sec. 2703(b). In the court's view, the $3 million redemption price was not full and adequate consideration for the shares because the insurance proceeds had to be included in Crown C's fair market value, and including the proceeds increased the value of Crown C and the shares. The court also found that the stock agreement was not comparable to similar agreements negotiated at arm's length given that the $3 million price was below fair market value. In the court's view, the lack of a control premium or a minority discount resulted in an undervalued majority intertest for Michael's shares.

Next, the court determined the fair market value of Crown C under the willing-buyer-willing-seller test. The court disagreed with the estate's assertion that a willing buyer would pay less for Crown C to account for the company's future decrease in assets when fulfilling the contractual obligation to purchase Michael's stock. The court noted that under Reg. Sec. 20.2031-2(f))(2), life insurance proceeds are considered nonoperating assets that generally increase the value of a company, and the question was whether Crown C's redemption obligation was a liability that offset the proceeds for valuation purposes. The court determined that a redemption obligation does not reduce the value of a company as a whole or the value of the shares being redeemed because, as the Tax Court observed in Estate of Blount, a redemption obligation is not a value-depressing corporate liability when the very shares that are the subject of the redemption obligation are being valued. A willing buyer purchasing Crown C on the date of Michael's death, the court found, would not demand a reduced purchase price because of the redemption obligation since the company's value was the same with or without it. Thus, excluding the insurance proceeds from Crown C's value would impermissibly treat Michael's shares as both outstanding and redeemed at the same time, reducing Crown C's value by the redemption price of the very shares whose value is at issue.

According to the district court, the Eleventh Circuit's holding in Estate of Blount notwithstanding, the text of Reg. Sec. 20.2031-2(f)(2) does not indicate that the presence of an offsetting liability means that the life insurance proceeds have already been "taken into account" in the determination of a company's net worth. In the court's view, the regulation by its plain terms means that the proceeds should be considered in the same manner as any other nonoperating asset in the calculation of the fair market value of a company's stock. The court also disagreed with the Eleventh Circuit's reliance on Estate of Cartwright. The court said that decision was distinguishable because most of the corporate liabilities in that case which offset the insurance proceeds were not obligations to redeem the company's own stock but were instead compensation for services.

Finding the Tax Court's reasoning in Estate of Blount persuasive, the court explained that a redemption obligation is not an ordinary corporate liability. The court noted that because a stock redemption involves a change in the ownership structure of the company, the redemption obligation does not change the value of the company as a whole before the shares are redeemed. Nor can a redemption obligation diminish the value of the same shares being redeemed, according to the court, since the shareholder is essentially cashing out his share of ownership in the company and its assets. Moreover, the court said that a stock redemption results in the company (and more specifically its remaining shareholder(s)) getting something of equal value for the cash spent, i.e. the decedent's share of ownership in the company. The exchange thus increases the ownership interest for each of the company's outstanding shares, including the surviving shareholders' shares. For these reasons, the court found the Eleventh Circuit's opinion in Estate of Blount was erroneous and rejected it.

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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