Supreme Court Case Could Upend a Key Succession Strategy

The case involves a life insurance strategy intended to keep remaining shareholders in control after a key shareholder’s death.

A case being considered by the U.S. Supreme Court could have a widespread impact on one common succession planning practice that closely held businesses often use to ensure continuity upon the death of a key shareholder.

Closely held businesses often enter into redemption agreements whereby the business agrees to redeem a deceased shareholder’s shares. These agreements are typically funded with life insurance. The goal, of course, is to ensure that remaining shareholders retain control of the business after a key shareholder’s death. 

In the case under consideration, Connelly v. United States, 23-146, the Internal Revenue Service claims that the value of that life insurance should increase the value of the deceased shareholder’s business interests for federal estate tax purposes. The Supreme Court is now contemplating how to resolve a split between how the Eighth Circuit and Eleventh Circuit have ruled on this issue.

While it remains to be seen how the justices will decide, closely held businesses that have entered into redemption-type agreements should carefully consider their funding options — and the potential estate tax impact of these arrangements.

The Connelly Case Facts

Connelly involves a situation where a closely held corporation purchased life insurance on the lives of key shareholders. The business here was jointly owned by two brothers. Upon either shareholder’s death, the surviving brother had the option of purchasing the deceased brother’s shares. In the event that the surviving brother did not opt to purchase the other’s shares, the corporation would redeem them.

The corporation purchased $3.5 million in life insurance on each shareholder. When the first brother died, the corporation received the life insurance proceeds and, pursuant to the redemption agreement, redeemed the deceased shareholder’s shares in the corporation.

The deceased brother’s son and the surviving brother agreed that the value of the deceased brother’s shares was $3 million. This value disregarded the valuation approaches contained in the original stock purchase agreement, which would have valued the decedent’s shares at $3.89 million. After the redemption, the decedent’s brother became the sole shareholder in the business and used the remaining $500,000 in life insurance proceeds to fund business operations.

The question being considered is whether the $3.5 million in life insurance proceeds received by the corporation should be considered a corporate asset that would increase the value of the ownership interest held by the deceased shareholder for federal estate tax purposes.

Assertions During Oral Arguments

During oral arguments, the estate argued that the life insurance proceeds should not increase the value of the deceased shareholder’s estate because the corporation had a contractual obligation to redeem the decedent’s shares (which should be considered a liability that offset the value of the insurance). The estate further argued that the proper value of the decedent’s ownership interest was the value of the estate’s interest in the business before the business’ receipt of the life insurance proceeds.

To support their assertions, the estate’s attorneys argued that a hypothetical buyer would not think that the life insurance proceeds would increase the value of the decedent’s shares because of the corporation’s contractual obligation to use the proceeds to redeem those shares. The hypothetical buyer would have no way to capture the value of the life insurance proceeds.

The government, on the other hand, pointed out that a redemption obligation is not the same as a corporate debt that would have reduced the business’ net worth. Instead, the obligation divides the existing “corporate pie” among the shareholders without changing the value of their interests in the business.

Therefore, the government argued that the deceased shareholder’s net worth at the time immediately before the division of ownership interests should reflect the addition of the life insurance proceeds. Because the estate did not include those proceeds when valuing the decedent’s corporate shares, the government argues that their value was significantly understated for estate tax purposes.

Questions From the Justices

Justice Elena Kagan pointed out that the decedent’s brother now had a 100% ownership interest in the company, which had significantly increased in value due to the receipt of the life insurance proceeds. 

However, the estate responded that that increase in value would eventually be subject to capital gains tax if and when the decedent’s brother sold his business interests. On the other hand, future capital gains tax does not affect current estate tax valuation.

When the estate argued that the business would have had to tap operating assets or engage in some other type of transaction to ensure business continuity after the key shareholder’s death, Justice Sonia Sotomayor responded that the corporation could have purchased additional life insurance to account for the increased estate tax liability.

Justice Clarence Thomas focused on the price for which the decedent’s brother would have been willing to sell his shares immediately after the decedent’s death — and whether he would have considered receipt of the life insurance proceeds to increase the shares’ value.

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