In Connelly, the United States Supreme Court held that when a corporation has a contractual obligation to use life insurance proceeds to redeem shares at fair market value, that redemption is not a liability that reduces the value of shares and, thus, must be included in a company’s valuation for purposes of federal estate tax. Connelly v. United States, 144 S. Ct. 1406 (U.S. 2024).
Background
As a Catholic estate planning lawyer can share, Brothers Michael and Thomas were the sole shareholders in a successful building supply corporation, Crown Supply. Michael and Thomas entered into an agreement with the company, which provided that if either Michael or Thomas died, the surviving brother would have the option to purchase the deceased brother’s shares. If the surviving brother declined to do so, then the company itself would be required to redeem the shares.
To ensure that the company would have enough money to redeem the shares if so required, the company obtained $3.5 million in whole life insurance on each brother.
When Michael died in 2013, Thomas opted not to purchase Michael’s shares. As a result, the company was obligated to redeem Michael’s shares.
Michael’s executor filed an estate tax return and reported the value of Michael’s shares at $3 million, in accordance with the agreement.
The estate’s accounting firm concluded that insurance proceeds should be “deduct[ed] from the value” of a corporation when they are “offset by an obligation to pay those proceeds to the estate in a stock buyout.”
The IRS, however, concluded that the redemption obligation did not offset the life insurance proceeds and added the $3 million in life insurance proceeds to the value of the company, thereby increasing the value of Michael’s estate and tax liability by $889,914.
Considerations And Takeaways
When deciding whether a redemption (company repurchasing shares or units) agreement or a cross-purchase (permits other members or shareholders to purchase units after death) agreement is best for a client’s closely held business, estate tax considerations should be taken into account as our friends at Aptt Law LLC would advise.
The benefit of a redemption agreement is the security that comes with the company making the life insurance premiums. Redemption agreements are also effective for professional practices or multi-member/multi-shareholder companies because it limits the number of policies that would need to be purchased.
The benefit of a cross-purchase agreement is that insurance is not added to the company’s net asset value or to the decedent’s estate. Another benefit of a cross-purchase agreement is that the shareholders/members get a basis equal to what they pay in shares. The downside is that with multi-shareholder/member companies, you need multiple policies (e.g., a company with 4 people would need 12 policies). Another downside is that you don’t have the security of a company paying the policy premiums.
A good alternative for professional companies or closely held multi-member/multi-shareholder companies is to form an insurance LLC. This provides the benefits of a cross-purchase agreement and reduces the number of policies required to be purchased. An insurance LLC can also be structured to compel the company to make distributions to cover the policy premiums. If you need help with this, contact an attorney near you.