Connelly v. Internal Revenue Service

LII note: The U.S Supreme Court has now decided Connelly v. Internal Revenue Service

    Issues

    Should a deceased shareholder’s stock valuation for federal estate tax purposes include company-owned life insurance proceeds used to buy back the shareholder’s stock?

    Oral argument:
    March 27, 2024
    Court below:
    United States Court of Appeals for the Eighth Circuit

     

    This case asks the Supreme Court to decide whether life insurance proceeds acquired by a corporation to redeem a deceased shareholder’s stock are a corporate asset when calculating the shareholder’s interest in the corporation for federal estate tax purposes. Connelly, the petitioner, argues that life insurance proceeds used to fulfill a corporation’s obligation to redeem a shareholder’s stock should not increase the taxable value of the estate because a closely held corporation’s obligation to redeem stock is a liability that offsets the value of life insurance proceeds. Connelly further contends that the estate tax valuation method used by the Internal Revenue Service (“IRS”), which includes insurance proceeds in the company’s share value, is detrimental to closely held corporations because it forces them to overspend on life insurance and redemption arrangements. The IRS counters that life insurance proceeds, which enhance a company’s equity, should not be offset by stock redemption obligations in share valuation. The IRS also contends that taxing life insurance proceeds aligns with legislative goals to tax a deceased shareholder’s property at its fair market value, emphasizing that the Connelly family’s undervaluation of shares bypasses market value impacts. The outcome of this case will affect estate planning strategies and the effectiveness of life insurance-funded redemption agreements that intend to ensure closely held business’s continuity of ownership.

    Questions as Framed for the Court by the Parties

    Whether the proceeds of a life-insurance policy taken out by a closely held corporation on a shareholder in order to facilitate the redemption of the shareholder’s stock should be considered a corporate asset when calculating the value of the shareholder’s shares for purposes of the federal estate tax.

    Facts

    Michael Connelly and Thomas Connelly (“Connelly”), who were brothers, owned all the shares of Crown C corporation (“Crown”). The brothers and Crown entered into a stock purchase agreement to ensure a seamless transfer of ownership in the event of either brother’s death. According to the agreement, if one brother died, the surviving brother had the option to purchase the deceased brother’s shares. However, if the surviving brother opted not to, Crown would then redeem the shares. Although the agreement specified mechanisms to determine the share price, the brothers never executed them. Instead, Crown acquired life insurance totaling $3.5 million on each brother.

    Following Michael’s death in 2013, Crown received the life insurance proceeds. Subsequently, Crown redeemed Michael’s shares according to a post-death agreement between Michael’s son and Thomas, in which they agreed on the value of Michael’s stock to be $3 million. This valuation disregarded any appraisals set by the original stock purchase agreement, which effectively valued Crown at $3.89 million based on Michael’s ownership percentage. Crown used the remaining life insurance proceeds, which were approximately $0.5 million, to fund its operations. Thomas, as the executor of Michael’s estate, filed a tax return and reported Michael’s shares at a value of $3 million based on the redemption payment, and paid an estate tax of approximately $300,000.

    The IRS determined that Michael’s shares were undervalued, asserting that the corporation’s fair market value should include the insurance proceeds. According to the IRS, Michael’s shares should be calculated pre-redemption, incorporating the insurance proceeds into the total fair market value of the company. This calculation would have assessed the estate value at $5.3 million, resulting in an additional tax liability of $1 million.

    The IRS issued a deficiency notice to the estate for the additional taxes. The estate paid the amount and sued the IRS for a refund. The estate claimed that the redemption transaction fixes the value of Michael’s shares for estate tax purposes based on the stock purchase agreement, in line with Section 2703(b) of the Internal Revenue Code, which specifies agreements that can affect property valuation. Alternatively, it contended that the life insurance proceeds immediately offset the liability from the redemption obligation. The district court granted summary judgment in favor of the IRS, ruling that the stock purchase agreement did not influence the valuation process and that the life insurance proceeds were substantial corporate assets, necessitating their inclusion.

    Connelly appealed the district court’s grant of summary judgment, and the United States Court of Appeals for the Eighth Circuit affirmed the district court’s ruling. The Eighth Circuit determined that the life insurance proceeds increased shareholders’ equity and that any willing buyer of the corporation would have considered the proceeds when evaluating Crown’s worth. As for the estate’s argument relying on the stock purchase agreement under Section 2703(b), the Eighth Circuit held that the agreement does not dictate Crown’s valuation because it lacked a fixed or determinable stock price. Moreover, the Eighth Circuit held that accepting the estate’s argument would disproportionately benefit the remaining shareholders, rather than simply offset liability.

    Connelly petitioned for a writ of certiorari, which the United States Supreme Court granted on December 13, 2023.

