Supreme Court Ruling on Connelly and Life Insurance Proceeds: Implications for Estate Tax Valuation

In a landmark decision, the Supreme Court addressed a crucial issue regarding the valuation of shares in closely held corporations for federal estate tax purposes. The case, Connelly v. United States (2024), clarified whether life insurance proceeds used to redeem a deceased shareholder’s stock should be factored into the stock’s valuation for estate tax calculations.

Case Overview

Michael and Thomas Connelly were the sole shareholders of Crown C Supply, a closely held building supply corporation. To ensure continuity and retain ownership within the family, they had a stock redemption agreement funded by corporate-owned life insurance policies worth $3.5 million each. Upon Michael’s death, the corporation used $3 million from the life insurance proceeds to redeem his shares.

The IRS and the Connelly estate disputed the proper valuation of Michael's shares. The estate valued the shares based on the $3 million redemption payment, while the IRS insisted that the life insurance proceeds should be included in the company's valuation. This inclusion would raise the total value to $6.86 million, consequently valuing Michael’s shares at $5.3 million. This valuation led to a significant additional estate tax liability.

Supreme Court Decision

The Supreme Court sided with the IRS, affirming that the life insurance proceeds must be included in the corporation's value when determining the value of the decedent's shares. The Court clarified that the obligation to redeem shares at fair market value is not a liability that reduces the corporation's value for estate tax purposes. This decision means that the life insurance proceeds used for the redemption increase the corporation's total value, thereby increasing the value of the shares held by the deceased at the time of death.

Contradiction in Blount v. Commissioner

The decision in Connelly also brings to mind the precedent set in Blount v. Commissioner (2005). In Blount, the Eleventh Circuit concluded that life insurance proceeds should be excluded from the valuation of a corporation when they are used to fund a stock redemption obligation. The Supreme Court in Connelly rejected this approach, finding it "demonstrably erroneous." The Court emphasized that a redemption obligation does not offset the value of the life insurance proceeds, which should be included in the corporation’s value for estate tax purposes. This divergence highlights the Supreme Court's intent to provide a clear and unified approach to handling such cases, contrasting sharply with the Blount decision's exclusion of life insurance proceeds from the corporate valuation.

Implications for Estate Planning

This ruling underscores the importance of strategic planning for closely held businesses to avoid unexpected tax liabilities. Here are some strategies to consider:

1. Cross-Purchase Agreements:

One effective strategy is to utilize a cross-purchase agreement instead of a corporate redemption agreement. In a cross-purchase agreement, the surviving shareholders individually purchase life insurance policies on each other. Upon a shareholder's death, the surviving shareholders use the proceeds to buy the decedent’s shares directly. This method ensures that the life insurance proceeds do not inflate the corporation's value for estate tax purposes, as the proceeds are not part of the corporate assets.

Advantages of Cross-Purchase Agreements:

• Tax Efficiency: The insurance proceeds do not increase the corporation’s value, avoiding higher estate taxes.

• Direct Ownership Transfer: Shares are directly transferred to surviving shareholders, maintaining business continuity.

• Flexible Ownership Structure: Allows for adjustments in ownership percentages without involving the corporation itself.

 Challenges and Considerations:

• Funding Requirements: Ensuring adequate funding for the insurance premiums and potential buyouts can be challenging, especially for smaller businesses.

• Regulatory Compliance: The agreement must comply with relevant laws and regulations, which may require professional legal and financial advice.

2. Defensible Valuation Methods:

To prevent disputes and ensure compliance with tax laws, it is crucial to establish defensible valuation methods within buy-sell agreements. These methods can include binding appraisals conducted by qualified professionals, formula valuations, or regularly updated agreed values.

Best Practices for Establishing Valuation Methods:

• Regular Review: Regularly reviewing and updating buy-sell agreements ensures they reflect current business values and comply with evolving laws.

• Professional Appraisals: Using qualified professionals for appraisals can provide a more accurate and defensible valuation.

3. Legal and Regulatory Compliance: 

Ensure that buy-sell agreements meet the requirements of Section 2703 of the Internal Revenue Code. This section disregards valuations in buy-sell agreements unless they are bona fide arrangements, not devices to transfer property to family members for less than full and adequate consideration, and comparable to similar arrangements in arm's-length transactions.

Conclusion

The Supreme Court's decision in Connelly v. United States (2024) highlights the need for closely held businesses to reassess their estate planning and buy-sell agreements. By considering alternative strategies like cross-purchase agreements and ensuring defensible valuation methods, businesses can better manage their estate tax liabilities and ensure smoother ownership transitions.

Anthony Venette, CPA/ABV is a Senior Manager, Business Valuation & Advisory, DeJoy & Co., CPAs & Advisors in Rochester, New York. He provides business valuation and advisory services to corporate and individual clients of DeJoy.