In the case of Connelly v. United States, US Supreme Court, Docket 23-146, June 6, 2024[1], the U.S. Supreme Court resolved inconsistent holdings in lower courts.  In a unanimous opinion, the Court, authored by Justice Thomas, found that although life insurance proceeds received by the corporation that were intended to be used to redeem a deceased majority shareholder had to be included in valuing the corporation as of the date the shareholder died, the estate could not use the obligation to redeem those shares to reduce the value of the corporation when valuing the interest.

The opinion begins by outlining the basic facts and the fundamental issue to be decided in this case:

Michael and Thomas Connelly owned a building supply corporation. The brothers entered into an agreement to ensure that the company would stay in the family if either brother died. Under that agreement, the corporation could be required to redeem (i.e., purchase) the deceased brother’s shares. To fund the possible share redemption, the corporation obtained life insurance on each brother. After Michael died, a narrow dispute arose over how to value his shares for calculating the estate tax. The central question is whether the corporation’s obligation to redeem Michael’s shares was a liability that decreased the value of those shares.[2]

The opinion notes that a decedent’s estate would include interests in any closely held corporation he/she might have owned an interest in at his/her death.  These interests have various unique features:

A decedent’s taxable estate includes his shares in a closely held corporation. 26 U.S.C. §2031(b). Closely held corporations ordinarily have only a few shareholders (often within the same family) and, unlike public corporations, those shareholders typically participate in the corporation’s day-to-day management. 3 J. Cox & T. Hazen, Law of Corporations §14.1 (3d ed. 2010) (Cox & Hazen). Given this close working relationship, shareholders sometimes enter into an agreement to restrict the transfer of shares to outside investors. 3 id., §14.9. One such arrangement involves “giving the corporation or the other shareholders the right to purchase the shares of a holder on his death.” Ibid. A related arrangement, called a share redemption agreement, contractually requires a corporation to repurchase a deceased shareholder’s shares. Although such an agreement may delineate how to set a price for the shares, it is ordinarily not dispositive for valuing the decedent’s shares for the estate tax. See 26 U.S.C. §2703. As a general rule, the fair market value of the corporation determines the value of the shares, and one must therefore consider “the company’s net worth, prospective earning power and dividend-paying capacity, and other relevant factors,” “including proceeds of life insurance policies payable to . . . the company.” 26 CFR §20.2031-2(f)(2).[3]

In this case, two brothers held the corporation’s shares and entered into a redemption agreement with the corporation that took effect upon either of their deaths.

Brothers Michael and Thomas Connelly were the sole shareholders in Crown C Supply, a small but successful building supply corporation in St. Louis, Missouri. Michael owned 77.18% of Crown’s outstanding shares (385.9 out of 500 shares), and Thomas owned the remaining 22.82% (114. 1 shares). The brothers entered into an agreement with Crown to ensure a smooth transition of ownership and keep Crown in the family in the event one of the brothers died. The agreement provided that if either Michael or Thomas died, the surviving brother would have the option to purchase the deceased brother’s shares. And, if the surviving brother declined to do so, then Crown itself would be contractually required to redeem the shares. With an exception not relevant here, the agreement specified that the redemption price for each share would be based upon an outside appraisal of Crown’s fair market value. App. 12-14. To ensure that Crown would have enough money to redeem the shares if required, Crown obtained $3.5 million in life insurance on each brother.[4]

But when Micheal died, Thomas and the heir, Michael’s son, did not exactly follow this agreement:

When Michael died in 2013, Thomas opted not to purchase Michael’s shares. As a result, Crown was obligated under the agreement to redeem Michael’s shares. Rather than secure an outside appraisal of the company’s fair market value (as the agreement contemplated), Michael’s son and Thomas agreed in an “amicable and expeditious manner” that the value of Michael’s shares was $3 million. Id., at 25-26. Crown then used $3 million of the life-insurance proceeds to redeem Michael’s shares, leaving Thomas as Crown’s sole shareholder.[5]

Thomas was also the executor of Michael’s estate, so he had prepared and filed an estate tax return as described below:

