IRS Prevails in Supreme Court Case Holding That Redemption Obligation Did Not Reduce Value of Estate’s Closely-Held Shares

On June 6, 2024, the Supreme Court unanimously held in Connelly vs. United States that a closely held corporation’s redemption obligation (related to a life insurance policy) does not diminish the fair market value of the corporation’s shares for federal estate tax purposes.

The Court held that a corporation’s redemption obligations were not liabilities that reduced a decedent’s estate tax value in the corporation’s shares. Connelly provides a cautionary reminder to taxpayers and advisers to closely scrutinize the potential risks associated with corporate ownership of life insurance policies.

Overview of Federal Estate Tax

The federal estate tax is a transfer tax which is imposed on the “taxable estate” of decedents who are citizens or residents of the United States (IRC §2001(a)). Many taxpayers are not subject to the federal estate tax due to available credits and the “exclusion amount" (currently set at $13,610,000 in 2024).

The taxable estate is valued to include all of a decedent’s property (including real, personal, tangible, and intangible property). An estate is generally required to value its property at “fair market value” as of the date of the decedent’s death.

Treasury Regulations generally define “fair market value” to be the price at which the property would change hands between a willing buyer and willing seller, each under no compulsion to buy or sell, and both having a reasonable knowledge of the relevant facts.

Background: Connelly vs. United States

Two brothers, Michael Connelly and Thomas Connelly, were the sole shareholders of Crown C Supply (“Crown”), a building supply corporation. Michael owned 77.18% of Crown and Thomas owned 22.82% of Crown.

The brothers set up a redemption agreement with Crown, which provided that if one of the brothers died, the surviving brother would have an option to purchase the deceased brother’s shares in Crown. If a brother decided against purchasing the deceased brother’s shares, then Crown would have the contractual obligation to redeem the deceased brother’s shares.

The Connellys and Crown agreed that the redemption price would be based upon a fair market valuation performed by an outside appraiser. To ensure that Crown would be able to fund the redemption obligation, Crown obtained two separate $3.5 million life insurance policies on each shareholder brother.

Michael passed away in 2013 and Thomas declined to purchase Michael’s shares. As a result, Crown redeemed Michael’s shares. The parties disregarded the fair market valuation provision in the redemption agreement (in substance ignoring the life insurance proceeds) and negotiated to value Michael’s shares at $3.0 million. The parties used the life insurance proceeds that were paid to Crown to fund the redemption of Michael’s shares, and Thomas was left as the sole shareholder of Crown.

Thomas, the executor of Michael’s estate, was required to file a federal estate tax return for Michael. Thomas reported the value of Michael’s shares in Crown to be $3.0 million on the federal estate return. The IRS audited Michael’s estate tax return and challenged the estate’s method in valuing Michael’s shares in Crown.

Valuation Arguments

The estate argued that the redemption obligation in Crown’s redemption agreement effectively acted as a liability that decreased the value of Michael’s shares in Crown. The estate argued that the insurance proceeds should be deducted from the corporation’s value and asserted that Michael’s 77.18% ownership value in Crown was approximately $3.0 million ($3.86 million x 0.7718).

The IRS countered, arguing that the redemption obligation did not offset the life insurance proceeds in the corporation. The IRS’s position was that Crown’s shares needed to be valued at fair market value in accordance with the Internal Revenue Code, Treasury Regulations, and established valuation principles.

The IRS included the $3.0 million in life insurance proceeds paid to Crown in the valuation and concluded that Crown had a total value of $6.86 million ($3.86 million + $3.0 million). The IRS then valued Michael’s shares at $5.3 million ($6.86 million x 0.7718).

Court Decisions in Connelly

Michael’s estate paid the estate tax deficiency and sued for a refund from the IRS in Missouri Federal District Court. The District Court granted summary judgment in favor of the IRS, and Michael’s estate appealed to the U.S. Court of Appeals for the 8th Circuit. The 8th Circuit also held in favor of the IRS, holding that “a[n] obligation to redeem shares is not a liability in the ordinary business sense” (Connelly v. United States, No. 21-36833 (8th Cir. June 5, 2023)).

The Supreme Court unanimously affirmed the 8th Circuit’s holding that the contractual obligation to redeem Michael’s shares did not diminish the value of those shares. The Court ruled that “redemption obligations are not necessarily liabilities that reduce a corporation’s value for purposes of the federal estate tax” (Connelly v. United States, U.S., No. 23-146 (2024)).

The Importance of Connelly

The Connelly case raises important considerations, including:

The holding of Connelly vs. United States has important implications for taxpayers who desire to fund stock redemptions with corporately-owned life insurance policies.

Our Wealth Transition Services team can help you understand estate planning structures and potential tax ramifications. The experienced tax professionals that make up our Wealth Transition Services team can advise and consult on the tax aspects of estate planning structures and help clients evaluate the potential transfer tax ramifications of corporately-owned life insurance policies.