A recent court decision could impact buy-sell agreements. The Supreme Court ruled unanimously in the case of Connelly vs. United States that the proceeds a company receives from a life insurance policy to redeem a decedent’s shares must be included in federal estate tax calculation. We have the details here.

Background- Connelly vs. U.S.

Brothers Michel and Thomas Connelly owned a small building supply corporation called Crown C Supply. Wanting the corporation to stay in the Connelly family upon the death of either brother, the Connelly brothers entered into a buy-sell agreement stipulating that the surviving brother would have the option to buy the deceased brother’s shares in the company.

If the surviving brother declined the offer, Crown C Supply would be obligated to purchase the shares. To make sure Crown would have the money to buy the shares, the company obtained $3.5 million in life insurance on either brother.

When Michael Connelly passed away in 2013, Thomas Connelly decided to decline the offer to buy the shares, meaning Crown C was on the hook for buying the shares.

When it came time to file Michael’s federal estate tax return, Thomas Connelly, as executor of Michael’s estate, worked with an outside accounting firm to determine the value of Michael’s shares and determined a value of $3.86 million. The IRS disagreed and maintained that the value of the life insurance ($3.0 million) was a corporate asset and should be added to the value, making Crown’s total value $6.86 million, broken down as follows:

$3.86 million (Crown’s fair market value at Michael’s death) + $3 million (insurance proceeds) = $6.86 million

Since Michael held 77.18% ownership interest in Crown, the IRS determined that the value of his shares was $5.3 million ($6.86 million x .7718), resulting in roughly an additional $890,000 in taxes.

What action did the estate take?

The estate paid the additional taxes, however Thomas Connelly, the estate’s executor, sued the United States, claiming he was owed a refund.

What did the court decide?

The court considered whether the buy-sell agreement set a $3 million price that controlled for estate tax purposes, and if not, the only issue after stipulations was whether the $3 million of life insurance proceeds used to purchase the estate’s shares should be considered in determining the value of the shares for estate tax purposes.

The district court and Eighth Circuit determined that the agreement did not set a price that was binding for estate tax purposes. In valuing the stock without regard to the agreement, both the district court and Eighth Circuit determined that the $3 million of life insurance proceeds should be included as a corporate asset in determining the value of the decedent’s shares. Both courts disagreed with the Eleventh Circuit’s rationale in Estate of Blount v. Commissioner (2005) that the contractual obligation of a company to purchase a decedent’s shares offsets the life insurance proceeds on the decedent’s life paid to the company.

The U.S. Supreme Court affirmed in a unanimous opinion.

What impact does this have on businesses?

Strategic estate planning is key, as highlighted by the Court’s decision. If your company has a redemption agreement funded by life insurance, review your agreement and consider making changes to avoid an unintended result. As part of this analysis, it is wise for business owners to:

• Analyze life insurance policies to make sure policies are valued correctly and set up to avoid unexpected tax obligations.
• Revisit buy/sell agreements
• Think about cross-purchase agreements
• Plan ahead for future tax obligations