As the executor of Michael’s estate, Thomas then filed a federal tax return for the estate. The return reported the value of Michael’s shares as $3 million, in accordance with the agreement between Michael’s son and Thomas. The Internal Revenue Service (IRS) audited the return. During the audit, Thomas obtained a valuation from an accounting firm. The firm’s analyst took as given the holding in Estate of Blount v. Commissioner, 428 F. 3d 1338 (CA11 2005), which concluded that insurance proceeds should be “deduct[ed] . . . from the value” of a corporation when they are “offset by an obligation to pay those proceeds to the estate in a stock buyout.” Id., at 1345. The analyst thus excluded the $3 million in insurance proceeds used to redeem Michael’s shares, and determined that Crown’s fair market value at Michael’s death was $3.86 million. Because Michael held a 77.18% ownership interest, the analyst calculated the value of Michael’s shares as approximately $3 million ($3.86 million x 0.7718).[6]

The Eleventh Circuit had, in the Estate of Blount cited above, approved considering the obligation to redeem the shares as a liability of the corporation, which was appropriate to consider as largely offsetting the life insurance proceeds the corporation received. But the IRS did not agree with the Eleventh Circuit holding, nor the estate’s use of that holding to reduce the value of the shares redeemed:

The IRS took a different view, insisting that Crown’s redemption obligation did not offset the life-insurance proceeds. The IRS counted the $3 million in life-insurance proceeds excluded by the analyst and assessed Crown’s total value as $6.86 million ($3.86 million + $3 million). And, the IRS thus calculated the value of Michael’s shares as $5.3 million ($6.86 million x 0.7718). Based on this higher valuation, the IRS determined that the estate owed an additional $889,914 in taxes.[7]

The estate paid the tax and then sued for a refund. However, the lower court disagreed with the Eleventh Circuit’s analysis and ruled that the estate was not entitled to a refund.

The estate paid the deficiency and Thomas, acting as executor, sued the United States for a refund. As relevant, Thomas argued that the $3 million in life-insurance proceeds used to redeem Michael’s shares should not be counted when calculating the value of those shares. The District Court granted summary judgment to the Government, concluding that Michael’s estate was not entitled to a refund. Connelly v. Department of Treasury, IRS, 2021 WL 4281288, *17 (ED Mo., Sept. 21, 2021). The court held that the $3 million in life-insurance proceeds must be counted to accurately value Michael’s shares. It explained that, under customary valuation principles, Crown’s obligation to redeem Michael’s shares was not a liability that reduced the corporation’s fair market value. Id., at *14. The court therefore held that Crown’s redemption obligation did not offset the life-insurance proceeds. Id., at *15-*17. The Court of Appeals affirmed on the same basis. Connelly v. Department of Treasury, IRS, 70 F. 4th 412 (CA8 2023).[8]

As there was now a clear split of opinion between the Eleventh Circuit's holding in Blount and the Eighth Circuit's holding in Connelly, the Supreme Court decided to hear the estate’s appeal of the Connelly holding.

The opinion notes that both parties agree that the life insurance proceeds increased the corporation’s value, but the question was whether a partially offsetting liability was also in place:

The dispute in this case is narrow. All agree that, when calculating 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, all agree that life-insurance proceeds payable to a corporation are an asset that increases the corporation’s fair market value. The only question is whether Crown’s contractual obligation to redeem Michael’s shares at fair market value offsets the value of life-insurance proceeds committed to funding that redemption.[9]

The opinion goes on to outline both parties’ position on the issue of whether or not the obligation to redeem the shares should be considered in valuing the shares:

Thomas argues that a contractual obligation to redeem shares is a liability that offsets the value of life-insurance proceeds used to fulfill that obligation. Brief for Petitioner 17. He accordingly contends that anyone purchasing “a subset of the corporation’s shares would treat the two as canceling each other out.” Ibid. By contrast, the Government argues that Crown’s obligation to pay for Michael’s shares did not reduce the value of those shares. It contends that “no real-world buyer or seller would have viewed the redemption obligation as an offsetting liability.” Brief for United States 15.[10]

The Court quickly states that, in its view, the answer is that redemption is irrelevant in determining the fair value of the interest.

