In light of the recent Supreme Court case of Connelly v. Internal Revenue Service, owners of closely held businesses may need to reconsider their plan to buy out a deceased owner’s stake in a business with life insurance proceeds.
In Connelly, two brothers, Michael and Thomas, were the sole owners of a building supply corporation. To guarantee that the survivor of them would become the sole owner of the company after the first of them died, they entered into a buy-sell agreement. That agreement provided that, after the first death of one of them, the survivor could purchase the predeceased brother’s shares at fair market value. If the surviving brother failed to purchase the shares, the company would be obligated to redeem those shares at fair market value. To ensure that the company would have sufficient cash for the redemption, the company purchased and was designated as the owner of a life insurance policy on each brother’s life. Michael’s policy had a death benefit of $3 million.
Michael died. Thomas declined to purchase Michael’s shares, so the company had an obligation to redeem those shares. An independent appraisal of the company was obtained to determine the redemption price. Per the appraisal, the fair market value of the entire company at Michael’s death was $3.86 million. The appraisal did not, however, include the $3 million of life insurance cash proceeds payable to the company at Michael’s death. The estate tax return filed for Michael’s estate reported the company’s value at $3.86 million, per with the appraisal. On audit, the IRS determined that the company’s fair market value was actually $6.86 million because the life insurance proceeds should have been added to the company’s overall value. They also assessed an additional $900,000 in estate tax against the estate. The District Court and Court of Appeals both sided with the IRS.
On appeal to the Supreme Court, the parties stipulated that the life insurance proceeds should have been included as part of the company’s fair market value. The narrow question before the Supreme Court was whether the company’s contractual obligation to redeem Michael’s shares at fair market value offset the value of the life insurance proceeds used to redeem his shares (similar to a liability or debt). The Court ruled unanimously that the company’s obligation to redeem shares at fair market value did not affect a shareholder’s economic interest in the company. A hypothetical buyer would treat the life insurance proceeds as an asset of the company and not as cash that would offset the price of the redeemed shares.
The takeaway from Connelly is that business succession planning must always evaluate potential estate and other tax consequences. The Court noted that it was not ruling that a redemption agreement could never reduce a corporation’s value. It was rejecting the proposition that any redemption obligation reduces a corporation’s value. This adverse outcome could have been avoided. For example, if the brothers had purchased life insurance on each other’s lives and the survivor then used the proceeds to purchase the shares directly from the deceased brother’s estate, the life insurance proceeds would not have been included in the value of the company. Alternatively, if the terms of the buy-sell agreement had been drafted to exclude the value of the life insurance from the valuation, the Court may have reached a different result. Other possible strategies to avoid the negative result of Connelly would be to (1) place the policy in an irrevocable life insurance trust; (2) utilize different entities to purchase the shares; and (3) conduct regular and thorough valuations of the company to ensure all relevant factors are taken into consideration prior to a succession plan being put place. Connelly is instructive as it emphasizes the importance of properly crafting a business succession plan with not only business advisors but with legal, tax and estate planning advisors as well.