Estate Tax Consequences Of Redeeming Stock With Life Insurance Proceeds

Timothy M. Todd (Liberty; Google Scholar) & Philip Manns (Liberty), Seeing Through the Sleight of Hand: Estate Tax Consequences of Redeeming Stock With Life Insurance Proceeds, 183 Tax Notes Fed. 437 (Apr. 15, 2024): 

The Supreme Court granted certiorari in Connelly v. United States to resolve a circuit court split concerning the federal estate tax valuation of shares in a closely held corporation when that corporation uses life insurance proceeds to satisfy its obligation to redeem the decedent-shareholder’s shares.

We argue that treating the insurance proceeds as suddenly appearing and then quickly disappearing is akin to the magician’s “now you see it, now you don’t” sleight of hand. 

Seeing through this sleight of hand, we advance the literature by explaining that the secret to dispelling this illusion is to properly consider the mortality gain, when it occurs, in the insurance policy. To accomplish this, we argue that life insurance used for liquidity purposes in the buy-sell context operates no differently than any sinking fund funded with corporate cash. Consequently, using that sinking fund analogy, the valuation of the corporate shares for estate tax purposes should include the corporation’s mortality gain, when it occurs. We also show that treating the redemption obligation as a liability does not change the value of the corporation because that liability arises from a transformation of the redeeming shareholder’s residual equity claim into a liability claim on corporate assets.

Conclusion
Buy-sell planning is a critical component of thoughtful business planning. In addition to having a plan in place, a business and its owners must also be able to fund and execute that plan, which requires a funding source. Often that funding source consists of life insurance policies on the lives of the owners. When the shareholder dies and the policy matures, the entity receives an influx of cash. The receipt of that cash does, in fact, result in an enlargement of the corporation equal to the mortality gain realized from the insurance policy — just like the investment gain on a sinking fund. Moreover, treating the redemption obligation as a liability (as an offset) does not make those proceeds vanish; it merely takes the claim from the equity section and places it in the liability section — the value of the corporation remains the same accounting for that adjustment. 

In conclusion, the insurance proceeds do not disappear, as in a magician’s stage illusion, through crafty sleight of hand. We have shown that such an illusion is exactly that — an illusion.