How a Recent U.S. Supreme Court Decision May Impact Business Succession Planning
Owners of closely-held companies may plan for the death of a shareholder of a corporation or member of an LLC by purchasing life insurance to cover the cost of purchasing a deceased owner’s interest in the company. Last month, the U.S. Supreme Court issued an opinion, Connelly v. United States, that may cause business owners to change how they use life insurance in their succession plans. In Connelly, the Court considered whether a corporation’s contractual obligation to redeem shares of stock owned by a deceased shareholder reduced the corporation’s value for purposes of the federal estate tax. The Court, in a unanimous opinion written by Justice Thomas, ruled that for purposes of determining the potential federal estate tax owed by a deceased shareholder’s estate, an estate erred when it discounted the corporation’s value by the purchase price the company was contractually required to pay for a deceased shareholder’s interest in the company.
In this case, two brothers, Michael and Thomas Connelly, were the sole owners of a building supply business, Crown C Supply, Inc. Michael and Thomas signed an agreement that provided an option for the surviving shareholder to purchase a deceased shareholder’s shares in the company. If the surviving shareholder declined to purchase the shares, then the corporation was required to purchase the shares. The corporation purchased a life insurance policy on both brothers so that it would have money on hand to redeem the shares if either brother died.
Michael died. Crown C received $3 million in life insurance proceeds from the policy the corporation had purchased on Michael’s life. Thomas declined to exercise his option to purchase Michael’s shares, triggering Crown C’s contractual obligation to purchase Michael’s shares in the corporation from his estate with the $3 million in life insurance proceeds. When the Personal Representative of Michael’s estate calculated the fair market value of his interest in the corporation for the purposes of filing a federal estate tax return, it discounted the corporation’s value by the $3 million in life insurance proceeds allocated to purchase Michael’s shares from his estate.
It is helpful to consider this case in context of the federal estate tax, which applies to estates with more than $13.61 million in assets for individuals who die in 2024. For purposes of calculating an estate’s federal estate tax liability, the IRS requires an estate to provide a date of death value of each of its assets. In Connelly, the corporation’s assets included the $3 million in life insurance proceeds to which it was entitled on Michael’s death because the stock redemption from his estate had not yet occurred. The question before the Court was not whether the life insurance proceeds should have been included in the corporation’s value, but rather whether that value should have been discounted by the corporation’s contractual obligation to redeem Michael’s stock from his estate.
The IRS disagreed with the approach Michael’s estate took to valuing the corporation, as did the Eighth Circuit Court of Appeals, and the Supreme Court. Instead, the IRS successfully argued, the fair market value of the corporation should not have been discounted by the corporation’s share redemption obligation when Michael died because the share redemption would have no economic impact on the shareholders. The Court reasoned that a corporation’s total value should be reduced after redeeming outstanding shares of stock in the corporation, because the company has paid out case in exchange for a number of its shares. After a share redemption, a corporation should be left with fewer remaining shareholders holding a larger proportional interest.
What’s a closely held corporation to do? Here, Justice Thomas offers a simple solution that many closely held corporations may already use: Rather that the corporation purchasing a life insurance policy on a shareholder’s life, the individual shareholders could enter an agreement among themselves to purchase life insurance on one another’s lives. In Connelly, if Thomas had been the owner of the life insurance policy (rather than Crown C), then Thomas could have purchased Michael’s interest in the business from his estate. If it is the other shareholders receiving the proceeds from life insurance for the purpose of purchasing a deceased shareholder’s interest in a company, then the life insurance proceeds would not be included in calculating the fair market value of the shares owned by the deceased shareholder, because the corporation did not own the policy.
The lesson? Details matter, and how a closely-held company structures its succession plan can have a significant financial impact. If you have questions about business succession planning, the lawyers at Beresford Booth can help you.
To learn more about How a Recent U.S. Supreme Court Decision May Impact Business Succession Planning, please contact Beresford Booth at info@beresfordlaw.com or by phone at (425) 776-4100.
