SCOTUS Rules Life Insurance Proceeds Are Assets, Increasing Business Valuation and Tax Liability

On June 6, the U.S. Supreme Court issued a ruling that could significantly impact federal estate tax liability for privately held businesses. The case focused on a life insurance policy taken out by a company to buy back a deceased shareholder’s stock. In upholding the appellate court’s decision, the Court found that the proceeds from “key person insurance” are assets that must be included in the business valuation for federal estate tax purposes.

The case and decision are reviewed in detail below. Please note that much of the text is taken directly from SCOTUS decision. Paragraph breaks, bolding and italics have been added for ease of reading and emphasis of key points.

Supreme Court of the United States
Case No. 23–146
Connelly v. United States

Situation: Michael and Thomas Connelly were the sole shareholders in Crown C Supply, a small building supply corporation. The brothers entered into an agreement to ensure that Crown would stay in the family if either brother died. Under that agreement, the surviving brother would have the option to purchase the deceased brother’s shares. If he declined, Crown itself would be required to redeem (i.e., purchase) the shares. To ensure that Crown would have enough money to redeem the shares if required, it obtained $3.5 million in life insurance on each brother.

After Michael died, Thomas elected not to purchase Michael’s shares, thus triggering Crown’s obligation to do so. Michael’s son and Thomas agreed that the value of Michael’s shares was $3 million. Crown paid the same amount to Michael’s estate. As the executor of Michael’s estate, Thomas then filed a federal tax return for the estate, which reported the value of Michael’s shares as $3 million.

The Internal Revenue Service (IRS) audited the return. During the audit, Thomas obtained a valuation from an outside accounting firm.

Point of Disagreement: The case hinged on the conclusion of the outside accounting firm. That firm determined that Crown’s fair market value (FMV) at Michael’s death was $3.86 million, an amount that excluded the $3 million in insurance proceeds used to redeem Michael’s shares on the theory that their value was offset by the redemption obligation.

Simply put, the firm, in retrospect, miscalculated the value of the shares.

Calculations: The analyst calculated the value of Michael’s shares as approximately $3 million ($3.86 million x 0.7718) based on Michael’s 77.18% ownership of Crown.

The IRS disagreed. It insisted that Crown’s redemption obligation did not offset the life-insurance proceeds, and accordingly, assessed Crown’s total value as $6.86 million ($3.86 million + $3 million).

The IRS then calculated the value of Michael’s shares as $5.3 million ($6.86 million x 0.7718). Based on this higher valuation, the IRS determined that the estate owed an additional $889,914 in taxes. This reduced the inheritance of Michael’s son by 51%.

The estate paid the deficiency and Thomas, acting as executor, sued the United States for a refund. The District Court granted summary judgment to the Government. The court held that, to accurately value Michael’s shares, the $3 million in life-insurance proceeds must be counted in Crown’s valuation. The Eighth Circuit affirmed.

Rationale: When calculating the federal estate tax, the value of a decedent’s shares in a closely held corporation must reflect the corporation’s FMV. Life insurance proceeds payable to a corporation are an asset that increases the corporation’s FMV.

The question before the Court is whether Crown’s contractual obligation to redeem Michael’s shares at FMV offsets the value of life insurance proceeds committed to funding that redemption.

The answer is no. Because a FMV redemption has no effect on any shareholder’s economic interest, no hypothetical buyer purchasing Michael’s shares would have treated Crown’s obligation to redeem Michael’s shares at FMV as a factor that reduced the value of those shares.

Conclusion: At the time of Michael’s death, Crown was worth $6.86 million—$3 million in life-insurance proceeds earmarked for the redemption plus $3.86 million in other assets and income-generating potential. Anyone purchasing Michael’s shares would acquire a 77.18% stake in a company worth $6.86 million, along with Crown’s obligation to redeem those shares at FMV. A buyer would therefore pay up to $5.3 million for Michael’s shares ($6.86 million x 0.7718)—i.e., the value the buyer could expect to receive in exchange for Michael’s shares when Crown redeemed them at FMV. Therefore, Crown’s promise to redeem Michael’s shares at FMV did not reduce the value of those shares.

For calculating the estate tax, however, the whole point is to assess how much Michael’s shares were worth at the time that he died—before Crown spent $3 million on the redemption payment. A hypothetical buyer would treat the life-insurance proceeds that would be used to redeem Michael’s shares as a net asset.

Finally, Thomas asserts that affirming the decision will make succession planning more difficult for closely held corporations. That is a consequence of how the Connelly brothers chose to structure their agreement.

This article illustrates the importance of estate planning, which is a key service area for Weiss. Our professionals understand the intricacies of estate planning for everyone, including owners of small to medium-sized businesses. If that’s you, we are eager to work with you and your advisory team to develop a plan that meets your needs.