Supreme Court life insurance ruling has estate tax implications

In a landmark decision earlier this year, the Supreme Court addressed a crucial issue regarding the valuation of shares in closely held corporations for federal estate tax purposes.

The case, Connelly v. United States (2024), clarified whether life insurance proceeds that are used to redeem a deceased shareholder's stock should be factored into the stock's valuation for estate tax calculations. The decision has many implications for CPAs, tax professionals, estate planners and investment advisors.

Case overview

Michael and Thomas Connelly were the sole shareholders of Crown C Supply, a closely held building supply corporation. To ensure continuity and to retain ownership within the family, they had a stock redemption agreement funded by corporate-owned life insurance policies worth $3.5 million each. '

Upon Michael's death, the corporation used $3 million from the life insurance proceeds to redeem his shares. But the IRS and the Connelly estate couldn't agree on the proper valuation of Michael's shares. The estate valued the shares based on the $3 million redemption payment, but the agency insisted that the life insurance proceeds should be included in the company's valuation. From the IRS perspective, the proceeds  would raise the total value of the estate to $6.86 million, consequently valuing Michael's shares at $5.3 million.

This valuation led to a significant additional estate tax liability for the Connelly estate.

Supreme Court decision

The Supreme Court sided with the IRS, affirming that life insurance proceeds should be included in the corporation's value when determining the value of the decedent's shares. The court clarified that the obligation to redeem shares at fair market value is not a liability that reduces the corporation's value for estate tax purposes.

The court's decision means that the life insurance proceeds used for the redemption would increase the corporation's total value, thereby increasing the value of the shares held by the deceased at the time of death.

Contradiction in Blount v. Commissioner

The Connelly decision brings to mind the precedent set in Blount v. Commissioner (2005) two decades earlier. In Blount, the Eleventh Circuit concluded that life insurance proceeds should be excluded (not included) from the valuation of a corporation when they are used to fund a stock redemption obligation.

As you can see, the Supreme Court's recent Connelly decision rejected the Eleventh Circuit's approach, finding it "demonstrably erroneous." Again, the Supreme Court emphasized that a redemption obligation does not offset the value of the life insurance proceeds and should be included in the corporation's value for estate tax purposes.

This divergence highlights the Supreme Court's intent to provide a clear and unified approach to handling such cases.

Implications for estate planning

This Connelly ruling underscores the importance of strategic planning for closely held businesses to avoid unexpected tax liabilities. Here are three strategies to consider:

1. Cross-purchase agreements. By using a cross-purchase agreement instead of a corporate redemption agreement, the surviving shareholders individually purchase life insurance policies on each other. Upon a shareholder's death, the surviving shareholders use the proceeds to buy the decedent's shares directly. This method ensures that the life insurance proceeds do not inflate the corporation's value for estate tax purposes, since the proceeds are not part of the corporate assets.

Advantages of cross-purchase agreements:

• Tax efficiency: The insurance proceeds do not increase the corporation's value, avoiding higher estate taxes.
• Direct ownership transfer: Shares are directly transferred to surviving shareholders, maintaining business continuity.
• Flexible ownership structure: This allows for adjustments in ownership percentages without involving the corporation itself.

 Challenges and considerations:

• Funding requirements: Ensuring adequate funding for the insurance premiums and potential buyouts can be challenging, especially for smaller businesses.
• Regulatory compliance: The agreement must comply with relevant laws and regulations, which may require professional legal and financial advice.

2. Defensible valuation methods. To prevent disputes and to ensure compliance with tax laws, it is crucial to establish defensible valuation methods within buy-sell agreements. These methods can include binding appraisals conducted by qualified professionals, formula valuations, or regularly updated agreed values.

Best practices for establishing valuation methods:

• Regular review: Regularly reviewing and updating buy-sell agreements ensures they reflect current business values and comply with evolving laws.
• Professional appraisals: Using qualified professionals for appraisals can provide a more accurate and defensible valuation.

3. Legal and regulatory compliance. Ensure that buy-sell agreements meet the requirements of Section 2703 of the Internal Revenue Code governing acquisition or transfer of property at less than FMV. This section disregards valuations in buy-sell agreements unless they are bona fide arrangements, not devices to transfer property to family members for less than full and adequate consideration. They must be comparable to similar arrangements in arm's-length transactions.

The Supreme Court's decision in Connelly v. United States highlights the need for closely held businesses to reassess their estate planning and buy-sell agreements. By considering alternative strategies like cross-purchase agreements and by ensuring defensible valuation methods, businesses can better manage their estate tax liabilities and ensure smoother ownership transitions.