Connelly v. U.S.: Stock Redemption Doesn’t Offset Estate Tax

The case involved a dispute over how to calculate the estate tax for a deceased shareholder in a closely held corporation. Michael and Thomas Connelly were the sole shareholders of Crown C Supply, a small business. They had a succession agreement that allowed the surviving brother to purchase the deceased brother’s shares. If the surviving brother declined, the corporation was required to redeem the shares. To fund this obligation, Crown C Supply purchased $3.5 million in life insurance on each brother.

After Michael’s death, Thomas declined to buy the shares, triggering Crown’s obligation to redeem them. The company used $3 million from the life insurance policy to buy back Michael’s shares. When filing the estate tax return, the estate reported the shares’ value as $3 million, excluding the life insurance proceeds. However, the IRS took a different view, arguing that the corporation’s total value should include the insurance proceeds, increasing the valuation of Michael’s shares to $5.3 million and resulting in an additional tax assessment of $889,914.

The estate paid the tax and sued for a refund, arguing that the redemption obligation offset the value of the life insurance proceeds and should not increase the estate tax.

Supreme Court’s Decision

The Supreme Court ruled in favor of the IRS, affirming that the life insurance proceeds used for share redemption must be included in the company’s valuation. The Court determined that:

• The fair market value of the deceased’s shares must be calculated based on the corporation’s total assets at the time of death, including life insurance proceeds.
• A share redemption obligation does not reduce the company’s value because the redemption process does not impact the company’s net worth before the transaction occurs.
• A hypothetical buyer would consider the life insurance proceeds as an asset available for redemption, thereby increasing the value of the deceased shareholder’s stake.

The Court rejected the estate’s argument that the redemption obligation should count as a liability, stating that a redemption at fair market value does not diminish the company’s overall worth.

Implications for Business Owners

This ruling has significant consequences for business succession planning and estate tax calculations:

• Life insurance proceeds intended for share redemptions may increase the estate tax burden on a deceased shareholder’s estate.
• Business owners should carefully structure buy-sell agreements to avoid unexpected tax liabilities.
• Alternative structures, such as cross-purchase agreements, may provide better tax treatment by keeping life insurance proceeds outside the corporation.

Conclusion

The Supreme Court’s decision clarifies how life insurance proceeds affect estate tax calculations in business succession planning. It underscores the importance of carefully structuring shareholder agreements to anticipate tax consequences.

Succession Planning and Guidance

Business owners should review their succession plans to ensure a smooth transition and long-term stability. If you need legal support for structuring buy-sell agreements, business continuity planning, or leadership transitions, contact us for experienced guidance.