Banking and Business Monthly – June 2024

On June 6, 2024, the United States Supreme Court unanimously decided Connelly v. United States, No. 23-146, ruling that a corporation’s contractual obligation to redeem shares at fair market value is not necessarily a liability that reduces a corporation’s value for purposes of the federal estate tax.

Background

Michael and Thomas Connelly were the sole shareholders of Crown C Supply (“Crown”), a building supply corporation. They had an agreement that if either brother died, the surviving brother may buy the deceased's shares. If the surviving brother declined his option, Crown must then redeem the deceased brother’s shares at fair market value. Crown funded its redemption obligation by purchasing $3.5 million of life insurance on each brother.

Michael passed away and Thomas declined his option to purchase Michael’s shares. Michael’s son and Thomas agreed that the value of Michael’s shares was $3 million. The corporation received the life insurance proceeds and redeemed the shares at that price. As the executor of Michael’s estate, Thomas then filed a federal estate tax return reporting the value of Michael’s shares as $3 million. The Internal Revenue Service (IRS) audited the return. During the audit, Thomas obtained a valuation from an outside accounting firm. That firm determined that Crown’s fair market value at Michael’s death was $3.86 million, an amount that excluded the $3 million in insurance proceeds used to redeem Michael’s shares on the theory that their value was offset by the redemption obligation. The IRS disagreed with the valuation, insisting that the corporation’s redemption obligation did not offset the life insurance proceeds, calculating the value of Michael's shares as $5.3 million. Based on this higher valuation, the IRS determined that the estate owed an additional $889,914 in taxes. The estate paid the deficiency under protest and subsequently sued the Government for a refund. The District Court granted summary judgment for the IRS, and the Eighth Circuit Court of Appeals affirmed this ruling. The Supreme Court granted certiorari to resolve this split between the Eighth Circuit and several other courts.

Legal Analysis by The Court

The U.S. Supreme Court held that a corporation’s contractual obligation to redeem shares at fair market value is not necessarily a liability that reduces a corporation’s value for purposes of the federal estate tax. The Court reasoned that a fair market value redemption has no effect on any shareholder’s economic interest, and thus, no hypothetical 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. Although the remaining shareholders have a larger ownership percentage in a less valuable company following the buyback, the value of their holdings stays the same. The Court rejected the argument that the buyback obligation is a liability that offsets the life insurance asset, noting that a stock buyback reduces a company's value and concentrates ownership among fewer shares. The Court concluded that Crown’s promise to redeem Michael’s shares at fair market value did not reduce the value of those shares.

Implications

Connelly has significant implications for our estate and succession planning clients and the valuation of closely held corporations:

1. The decision confirms that life insurance proceeds intended to fund share redemptions are a corporate asset and should be included in valuations for estate tax purposes.
2. A corporate redemption obligation in a shareholder agreement does not reduce the value of the decedent’s shares if the redemption is at fair market value.

The Court acknowledged that its decision “will make succession planning more difficult for closely held corporations.” The Court, however, also identified “other options,” such as cross-purchase agreements, that are still available to carry out the same goals as the device employed here but acknowledged that those options pose a drawback of their own. Shareholders of closely held corporations, especially those with potential taxable estates, should review their shareholder agreements and estate plans with their attorneys and advisors and make any necessary changes. We can assist with the review and changes.

For further inquiries or questions, please contact me at smigala@lavellelaw.com or (847) 705-7555. Thanks go to Jacob Rotolo for assistance with this month’s article.