Life Insurance Proceeds Included in Estate Tax Value of Corporation

In a unanimous decision issued on June 6, 2024, the Supreme Court held that life insurance proceeds payable to a corporation are includible in the corporation’s value for Federal Estate Tax purposes, with no offset allowed for the obligation to purchase a deceased shareholder’s interest.  Estate of Connelly v. United States, 602 U.S. ___ (2024) (No. 23-146, June 6, 2024).

Michael and Thomas Connelly were the owners of Crown C Supply, a building supply corporation (the “Company”).  Michael was the CEO and owned almost 80% of the stock, with Thomas owning the rest.  The brothers had entered into a buy-sell agreement that was to be effective in the event of their deaths.  Under the agreement, the surviving brother was given the option to purchase the deceased brother’s shares.  If he did not do so, the Company itself would be required to redeem the shares.  The Company obtained life insurance policies of $3.5 million on each brother.

When Michael died in 2012, Thomas elected not to purchase Michael’s shares and therefore the Company was obliged to redeem them.  The Company received the insurance proceeds and redeemed Michael’s shares for $3 million, a value agreed to by Thomas and Michael’s son.

The Federal Estate Tax return filed for Michael’s estate reported the fair market value of the Company at Michael’s death to be $3.86 million, which did not include the $3 million in life insurance proceeds used to redeem Michael’s shares.  The appraisal supporting the fair market value of the Company offset the insurance proceeds by the redemption obligation.  On audit, the IRS disagreed with the estate’s appraisal and included a portion of the insurance proceeds in the value of the Company, thereby increasing the Federal Estate Tax bill by $1 million.

Two lower federal courts, a Missouri District Court and the U.S. Court of Appeals for the Eighth Circuit, held for the IRS, and the Supreme Court affirmed.

In the Supreme Court’s ruling, the Court agreed with the IRS.  The Court held that contractual agreements to purchase shares of deceased shareholders do not serve to diminish the value of those shares, which must reflect the corporation’s fair market value when calculating the Federal Estate Tax.  Therefore, a company may not deduct a contractual obligation to purchase a deceased shareholder’s shares with life insurance proceeds.  The Court stated that “[a]n obligation to redeem shares at fair market value does not offset the value of life-insurance proceeds set aside for the redemption because a share redemption at fair market value does not affect any shareholder’s economic interest.”  Connelly Slip Op. at pp. 5-6.

A more favorable result could have been obtained if the brothers had established a cross-purchase buy-sell agreement or a life insurance LLC, thus avoiding payment of the insurance proceeds to the Company.  It appears clear that in view of the result in Connelly, now is the time for business owners to review their buy-sell agreements and consider what changes may be advisable.

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