Supreme Court Decision Impacts Closely Held Corporation Succession Planning
On June 6, 2024, the Supreme Court unanimously held in Connelly vs. United States that a closely held corporation’s redemption obligation (related to a life insurance policy) does not diminish the fair market value of the corporation’s shares for federal estate tax purposes.
Background: Connelly vs. United States
The Connelly case involved a typical succession planning and estate tax issue for closely held corporations.
Two brothers, Michael and Thomas Connelly, were the sole shareholders of Crown C Supply (“Crown”), a closely held building supply company.
Using a common succession planning technique for closely held businesses, the brothers established a redemption agreement with Crown. The agreement stipulated that if one brother died, the surviving brother would have the option to purchase the deceased brother’s shares in Crown. If the surviving brother chose not to purchase the shares, Crown would be contractually obligated to redeem the deceased brother’s shares.
The brothers and Crown agreed that the redemption price would be based on a fair market valuation performed by an outside appraiser. To fund this obligation, Crown obtained two separate $3.5 million life insurance policies on each shareholder.
When Michael passed away in 2013, Thomas declined to purchase Michael’s shares. As a result, Crown redeemed Michael’s shares. The parties disregarded the fair market valuation provision in the redemption agreement (in effect ignoring the life insurance proceeds) and negotiated to value Michael’s shares at $3.0 million. The life insurance proceeds paid to Crown were used to fund the redemption, leaving Thomas as the sole shareholder of Crown.
As executor of Michael’s estate, Thomas was required to file a federal estate tax return for Michael. He reported the value of Michael’s shares in Crown as $3.0 million on the estate tax return. The IRS audited the return and challenged the estate’s valuation method.
IRS Challenge to the Valuation and Supreme Court Decision
The central question in the Connelly case was the effect of the life insurance proceeds on the company’s value. Thomas Connelly argued that if the life insurance proceeds increased the company’s value, the obligation to redeem Michael’s shares should offset the proceeds, thereby reducing the company’s value. The IRS disagreed, and ultimately, so did the Supreme Court in a unanimous 9-0 decision.
Why Does it Matter?
When a shareholder dies, the fair market value of the corporation becomes crucial for estate tax considerations. The IRS values a taxpayer’s estate as the total fair market value of all assets owned immediately upon the taxpayer’s death. The total fair market value of the shares owned at death is then reported on the deceased’s estate tax return.
According to the Supreme Court, based on the following example, the redemption obligation does not affect the company’s value:
“A corporation holding $10 million in cash and nothing else, with each of its 100 shares accordingly worth $100,000 ($10 million divided by 100). Suppose that the corporation redeems twenty shares from one of the shareholders. To redeem [the] shares at fair market value, the corporation would thus have to pay $2 million. After the redemption, A would be the sole shareholder in a corporation worth $8 million and with 80 outstanding shares. A’s shares would still be worth $100,000 each ($8 million ÷ 80 shares).”
The Court asserted that this example effectively resolves the case: “because a fair-market value redemption has no effect on any shareholder’s economic interest, no willing buyer would have treated [the] obligation to redeem … as a factor that reduced the value of those shares.”
Recommendations
The Supreme Court’s decision in the Connelly case will make succession planning more challenging for closely held corporations. However, there are steps you can take to mitigate potential issues:
- Review buy-sell agreements to ensure they are structured with tax implications in mind.
- Consider a cross-purchase agreement instead of a buy-sell agreement.
- Analyze existing and proposed life insurance planning with estate and income tax ramifications in mind.
- Be aware that the IRS often scrutinizes closely held business agreements and valuations. Consult tax and legal experts for succession planning and seek qualified professionals to value the corporation.
- Plan for future tax obligations resulting from your chosen succession plan structure.
- Document agreements thoroughly to successfully defend against potential IRS challenges.
Please contact your Herbein tax consultant if you have any questions regarding this article or need assistance with your business succession planning.
Article contributed by Sarah R. Knox
