For closely held companies, a frequently used estate planning strategy is to have the company buy life insurance policies on each major shareholder to fund the buyout of the shareholder’s shares in the event of his or her death. A recent decision by the California Supreme Court requires a fresh look at this approach.

In the recent Supreme Court case of Connelly v. U.S., Michael Connelly (“Michael”) and Thomas Connelly (“Thomas”) were brothers and sole shareholders in Crown Supply, a closely held building supply corporation.

Their shareholder agreement gave each brother an option to buy the shares of the deceased brother. If the surviving brother declined, Crown Supply was required to redeem the deceased brother’s shares.

Crown Supply bought a $3.5 million life insurance policy on each brother to fund this potential redemption. Michael died, and Thomas elected not to buy Michael’s shares. Crown Supply then paid Michael’s estate $3 million (a value agreed upon by Michael’s son and Thomas).

Not surprisingly, the IRS audited Michael’s estate tax return.

Thomas then obtained an outside appraisal to value Crown Supply. The appraiser excluded the insurance proceeds, valuing Crown Supply at $3.86 million and Michael’s 77.18% interest at approximately $3 million.

The IRS rejected this exclusion of the life insurance proceeds, and valued Michael’s shares at $5.3 million. This was based on calculating the total value of Crown Supply at $6.86 million, consisting of $3.86 million as the appraised value of the corporation, plus the $3 million of insurance proceeds, and multiplying the $6.86 million by Michael’s 77.18% stake in the company.

The case presented the Supreme Court with the narrow legal issue of whether the value of life insurance proceeds received by a corporation is offset by the obligation to redeem shares from an estate.

This issue had resulted in a split of decisions between two Court of Appeals confronted with this issue.

In Estate of Blount v. Commissioner, the 11th Circuit had held that insurance proceeds should be deducted from the value of a corporation when they are offset by an obligation to pay those proceeds to the estate in a stock buyout.

Conversely, in Connelly v. Department of Treasury, the Eighth Circuit found that Crown Supply’s obligation to redeem Michael’s shares was not a liability that reduced the corporation’s fair market value.

The Supreme Court affirmed the Eighth Circuit decision, accepting the IRS argument that no real-world buyer or seller would have viewed the redemption obligation as an offsetting liability.

In support of its ruling, the Supreme Court offered an example in which a corporation had $10 million cash as its only asset and two shareholders, A and B, who owned 80 and 20 shares. A’s shares were worth $8 million, and B’s shares were worth $2 million.

To redeem B’s shares, the corporation would pay $2 million, leaving A as the sole shareholder in a corporation worth $8 million. But the value of these shareholders’ interests after redemption – A’s 80 shares worth $8 million and B’s $2 million in cash – equaled the $10 million value of their interests before redemption. Thus, a corporation’s contractual obligation to redeem shares didn’t reduce the value of those shares in and of itself.

In Connelly v. U.S., the Supreme Court concluded that the fair market value redemption had no effect on any shareholder’s economic interest in Crown Supply. It stated that the whole point was to assess how much Michael’s shares were worth at the time he died, before Crown Supply spent $3 million on its redemption payment.

Connelly v. U.S. provides useful succession planning lessons for shareholders of a closely-held corporation.

Had Michael and Thomas used a cross-purchase agreement, where each brother had taken out an insurance policy on the other brother’s life to fund the stock purchase, the value of company’s shares wouldn’t have gotten increased by life insurance proceeds (which in turn resulted in considerable additional estate tax.)

Moreover, had the surviving brother Thomas purchased the deceased brother Michael’s shares, Thomas would have gotten a cost basis for them, which would be used to determine gain when those shares were sold. There is no beneficial cost basis to the surviving shareholder in a corporate redemption.

It should also be noted that the valuation of a company in a buy‑sell agreement doesn’t bind the IRS.

Internal Revenue Code (“IRC”) §2703(a) provides the value of any property is determined without regard to any option, agreement, or other right to acquire or use the property at less than the fair market value of the property (without regard to such option, agreement, or right), or to any restriction on the right to sell or use such property, unless an exception applies under IRC §2703(b).

This rule disregarding rights and restrictions does not apply to any right or restriction that meets each of the following requirements:

  • it is a bona fide business arrangement;
  • it is not a device to transfer the property to members of the decedent’s family for less than full and adequate consideration in money or money’s worth; and
  • its terms are comparable to similar arrangements entered into by persons in an arm’s‑length transaction.

Agreements among shareholders can provide for the orderly transfer of shares in the event of a shareholder’s death, and be of great value to both surviving shareholders and the estate of a deceased shareholder. However, as demonstrated by the Supreme Court’s ruling in Connelly v. U.S., such agreements should be carefully drawn, with particular attention to whether life insurance will fund a share transfer, and who should own the insurance policies.

By Michael R. Morris