Todd: While Tax World Waits For Moore, Supreme Court Decides Important Connelly Estate Tax Case

TaxProf Blog op-ed:  While Tax World Waits For Moore, Supreme Court Decides Important Connelly Estate Tax Case, by Timothy M. Todd (Interim Dean, Liberty; Google Scholar):

Although the eyes of the tax world have been focused on the pending decision in Moore v. United States—a case that challenges the one-time “mandatory repatriation tax,” and depending on the contours of the decision could upend (or cement, depending on whom you ask) critical tax norms—the Supreme Court issued another tax decision this term that has important and weighty practical implications for countless closely held businesses and those who advise them.

In Connelly v. United States, the Supreme Court was called upon to resolve a circuit split that had arisen concerning the estate tax valuation of a closely held business that used an extremely common planning structure: the use of life-insurance proceeds to redeem the shares of a shareholder upon his or her death. Tax and business lawyers undoubtedly agree with Benjamin Franklin’s sentiment that “in this world, nothing is certain except death and taxes,” and prudent lawyers plan for both these certainties.

The circuit split concerned the interaction between the receipt of the life-insurance proceeds, which increases the value of the business, and the redemption obligation, which some have argued reduces the value of the business.

According to the argument, then, the two net out; that is, to the extent that the life-insurance proceeds were used to fund the redemption, there has been no net change to the value of the business. To illustrate the argument using some simple numbers, assume a company was worth $4 million before the death, and it then receives $3 million of life-insurance proceeds because of the shareholder’s death, which it quickly uses to pay out (i.e., redeem) the deceased shareholder’s shares. The government would likely argue that the corporation was worth $7 million for estate tax purposes. And the taxpayer may argue, on the other hand, that the corporation was worth $4 million because the plus $3 million and the minus $3 million cancel each other out for valuation purposes. Stated otherwise, the redemption obligation is a liability of the corporation that should be subtracted for valuation purposes.

A unanimous Supreme Court, however, (rightly) disagreed with the taxpayer’s argument in this case. The Court held that “[a]n 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.” In other words, “a corporation’s contractual obligation to redeem shares at fair market value does not reduce the value of those shares in and of itself.”

Conceptually, to analytically answer the question presented, two discrete issues must be considered. First, how does the receipt of life-insurance proceeds affect the valuation of the business (i.e., do the proceeds increase the value of the business, as the receipt of other cash assets would). Then, second, how does the contractual redemption obligation affect the valuation of the business (i.e., does it decrease the value, as other liabilities would).

A noteworthy aspect of the Court’s decision is its emphasis on the narrowness of its holding; twice it emphasized that the case gave rise to a narrow dispute. It stated as a given that “all agree that life-insurance proceeds payable to a corporation are an asset that increases the corporation’s fair market value”—in short, the Court took the first analytical issue as a given and focused exclusively on the second. Even though the Court assumed this point, it is still worth providing an explanation for why that is the case. A cash-value life insurance policy undoubtedly is an asset of the company and should be reflected as such on the balance sheet; when the death of the insured happens and the proceeds are received—likely for an amount greater than the cash value—the corporation has received the economic benefit of a mortality gain, which represents an increase to shareholders’ equity (see Timothy M. Todd & F. Philip Manns, Seeing Through the Sleight of Hand: Estate Tax Consequences of Redeeming Stock with Life Insurance Proceeds, 183 Tax Notes Fed. 437 (Apr. 15, 2024)). Stated otherwise, “a life insurance policy is not meaningfully different from a sinking fund, except for the possibility of mortality gain” (Id. at 455).

On the second issue—which was the main focus of the Court’s opinion—the Court rightly held that the redemption obligation did not reduce the value of the corporation. The Court used a simple two-shareholder example to show that the redemption does not change the value of the economic interest of either shareholder. One of the arguments raised in the case was that the redemption obligation should be treated as a liability—and liabilities, by definition, decrease equity. And to be fair, contractual redemption obligations do bear some resemblance to typical accounting liabilities insofar as they represent an obligation to transfer an economic benefit (e.g., the contractually obligated cash payment to the deceased shareholder’s estate).

As the Court’s example demonstrates, though, the redemption payment does not change the value of the underlying economic interests. This is the critical conceptual point, which differentiates this type of liability (even if you want to call it that) from other liabilities. As Philip Manns and I have argued, these redemption obligations essentially transform the deceased shareholder’s economic interest from a residual equity claim to a contractual creditor claim (see id. at 454). Another way to rightly appreciate the valuation issue is that “[a]ny valuation that takes the redemption obligation into account effectively values the corporation on a ‘post-redemption’ basis, i.e., after the decedent’s shares have been redeemed” (Adam S. Chodorow, Valuing Corporations for Estate Tax Purposes, 3 Hastings Bus. L. J. 1, 25 (2006)). A caveat though—and an additional example of the Court’s intentional narrowing—is that the Court noted in footnote 2 that it was not holding that a redemption could never decrease a corporation’s value, but rather it was rejecting the argument that all redemptions decrease the value of a corporation.

A practical pushback to the Court’s conclusion (and to those who have argued similarly) is that without the netting out, stock redemptions will require substantially more life insurance to effectuate. “True enough,” the Court acknowledges. Although it did not elucidate a fuller response to that critique, the Court’s conclusion is correct nonetheless. In an economic sense, life insurance is not materially different from other assets (but for the mortality gain potential), and if the corporation wants to use its own assets to buy out an owner, it will need to accumulate additional assets to do that, like retained earnings. And as the corporation stockpiles those assets internally, it concomitantly increases the value of the corporation (for a mathematical explanation with examples, see Todd and Manns, supra). Of course, another way to avoid this is to structure the purchase as a cross-purchase, which, as the Court acknowledges, has its own pros, cons, and tax consequences.

To be sure, the Court came to the correct answer in this case. In the wake of Connelly, tax and planning lawyers may need to reassess their deathtime buy-sell planning. Those who have been relying on netting-out valuations will need to revise their projected valuations and consider the need for additional life insurance or increased estate tax exposure. Indeed, businesses that were on the margin of estate tax exposure with a netting approach may very well flip over into exposure with updated, post-Connelly valuations. Planning lawyers may want to rethink whether to retool their planned redemptions into cross-purchases. Relatedly, with the use of life insurance to fund these agreements, trust structures may need to be evaluated for additional estate tax planning considerations. In any event, Connelly serves as a prompting for business owners and those who advise them to reconsider (or perhaps consider in the first instance) their deathtime and succession plans, and it serves as another reminder of the certainty (and inevitability) of death and taxes.