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.[11]

Justice Thomas offers an example to explain this holding:

A simple example proves the point. Consider a corporation with one asset — $10 million in cash — and two shareholders, A and B, who own 80 and 20 shares respectively. Each individual share is worth $100,000 ($10 million ÷ 100 shares). So, A’s shares are worth $8 million (80 shares x $100,000) and B’s shares are worth $2 million (20 shares x $100,000). To redeem B’s shares at fair market value, the corporation would thus have to pay B $2 million. After the redemption, A would be the sole shareholder in a corporation worth $8 million and with 80 outstanding shares. A’s shares would still be worth $100,000 each ($8 million ÷ 80 shares). Economically, the redemption would have no impact on either shareholder. The value of the shareholders’ interests after the redemption — A’s 80 shares and B’s $2 million in cash — would be equal to the value of their respective interests in the corporation before the redemption. Thus, a corporation’s contractual obligation to redeem shares at fair market value does not reduce the value of those shares in and of itself.[12]

Thus, Justice Thomas goes on to note that the theoretically willing buyer would not consider the redemption when buying the decedent’s shares.

Because a fair-market-value redemption has no effect on any shareholder’s economic interest, no willing buyer purchasing Michael’s shares would have treated Crown’s obligation to redeem Michael’s shares at fair market value as a factor that reduced the value of those shares. At the time of Michael’s death, Crown was worth $6.86 million — $3 million in life-insurance proceeds earmarked for the redemption plus $3.86 million in other assets and income-generating potential. Anyone purchasing Michael’s shares would acquire a 77.18% stake in a company worth $6.86 million, along with Crown’s obligation to redeem those shares at fair market value. A buyer would therefore pay up to $5.3 million for Michael’s shares ($6.86 million x 0.7718) — i.e., the value the buyer could expect to receive in exchange for Michael’s shares when Crown redeemed them at fair market value. We thus conclude that Crown’s promise to redeem Michael’s shares at fair market value did not reduce the value of those shares.[13]

The Court then outlines the estate’s argument against this position, which relies upon the holding in Blount:

Thomas resists this straightforward conclusion. He suggests that Crown’s redemption obligation “would make it impossible” for a hypothetical buyer seeking to purchase 77.18% of Crown “to capture the full value of the insurance proceeds.” Brief for Petitioner 26. That is so, according to Thomas, because the insurance proceeds would leave the company as soon as they arrived to complete the redemption. He argues that the “buyer would thus not consider proceeds that would be used for redemption as net assets.” Ibid. In other words, Thomas views the relevant inquiry as what a buyer would pay for shares that make up the same percentage of the less-valuable corporation that exists after the redemption. See Estate of Blount v. Commissioner, 87 TCM 1303 (2004), ¶2004-116 RIA Memo TC, aff’d in part and rev’d in part, 428 F. 3d 1338 (CA11 2005); see also A. Chodorow, Valuing Corporations for Estate Tax Purposes, 3 Hastings Bus. L. J. 1, 25 (2006) (“Any valuation that takes the redemption obligation into account effectively values the corporation on a ’post-redemption’ basis, i.e., after the decedent’s shares have been redeemed”).[14]

But the Justices’ opinion holds that the proper time to value the corporation is before the redemption takes place:

But, for calculating the estate tax, the whole point is to assess how much Michael’s shares were worth at the time that he died — before Crown spent $3 million on the redemption payment. See 26 U.S.C. §2033 (defining the gross estate to “include the value of all property to the extent of the interest therein of the decedent at the time of his death”); 26 CFR §20.2031-1(b) (the “value of every item of property includible in a decedent’s gross estate . . . is its fair market value at the time of the decedent’s death” (emphasis added)). A hypothetical buyer would thus treat the life-insurance proceeds that would be used to redeem Michael’s shares as a net asset.[15]

The opinion goes on to consider an issue that took up quite a bit of time in the oral arguments before the Court, that the estates’ position ignores the fact that while Michael’s son received cash equal to what the estate claimed was the value of his father’s shares, at the same time Thomas managed to go from holding a minority interest in the company to now holding 100% of the shares of a company still worth what the estate claimed it was worth at his brother’s passing.