    Analysis

    APPLYING THE WILLING-BUYER/WILLING-SELLER TEST

    Connelly explains that the first step in calculating the estate subject to federal income tax is determining the value of the gross estate, which consists of all tangible or intangible property at the time of the decedent’s death, including any stock held by the decedent. Connelly argues that the Court should apply the willing-buyer/willing-seller test to determine the value of the gross estate. Connelly describes the test as calculating the sale price that a hypothetical buyer and a hypothetical seller would agree on after considering all relevant facts that would affect the net value of the corporation, including its assets and liabilities Connelly adds that, under the traditional principles of valuation, a closely held corporation’s obligation to redeem a shareholder’s stock is a corporate liability that offsets the value of any life insurance proceeds, thereby not adding to the value of the corporation’s stock. Accordingly, Connelly contends that the life insurance proceeds should be untaxed because a reasonable hypothetical buyer and a hypothetical seller will disregard the life insurance proceeds when valuing Crown’s gross estate.

    The IRS responds that a redemption obligation is not a liability that depreciates the value of Michael’s redeemable shares. . The IRS contends that the value of a decedent’s shares reflects all corporate assets and a corporation’s income-generating potential, including any asset the corporation will expend to satisfy its redemption obligation. The IRS maintains that Crown’s fair market value must account for the life insurance proceeds because they generate millions of dollars’ worth of lump-sum cash payments that increase the company’s equity value. Also, applying the willing-buyer/willing-seller test, the IRS contends that no reasonable buyer or seller would disregard the life insurance proceeds in pricing Michael’s shares because Crown’s obligation to redeem Michael’s shares requires the company’s resources to flow to the holder of his shares, thereby not reducing the value of his shares. Moreover, the IRS points out that Connelly’s tax calculation method violates the principle that each equity share should have an equal worth. The IRS claims that excluding the life insurance proceeds from calculating the value of Crown’s gross estate leads to a nonsensical result where the value of the shares held by Thomas, a minority shareholder, exceeds the value of the shares held by Michael, a majority shareholder.  

    VALUING THE ESTATE ASSUMING A PURCHASE OF THE ENTIRE COMPANY

    Connelly argues that the Eighth Circuit wrongly calculated the value of Michael’s shares based on a hypothetical purchase of all of Crown’s shares in one transaction. Connelly emphasizes that the fair market value of a portion of the corporation’s stock can differ significantly from that of the whole company sold at once. Connelly maintains that U.S. Treasury Department regulations and the IRS guidance regarding estate taxation consider the degree of control that a block of stock to be valued has. Connelly stresses that, especially for a closely held stock like Michael’s, a hypothetical buyer can only capture the value of life insurance proceeds by purchasing the company’s entire stock but not by purchasing a subset of corporate shares. Connelly explains that a purchaser of the company’s entire shares can capture the value of the proceeds, thus adding to the company’s gross estate, by extinguishing the stock purchase agreement between shareholders and terminating the company’s redemption obligation or redeeming the shares for oneself. However, Connelly asserts that the circuit courts have consistently rejected the IRS’s approach to a hypothetical full purchase because treating a portion of the asset as the whole asset inflates the asset's value and disregards Michael’s lack of control over all the corporate shares.  

    The IRS counters that, until filing in the Supreme Court, Connelly never argued that considering life insurance proceeds in valuing Crown’s estate would improperly reflect the degree of control that Michael’s shares had. . Thus, the IRS insists that Connelly waived such a claim by failing to raise it in lower courts. The IRS further points out that Connelly failed to provide evidence that the IRS erroneously attached premiums to Michael’s shares, thus failing to meet the burden of proof a petitioner has in a tax-refund suit.Moreover, the IRS argues that a hypothetical purchaser buying all of Crown’s shares is only one of the scenarios that illustrates how the life insurance proceeds would increase Crown’s corporate value. The IRS adds that a third-party buyer of Michael’s shares would also include the proceeds in calculating the value of the shares because the buyer would receive a payment from stock redemption. The IRS further states that if Thomas bought Michael’s shares, he would have extinguished Crown’s obligation to redeem Michael’s shares but still received the proceeds.

