Unanimous Supreme Court Affirms IRS's Position On Life Insurance Proceeds Used To Fund A Stock Redemption

Connelly v. United States, No. 23–146 (June 6, 2024):

Syllabus
Michael and Thomas Connelly were the sole shareholders in Crown C Supply, a small building supply corporation. 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, 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 Internal Revenue Service (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. Because Michael had held a 77.18% 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 disagreed. 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 the United States for a refund. The 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. The Eighth Circuit affirmed.

Held: A corporation’s contractual obligation to redeem shares is not necessarily a liability that reduces a corporation’s value for purposes of the federal estate tax.

When calculating the federal estate tax, the value of a decedent’s shares in a closely held corporation must reflect the corporation’s fair market value. And, life-insurance proceeds payable to a corporation are an asset that increases the corporation’s fair market value. The question here is whether Crown’s contractual obligation to redeem Michael’s shares at fair market value offsets the value of life-insurance proceeds committed to funding that redemption.

The answer is no. Because a fair-market-value redemption has no effect on any shareholder’s economic interest, no hypothetical buyerpurchasing Michael’s shares would have treated Crown’s obligation toredeem Michael’s shares at fair market value 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 earmarkedfor the redemption plus $3.86 million in other assets and income-generating potential. Anyone purchasing Michael’s shares would acquirea 77.18% 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 exchangefor Michael’s shares when Crown redeemed them at fair market value. Crown’s promise to redeem Michael’s shares at fair market value did not reduce the value of those shares.

Thomas’s efforts to resist this straightforward conclusion fail. He views the relevant inquiry as what a buyer would pay for shares thatmake up the same percentage of the less-valuable corporation that exists after the redemption. For calculating the estate tax, however, the whole point is to assess how much Michael’s shares were worth at thetime that he died—before Crown spent $3 million on the redemption payment. See 26 U. S. C. §2033 (defining the gross estate to “include the value of all property to the extent of the interest therein of thedecedent at the time of his death”). A hypothetical buyer would treat the life-insurance proceeds that would be used to redeem Michael’s shares as a net asset.

Thomas’s argument that the redemption obligation was a liability also cannot be reconciled with the basic mechanics of a stock redemption. He argues 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 argues that Crown was worth $3.86 million after Michael’s shares were redeemed. See ReplyBrief 6. Both cannot be right: A corporation that pays out $3 million to redeem shares should be worth less than before the redemption.

Finally, Thomas asserts that affirming the decision below will make succession planning more difficult for closely held corporations. But the result here is simply a consequence of how the Connelly brothers chose to structure their agreement. Pp. 5–9.

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