Death, Taxes and Shareholder Agreements: Lessons from the Connelly Case

Recently, the U.S. Supreme Court ruled unanimously in Connelly v. United States, that the valuation of a decedent’s shares in a closely held corporation for federal estate tax purposes must include insurance proceeds received by the corporation in connection with a planned redemption. The case involved brothers Michael and Thomas Connelly, sole shareholders of Crown C Supply, a building supply company. As part of their succession planning, the brothers had a buy-sell agreement in place that stated upon one brother’s death, the surviving brother would have the option to purchase the deceased’s shares; if declined, the corporation was obligated to redeem such shares. In order to fund this potential redemption, Crown C Supply owned and was the beneficiary of life insurance policies on each brother. After Michael’s death, Thomas opted not to purchase Michael’s shares, triggering the redemption obligation of Crown C Supply.

Michael’s estate valued his shares at around $3 million (with a company valuation at around $4 million), stating that Crown C Supply’s obligation to redeem the shares at fair market value should offset the value of the insurance proceeds, and thus, reduce the value of the stock (and consequently, the decedent’s estate tax liability). The estate’s argument was premised on the view that the proceeds of the life insurance policy should not increase the value of the company as the proceeds were immediately used for the redemption of Michael’s shares. By way of example, assume Crown C Supply was worth $4 million and Michael owned 75% and Thomas owned 25%. Upon Michael’s death, his estate claimed that his shares were worth $3 million. However, the IRS argued that with the additional $3 million from the life insurance policy proceeds payable to the company as a result of Michael’s death, the company was worth $7 million, with Michael’s shares worth approximately $5 million.

The U.S. Supreme Court unanimously disagreed with Michael’s estate and sided with the IRS concluding that such a redemption obligation does not diminish the value of the company and the insurance proceeds should be included in the company valuation. The Court reasoned that an obligation to redeem shares at fair market value does not affect the economic interests of the shareholders and, therefore, should not reduce Crown C Supply’s value for estate tax calculations. Their decision hinged on the fact that with the inclusion of the proceeds of the insurance policy, if Michael’s shares were offered on the free market, the value of Michael’s shares would be approximately $5 million, the amount that the buyer could expect to receive in liquidation for Michael’s shares. In other words, the buyer would consider the life insurance proceeds as part of Crown C Supply’s assets. Crown C Supply’s buyback of the shares reduces its overall value but also reduces the number of outstanding shares, therefore leaving the economic value of each share unchanged.

The ruling has significant implications for estate planning, particularly for closely held businesses with buy-sell arrangements funded by company owned life insurance. The result in Connelly can be avoided by having the buy-sell structured as a cross purchase among the surviving shareholders with the insurance paid directly to the surviving shareholder as the purchases. The cross-purchase is also beneficial from an income tax standpoint as the cross-purchase increases the survivor’s basis in the acquired stock. The cross purchase arrangement adds complexity when there are more than two shareholders as each shareholder will need to have a policy on every other shareholder. The administrative mechanics of maintaining each policy will expand as the shareholder group grows – the use of trusts to own the policies may reduce the administrative burden. Shareholders or Members in a closely held business should speak with their corporate and estate planning advisors to determine their best course of action in light of the Connelly decision.