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In Connelly v. United States, the Supreme Court has held that a closely held corporation's obligation to redeem (i.e., purchase) shares in the event of a shareholder's death is not a liability that reduces a corporation's value for federal estate tax purposes.

Facts

Michael and Thomas Connelly, the sole shareholders in Crown C Supply (Crown), a building supply corporation, entered into an agreement under which, if either brother died, the surviving brother had the option to purchase the deceased brother's shares. If the surviving brother declined, Crown was required to redeem the shares. The agreement also required an outside appraisal of Crown's fair market value to determine the redemption price for each share. Crown obtained a $3.5 million life insurance policy on each brother, so that it could redeem the shares in the event of one of their deaths and the surviving brother declined to purchase the deceased brother's shares.

Michael died and Thomas chose not to purchase Michael's shares, which required Crown to purchase the shares. Instead of having an outside appraisal conducted to determine Crown's fair market value for estate tax purposes, Thomas and Michael's son agreed that the shares were worth $3 million, and Crown paid that amount to Michael's estate out of the life insurance proceeds.

Thomas was the executor of Michael's estate and filed a federal tax return for the estate. He reported the value of Michael's shares as $3 million. The IRS audited the return and, during that period, Thomas obtained a valuation of Crown's fair market value from an accounting firm. According to that firm, Crown's fair market value when Michael died was $3.86 million, which excluded the $3 million in insurance proceeds Crown used to purchase Michael's shares. That amount was excluded because the accounting firm relied on the holding in Estate of Blount v. Commissioner, 428 F. 3d 1338 (CA 11 2005), which held that insurance proceeds are deducted from a corporation's fair market value when those proceeds are "'offset by an obligation to pay those proceeds to the estate in a stock buyout.'"

The IRS disagreed with the accounting firm's calculation, asserting that Crown's obligation to purchase the shares did not offset the life insurance proceeds. Thus, the IRS determined Crown's total value was $6.86 million. Because Michael owned 77.18% of the shares, the IRS calculated the value of Michael's shares as $5.3 million and determined that the estate owed an additional $889,914 in taxes.

The estate paid the deficiency, and then Thomas sued for a refund. The district court granted summary judgment to the government, holding that Crown's valuation must include the $3 million in life insurance proceeds for Michael's shares to be accurately valued. The Eighth Circuit Court of Appeals affirmed the district court's decision.

Arguments

Thomas argued that Crown's contractual obligation to purchase the shares was a liability that offset the value of the life-insurance proceeds used to satisfy Crown's obligation. He asserted that a buyer purchasing the corporation's shares would treat the contractual obligation to buy the shares as canceling out the value of the life insurance proceeds.

The government contended that Crown's obligation to buy Michael's shares did not offset the value of the life-insurance proceeds, and "'no real-world buyer or seller would have viewed the redemption obligation as an offsetting liability.'"

Holding

The Supreme Court observed that, when an estate calculates 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 increase the corporation's fair market value. The Court also noted that an "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." Because a fair-market-value redemption does not affect a shareholder's economic interest, the Court concluded that a hypothetical buyer purchasing Michael's shares would not treat Crown's purchase obligation "as a factor that reduced the value of those shares."

Accordingly, the Court held that Crown's contractual obligation to purchase Michael's shares at fair market value did not offset the value of the life-insurance proceeds used to fund the purchase. The Court found that a buyer purchasing Michael's shares would acquire a 77.18% stake in Crown worth $6.86 million, including Crown's obligation to purchase the shares, and would pay up to $5.3 million for those shares. Therefore, the Court concluded Crown's obligation to purchase the shares at fair market value did not reduce the shares' value.

Implications

In this decision, the Court resolved the existing circuit split between the Eighth Circuit and the Eleventh Circuits regarding the value of a decedent's interest in a closely held corporation when an obligation exists to redeem the decedent's interest. This ruling is the correct result given the potential implications of excluding insurance proceeds from the value of a corporation, unlike other non-operating assets, and allowing taxpayers to artificially devalue an interest by creating contractual redemption obligations. In this case, the corporation was only required to purchase Michael's shares if Thomas did not so choose, making the obligation only contingent.

The lesson to be learned from the Court's decision is that buy-sell arrangements wherein insurance must be purchased should not be held inside the corporation. The Court recognized there were alternative arrangements, such as a cross-purchase agreement wherein the brothers purchased insurance on each other's lives (outside of the corporation). Another possibility is to create a life insurance trust that would purchase a policy on the lives of each brother and distribute the proceeds to the surviving brother or purchase the shares of the deceased brother.

One other item of note is the Court's decision to include a clarification in the second footnote regarding what its holding does not address. In the footnote, the Court makes it clear that the decision in Connelly does not imply that a redemption obligation can never decrease the value of a corporation and includes a hypothetical where a redemption obligation could require the liquidation of operating assets to pay for the shares. The Court acknowledges that such an obligation could reduce the value of the corporation due to a decrease in future earning potential, but such a determination is outside the scope of this ruling.