Bulletins

Client Advisory: Valuing Closely-Held Stock for Estate Tax Purposes | Connelly v. US

April 12, 2024

   

Argued in the Supreme Court of the United States on March 27, 2024.

The issue in Connelly v. US is whether, for estate tax purposes, the value of a closely-held corporation using corporate-owned life insurance to redeem the shares of a decedent shareholder increases the value of the company by the insurance proceeds or whether the offsetting liability to pay for the stock redemption leaves the value of the company unchanged.

The IRS argued that the insured death benefit used to redeem the stock of the decedent shareholder of a closely held corporation increases the value of the corporation by the redemption amount and that the decedent’s shares should be valued accordingly. The taxpayer estate argued that the redemption was a liability offsetting the insured death benefit.

Brothers Michael and Thomas Connelly were the sole shareholders of a construction business. The corporation obtained insurance on each brother’s life so that upon the death of the first to die, it could use the insurance proceeds to redeem his shares. When Michael died, the corporation redeemed his stock for $3 million, an amount the brothers had agreed to, but which was not based on any independent appraisal of the company. Michael’s estate paid estate tax on the shares which it valued at $3 million.

The IRS did not recognize the redemption price as the value of Michael’s stock; instead, assessed additional estate taxes on his estate by including the value of the corporation’s life insurance proceeds used for the stock redemption. Michael’s estate argued that because the redemption cost offsets the insurance proceeds the value of the company was not increased by the insured death benefits. The estate paid the assessment and sued for a refund. Both the federal district court below and the Eighth Circuit Court of Appeals held for the IRS.

Eighth Circuit Decision

The Eighth Circuit Court quoted the IRS regulation that in valuing a closely held corporation, “consideration shall also be given to nonoperating assets, including proceeds of life insurance policies payable to or for the benefit of the company, to the extent such nonoperating assets have not been taken into account in the determination of net worth, prospective earning power and dividend-earning capacity.”    26 C.F.R. §   20.2031-2(f)(2).

The Eighth Circuit Court noted the contrary decision by the Eleventh Circuit in
Estate of Blount v. Commissioner, 428 F.3d at 1345-46, which involved a stock-purchase agreement for a closely held corporation. Although the Eleventh Circuit referenced 26  C.F.R.  § 20.2031-2(f)(2) that life insurance policies be “taken into account,” it concluded that such policies had been accounted for by the redemption obligation, which a willing buyer would consider.  428 F.3d at 1345. In balance-sheet terms, the court had viewed the life insurance policy as an “asset” directly offset by the “liability” to redeem shares,  yielding zero effect on the company’s value.   

The IRS argued, however, that redemption is not the satisfaction of liability but a retirement of shares no longer owned by a shareholder. From the selling shareholder’s viewpoint, the value of the corporation would include the insurance proceeds, as should the price of the shares sold.

The Eighth Circuit Court noted that extinguishing Michael’s approximate three-quarters ownership in the corporation meant that his shares were worth $7,720 each (i.e. $3.86 million value of the company without the insurance asset divided by 500 shares). If the company’s value was $3.86 million, then immediately after the redemption, Thomas’s shares were worth four times as much as Michael’s (i.e. $33,800, or $3.86 million divided by 114.1 shares). Thus, reasoned the Eighth Circuit, the insurance proceeds could not have offset a redemption liability dollar for dollar, as a true offset would not have changed the share values. (The fallacy in this reasoning rests with the changing number of shares before and after a redemption. The total number of shares outstanding before Michael’s shares were redeemed was 614.1. Thus, immediately before the redemption, Michael’s and Thomas’s shares were each worth $6,286 based on a company value of  $3.86 million. After the redemption, the value of Thomas’s 114.1 outstanding shares jumped to $33,829 because there were fewer shares outstanding, not because the company was worth more.)

SCOTUS

In the oral arguments before the U.S. Supreme Court, the taxpayer argued that the insurance proceeds did not increase the net value of the corporation because the insurance would be paid to redeem Michael’s shares. In oral arguments, the justices recognized that a third-party buyer of the corporation would not benefit from the $3 million of insurance proceeds because that amount was owed to Michael’s estate. That observation would support a view that the value of the corporation was $3.86 million, as the taxpayer argued, not $6.86 million.

The Court also noted that the Ninth and Eleventh Circuits held for the taxpayers in similar cases.

In contrast, the IRS argued that the redemption obligation is not a debt that reduces the value of the corporation but instead reflects a division between two shareholders of a $6.86 million corporate pie (including the insurance proceeds). The IRS further argued that it is not bound by the shareholders’ undervaluation of closely held shares for purposes of the estate tax. Thus, the IRS rejected that Michael’s 77% interest was worth $3 million in a redemption, and Thomas’s 23% interest was worth $3.86 million after the redemption.

The Supreme Court decision in this case will be issued later this year.

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