These Business Owners Could Have Avoided a Million-Dollar Mistake

When family members own a business, they often plan for a time when one of them will die or become unable to contribute to the business.  Often, they plan for the decedent’s estate to sell ownership interests in a way that allows the remaining family members to retain control of the business.  If the business’s cash flow permits, they commonly buy insurance to fund that purchase.

Affirming the IRS’s position after arguments in a potentially avoidable million-dollar estate tax dispute, the U.S. Supreme Court, in a case styled Connelly v. United States, recently unanimously decided a case that suggests some estate planning considerations to influence those plans.[i] 

Connelly v. United States: The Case in Brief

The suit involved two brothers who owned a building materials company in corporate form in the St. Louis area.  The company bought life insurance on the brothers.  The brothers agreed that, if one of them died, the survivor could buy the decedent’s shares, and, if the survivor chose not to buy the shares, the company itself would buy the decedent’s shares. The company bought $3.5 million in life insurance to fund the purchase, if the company redeemed the shares from the estate.

The agreement contemplated that an independent appraiser would set the purchase price of the shares.

The surviving brother chose not to buy the shares, and the estate and the survivor did not immediately hire a third-party appraiser.  The estate and the survivor, as an officer of the company, agreed to a $3 million purchase price that they characterized as fair market value for the deceased brother’s shares, which represented about three-quarters of the outstanding shares.  One take away of Connelly v. United States is that, following the terms of the buy-sell agreement, a genuine appraisal would likely have been advisable.

The decedent’s estate filed an estate tax return that the IRS audited.  Based on the appraisal that came later, the return analyzed the arrangement for the purchase of the shares as an offset to the company’s receipt of the insurance proceeds, based on the decision in Blount v. Commissioner.[ii]  The IRS instead insisted that the repurchase obligation did not offset the company’s receipt of the insurance proceeds.  Both the federal district court[iii] and a panel of the Eighth Circuit Court of Appeals[iv] had upheld the IRS’s view.

The difference between the estimated and actual values of the shares held by the estate upon the decedent’s death resulted in an almost $1 million estate tax bill.     

The Supreme Court Weighs In on Estate Planning

The Supreme Court upheld the IRS’s valuation.  Justice Clarence Thomas’s opinion stated, “[a]n 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.”

The opinion used the following example.  Assume a corporation with $10 million in cash as its sole asset has 100 shares outstanding. One shareholder has 80 shares and the other has 20 shares.  Each share is worth $100,000.  If the 80 shares valued at $100,000 per share are redeemed, then the remaining shareholder continues to hold 20 shares with a value of $100,000 each, just as before the other shareholder’s redemption.

The court reasoned that, if a third-party purchaser (instead of the company) had purchased the estate’s shares, the third-party purchaser would have paid for the shares with the insurance proceeds in the company.  Therefore, for estate tax purposes, the estate’s shares would be worth what a third-party purchaser would have paid.  From a different point of view, it could be that a third party would attribute to a controlling block of shares a control premium.  Justice Thomas’s opinion does not explain why that possibility was not part of the analysis.

Justice Thomas’s opinion on behalf of all nine justices affirmed a basic tenet of corporate law: accountants should not necessarily treat a redemption as a corporate liability.  Instead, a redemption simply reduces “surplus” on the balance sheet.  The Eighth Circuit opinion held, “[t]he proceeds were simply an asset that increased shareholders’ equity.”  After a redemption, a remaining shareholder simply owns a larger piece of a smaller entity.

There’s a timing anomaly in this.  The company had the right to collect the death benefit immediately upon the decedent’s death, assuming the insurance company would actually pay the death benefit.  However, in this case, neither the company’s obligation to make the purchase nor the purchase price was fixed until later.  But at the date of death the insurance company’s obligation (subject to conditions) was triggered.  Similarly, the idea that a third-party would have purchased the company with the insurance proceeds in the company, prior to the redemption, depends upon specific timing of the third-party purchase.

Analysis

The decision’s analysis assumed that all these data points were created at the date of death.

The timing is critical, but the opinion doesn’t mention this.  Of course, it’s correct that, if a third party had purchased the company during the interval between the decedent’s death and the company’s receipt of the policy’s death benefit but before the company redeemed its shares, the buyer would have included the death benefit’s value in the corporation’s worth.  That’s the moment that counts, in the Supreme Court’s view.  If the hypothetical third party purchase had occurred prior to the death of either brother, the hypothetical buyer would also have included as a corporate asset the life insurance policy’s value related to the “first to die” brother.  On the other hand, if the purchase had occurred right after the redemption transaction, the $3 million purchase price would not have figured into the value attributed to the business.

