30.2 C
New York
Friday, June 21, 2024

U.S. Supreme Court Rules Insurance Proceeds Included in Estate


In Connelly v. United States, 602 U.S. _____ (2024), the U.S. Supreme Court addressed the narrow question of whether a corporation’s obligation to redeem a decedent’s shares at fair market value offsets the value of the life insurance proceeds received by the corporation on a policy on the decedent’s life when those proceeds are committed to funding the redemption.  Justice Clarence Thomas authored a unanimous opinion affirming the lower courts’ findings that the corporation’s redemption obligation isn’t a liability that reduces the estate tax value of the decedent’s shares.  

Background of Redemption

Brothers Michael Connelly and Thomas Connelly were the sole shareholders in Crown C. Supply. Michael owned 77.18% of the shares, and Thomas owned the remaining 22.82%.

Michael and Thomas had entered into an agreement that provided that, on the death of the first brother, the surviving brother would have the option to purchase the deceased brother’s shares, and if the surviving brother didn’t do so, Crown was obligated to redeem the shares. Under either option, the surviving brother would be the sole shareholder of Crown. The agreement provided that the redemption price would be based on an independent appraisal of Crown. Crown purchased life insurance policies on each of the brothers, each providing a $3.5 million death benefit, payable to Crown.

On Michael’s death, Thomas, in his individual capacity, declined to exercise his right to purchase Michael’s shares, and Crown was obligated to redeem the shares. Thomas was also the executor of Michael’s will. Michael’s son and Thomas agreed that Michael’s shares were worth $3 million, and Crown used $3 million from the life insurance proceeds to redeem the shares, leaving Thomas as the sole shareholder of Crown. Crown didn’t obtain an appraisal, nor did Thomas, in any of his capacities.

Estate Tax Return Filing and Audit

As executor, Thomas filed a federal estate tax return and reported that Michael’s shares in Crown were worth $3 million, based on the agreement between Michael’s son and Thomas.

After the return was selected for audit, Thomas, as executor, obtained a valuation for the first time, and the appraiser took the position that, based on Estate of Blount v. Commissioner, 428 F. 3d 1338 (CA 11 2005), life insurance proceeds should be deducted from the value of a corporation when those proceeds are offset by an obligation to pay those proceeds to an estate in a stock buyout. The appraiser concluded that Crown was worth $3.86 million in its entirety and that Michael’s shares, representing a 77.18% ownership interest, were worth approximately $3 million ($2,979,148). The Internal Revenue Service took the position that Crown’s value was $6.86 million (adding $3 million in insurance proceeds to $3.86 million value) and that Michael’s ownership interest was worth $5.3 million and assessed an additional $889,914 in estate tax.

Based on a 40% tax rate, the estate tax attributable to the Crown shares would be $2.12 million.  There’s no indication that the $3 million redemption price would be changed on an audit, meaning that $2.12 million of the $3 million in proceeds (70.66%) would be consumed by estate tax based on the IRS’ position.

IRS Wins Summary Judgment

The estate paid the deficiency, and Thomas, as executor, sued for a refund, arguing that the $3 million used to redeem the decedent’s shares shouldn’t be counted when calculating the value of those shares. The District Court granted summary judgment in favor of the IRS and denied the refund, concluding that Crown’s obligation to redeem Michael’s shares wasn’t a liability that reduced the corporation’s FMV. The Court of Appeals affirmed the grant of summary judgment.

Supreme Court Review

The Court asserted that a share redemption at FMV doesn’t affect any shareholder’s economic interest and that no willing purchaser of Michael’s shares would treat Crown’s redemption obligation as a factor that reduced the value of the shares. The Court concluded that Thomas, as executor, approached the question as what a buyer would pay for shares of the less-valuable corporation that exists after the redemption, missing the basic point that the estate tax is imposed on the value of Michael’s shares when he died (and before Crown spent $3 million on the redemption).

The Court also noted that Thomas took the illogical position that Crown was worth $3.86 million in total before the redemption and worth $3.86 million in total value after the redemption, even though Crown had paid out $3 million in the redemption.

The Court was dismissive of the argument that this would make succession planning more difficult. The Court pointed out that there were other options, such as a cross-purchase agreement in which each brother had an obligation to purchase the shares of the first deceased brother, and the brothers owned life insurance on each other’s lives to fund the purchase, which would have avoided having funds flow to Crown. The Court pointed out that such an agreement would have solved the tax problem but created a risk that one brother would let a policy lapse and then be unable to make the purchase. An advantage of the actual structure was that Crown was paying the premiums. This avoids a scenario in which one brother, unbeknownst to the other, allows a policy to lapse.

Open Question

In a footnote, the Court stated:

 “We do not hold that a redemption obligation can never decrease a corporation’s value (emphasis in original).  A redemption obligation could, for instance, require a corporation to liquidate operating assets to pay for the shares, thereby decreasing its future earning capacity.  We simply reject Thomas’s position that all redemption obligations reduce a corporation’s net value.  Because that is all this case requires, we decide no more.”

Therefore, there’s still the possibility that a redemption obligation could decrease the estate tax value of a decedent’s shares, depending on the particular facts.

Related Articles

LEAVE A REPLY

Please enter your comment!
Please enter your name here

Latest Articles