    ECONOMIC HARM TO CLOSELY HELD CORPORATIONS

    Connelly maintains that the IRS’s approach to taxing life insurance proceeds forces closely held corporations, mostly small businesses, to spend disproportionate corporate resources to preserve redemption arrangements and counterbalance increased federal estate tax. Connelly contends that closely held corporations will have to purchase life insurance policies many times larger than the value of stocks subject to redemption arrangements because the IRS’s approach captures the increase in value attributable to insurance proceeds in its tax scheme. Connelly further counters that, in suggesting alternate methods that closely held corporations can rely on instead of the redemption arrangement, the IRS fails to explain how those methods will achieve shareholders’ goals of preserving the closely held nature of their corporation without incurring substantial costs. Connelly emphasizes that the IRS’s approach will significantly hamper the benefits that closely held corporations bring to the American economy, especially because closely held corporations account for over 90% of all American companies.Moreover, Connelly argues that the IRS’s approach confers to the IRS an unfair gain which subjects the life insurance proceeds to double taxation by taxing the transfer of the proceeds under the estate tax and taxing the increase in the value of Thomas’s shares due to redemption under the capital gains tax.

    The IRS rebuts that closely held corporations have various planning options available that they can use to preserve the closely held nature. For instance, the IRS states that a shareholder can transfer one’s shares to another party involved in the business and restrict further business transfer, which the IRS asserts does not require corporations to expend assets. Alternatively, the IRS contends that shareholders can hold life insurance through a trust or create cross-purchase arrangements that avoid complicating corporate valuation. The IRS argues that Connelly’s goal to redeem Michael’s interest without affecting Crown’s estate is inconsistent with the nature of stock redemption because redeeming a shareholder’s shares leads to proportionally depreciating the value of the remaining shareholders’ shares. Furthermore, the IRS counters that Congress intended to tax a decedent’s property at its fair market value regardless of any private agreements that transfer the property that avoid affecting the market value.The IRS maintains that the estate tax levied on the life insurance proceeds is a consequence of the Connelly family’s private agreement to undervalue Michael’s shares and let Thomas disproportionately benefit from the proceeds as a sole remaining shareholder.   

    Discussion

    EFFECTS ON CLOSELY HELD BUSINESSES

    In support of Connelly, the United States Chamber of Commerce (“USCC”) argues that redemption agreements funded by life insurance policies play a crucial role in ensuring the survival of closely held businesses across generations. The USCC asserts that such policies do not alter the economic fundamentals of companies but instead safeguard their value and sustainability by facilitating continuity in ownership and preventing the potentially disruptive liquidation of capital assets or the sudden assumption of significant debt. Also, the USCC contends that such agreements ensure smooth transitions in ownership changes, which is critical for closely held companies, especially because ownership changes that rarely occur may be particularly disruptive. Finally, the USCC claims that the IRS’s position penalizes deliberate succession planning using effective legal arrangements that enable closely held businesses to ensure seamless transitions and continuity in serving stakeholders.

    In support of the IRS, Professor Hellwig argues that redemption agreements funded by insurance policies would rather complicate estate planning. Professor Hellwig asserts that economically similar transactions would yield different tax results depending on the timing of a corporation’s redemption agreement because it would reduce corporate net worth only if the agreement is in effect at the time of the shareholder’s death. Conversely, Hellwig contends that the estate tax value would increase if the decedent’s estate sold the shares to an existing shareholder by a cross-purchase agreement or distributed the stock to the decedent’s heirs instead of selling them. Furthermore, Hellwig claims that the court ruling for Connelly would lead to significant estate tax avoidance beyond small business owners because other entities may use closely held businesses as wealth management vehicles with life insurance investments to fund redemption obligations.

    CREDIBILITY OF REDEMPTION AGREEMENTS AS ESTATE PLANNING TOOLS

    The USCC, in support of Connelly, argues that redemption agreements paired with life insurance policies have been a long-standing and widely practiced approach for closely held companies in case of disruption in company ownership, benefitting both the company and the estate. . According to USCC, the passing of a significant owner presents a challenge in fulfilling estate tax obligations, often requiring quick access to liquid funds, which may entail selling off important assets or assuming substantial debt. The USCC contends that many closely held companies opt for redemption agreements paired with life insurance to mitigate such challenges. Furthermore, the USCC argues that such arrangements do not disadvantage the IRS, as they ensure that the estate's stake in the company retains its value as it would if alternative methods were used to fulfill the redemption obligation.

    In support of the IRS, Professor Chodorow argues that accepting Connelly’s argument leads to irrational results as redemption obligations extend beyond insurance proceeds because, legally, insurance proceeds are treated equally to other non-operating assets. Furthermore, Professor Chodorow asserts that excluding insurance proceeds from the corporation’s fair market value would encourage closely held corporations to intentionally create defective redemption obligation agreements as a tax planning strategy because the failed attempt to lower the value of their shares using the agreement would instead allow the closely held companies to pay less in taxes. Finally, Professor Chodorow points out that Congress or the IRS would not have intended to incentivize failed redemption obligations.

    Conclusion

    Written by:   

    Jae Choi

    Su Kim

    Jiwon Lee

    Edited by:     

    Matthew Hornung

    Additional Resources