Under the statute, the estate tax values the decedent’s assets at the time of death.  Inherent in the IRS’s determination and the court’s affirmation of it is that the death benefit is treated as an asset and the obligation to repurchase the decedent’s stock is not treated as an offsetting liability.  Justice Thomas’s opinion does not explain what factors justify this timing anomaly.  If all the factors that came to be known later had been assumed as part of the valuation, just as the IRS’s valuation assumed the company’s receipt of the death benefit, then the outcome might have been different. 

The redemption price as finally paid was uncertain at the moment of death, and whether the surviving brother would personally purchase the decedent’s shares was also apparently unknown at the moment of death. 

When the appraisal came, the estate’s argument was that the business was worth $3.86 million before and after the redemption.  However, the value per share in the estate was what was being measured, rather than the stand-alone value of the underlying asset.  The way the per share math works, the $3 million of purchase price derived from the death benefit needs to be added to the $3.86 million to make the per share value of the survivor’s shares the same as the redemption price of the decedent’s share.  In other words, if the company is worth $3.86 million before and after the redemption, the roughly three quarters of the outstanding shares held by the decedent’s estate gets a big control premium, a kind of disproportionate transfer of attributed value to the decedent’s shares.  The estate tax value per share requires the shares to all be treated, for fair market value purposes, as equal in value, a point Justice Thomas’s opinion does not make explicit.

The decision suggests that it might have been more favorable to the estate if the shareholders had owned the insurance and taken on the obligation to buy the shares.  What’s less clear is whether the surviving brother would have fared more favorably if he had purchased the shares himself.

Of course, arranging for all shareholders to buy the necessary insurance policies and pay the annual premiums for that insurance would be more cumbersome and difficult to manage.  That sort of arrangement might work better in a family setting with a small number of shareholders than in a company with numerous shareholders who lack family ties.  The more shareholders, the greater the management burden to keep all insurance in force.  Some shareholders might not be insurable at any price.

Lessons for Estate Planners

Connelly v. United States provides insight for estate planning practitioners.  First, as a general proposition, business owners typically are well advised to set themselves up personally to purchase the shares from a decedent’s estate.  That way, the survivors get a “stepped up” basis in the holdings purchased from the deceased owner’s estate, which benefits them down the road if they sell.  Also, if the business’s owners own the insurance, the proceeds never go into the entity.  The death benefit does not go into the decedent’s estate until the other owners buy the decedent’s shares in a transaction treated as a capital transaction, not as ordinary income.

Second, practitioners should remember that, because the premiums on life insurance purchased for this purpose are not “ordinary and necessary” business expenses, federal income tax rules do not permit the entity or the owner to deduct the premiums on tax returns.  The entity may have more access to cash than the owners, but the entity does not get a deduction for paying the premiums.  There is an added layer of tax if the cash used for the premium payments comes to the shareholders as salary or as a dividend.

Third, to save out-of-pocket costs, business owners often resist having an outside appraiser periodically assess a business’s value.  Instead, business owners often choose to promise to agree periodically (usually annually) on a value for their own equity interests using a document often called a “certificate of agreed value.”  In this case, the brothers had promised to agree from time to time on a certificate of agreed value, but they never did.  In a recent New Jersey case[v], the doctors in a busy medical practice similarly agreed to make a new certificate of value every year, but they didn’t adhere to that agreement.  In that case, although for other retirees the practice had redeemed shares based on third-party appraisals, the retiring doctor was limited to a two-decades-old certificate of value.  Accordingly, practitioners should consider an estate planning provision requiring an appraisal if no certificate is agreed upon within a two-year period prior to death.  Such a provision might avoid the issues present in Connelly and the recent case from New Jersey.

About the Author

A transactional lawyer working closely with business clients, Noel Humphreys actively participates in the ins and outs of business organizations. He focuses his practice on business transactions, lending transactions, organizational governance, and intellectual property. Noel has participated in hundreds of business combinations ─ mergers, asset acquisitions, joint ventures, strategic alliances, sourcing relationships and stock purchases ─ as well as settlements of disputes within family-owned businesses.

[i] Connelly v. United States, https://www.supremecourt.gov/opinions/23pdf/23-146_i42j.pdf, June 6, 2024).

[ii] Blount v. Commissioner, 428 F. 3d 1338 (11th Cir. 2005).

[iii] Connelly v. Department of Treasury, IRS, 2021WL 4281288 (E.D. Mo. Sept. 21, 2021).

[iv] Thomas Connelly v. United States, 70 F. 4th 412 (8th Cir. 2023).

[v] Namerow v Pediacare Assoc., 461 N.J. Super. 133 (Ch. Div. 2018), 218 A.3d 839.