Moreover, Thomas’s argument that the redemption obligation was a liability cannot be reconciled with the basic mechanics of a stock redemption. As the District Court explained, when a shareholder redeems his shares he “is essentially ’cashing out’ his shares of ownership in the company and its assets.” 2021 WL 4281288, *16. That transaction necessarily reduces a corporation’s total value. And, because there are fewer outstanding shares after the redemption, the remaining shareholders are left with a larger proportional ownership interest in the less-valuable corporation. Thomas’s understanding, however, would turn this ordinary process upside down. In Thomas’s view, Crown’s redemption of Michael’s shares left Thomas with a larger ownership stake in a company with the same value as before the redemption. Thomas argues that Crown was worth only $3.86 million before the redemption, and thus that Michael’s shares were worth approximately $3 million ($3.86 million x 0.7718). But, he also argues that Crown was worth $3.86 million after Michael’s shares were redeemed. See Reply Brief 6. That cannot be right: A corporation that pays out $3 million to redeem shares should be worth less than before the redemption. See Cox & Hazen §21.2. Thomas’s argument thus cannot be reconciled with an elementary understanding of a stock redemption.[16]

Finally, the Court did not consider the estate’s argument that this decision would make estate planning for closely held corporations much more difficult, noting that the entire issue could have been avoided with a cross-purchase structure, although the Court concedes that a cross-purchase agreement adds certain non-estate tax issues to the transaction.

Finally, Thomas asserts that affirming the decision below will make succession planning more difficult for closely held corporations. He reasons that if life-insurance proceeds earmarked for a share redemption are a net asset for estate-tax purposes, then “Crown would have needed an insurance policy worth far more than $3 million in order to redeem Michael’s shares at fair market value.” Brief for Petitioner 33. True enough, but that is simply a consequence of how the Connelly brothers chose to structure their agreement. There were other options. For example, the brothers could have used a cross-purchase agreement — an arrangement in which shareholders agree to purchase each other’s shares at death and purchase life-insurance policies on each other to fund the agreement. See S. Pratt, Valuing a Business 821. (6th ed. 2022). A cross-purchase agreement would have allowed Thomas to purchase Michael’s shares and keep Crown in the family, while avoiding the risk that the insurance proceeds would increase the value of Michael’s shares. The proceeds would have gone directly to Thomas — not to Crown. But, every arrangement has its own drawbacks. A cross-purchase agreement would have required each brother to pay the premiums for the insurance policy on the other brother, creating a risk that one of them would be unable to do so. And, it would have had its own tax consequences. By opting to have Crown purchase the life-insurance policies and pay the premiums, the Connelly brothers guaranteed that the policies would remain in force and that the insurance proceeds would be available to fund the redemption. As we have explained, however, this arrangement also meant that Crown would receive the proceeds and thereby increase the value of Michael’s shares. Thomas’ concerns about the implications of how he and Michael structured their agreement are therefore misplaced.[17]

[1] Connelly v. United States, US Supreme Court, Docket 23-146, June 6, 2024, https://www.taxnotes.com/research/federal/court-documents/court-opinions-and-orders/insurance-proceeds-included-estate-tax-value-supreme-court-holds/7k9cn

[2] Connelly v. United States, US Supreme Court, Docket 23-146, June 6, 2024

[3] Connelly v. United States, US Supreme Court, Docket 23-146, June 6, 2024

[4] Connelly v. United States, US Supreme Court, Docket 23-146, June 6, 2024

[5] Connelly v. United States, US Supreme Court, Docket 23-146, June 6, 2024

[6] Connelly v. United States, US Supreme Court, Docket 23-146, June 6, 2024

[7] Connelly v. United States, US Supreme Court, Docket 23-146, June 6, 2024

[8] Connelly v. United States, US Supreme Court, Docket 23-146, June 6, 2024

[9] Connelly v. United States, US Supreme Court, Docket 23-146, June 6, 2024

[10] Connelly v. United States, US Supreme Court, Docket 23-146, June 6, 2024

[11] Connelly v. United States, US Supreme Court, Docket 23-146, June 6, 2024

[12] Connelly v. United States, US Supreme Court, Docket 23-146, June 6, 2024

[13] Connelly v. United States, US Supreme Court, Docket 23-146, June 6, 2024

[14] Connelly v. United States, US Supreme Court, Docket 23-146, June 6, 2024

[15] Connelly v. United States, US Supreme Court, Docket 23-146, June 6, 2024

[16] Connelly v. United States, US Supreme Court, Docket 23-146, June 6, 2024

[17] Connelly v. United States, US Supreme Court, Docket 23-146, June 6, 2024