Connelly v. United States, 2024
The U.S. Supreme Court took on this case because of a split between two circuit courts. In the first case, Blount v. Commr., the 11th Circuit Court of Appeals reversed the Tax Court and excluded the insurance proceeds that accrued as a result of the death of the shareholder since there was a binding liability to pay the proceeds to the estate of the decedent. In the Connelly case, the Tax Court once again included the insurance proceeds in the estate. The 8th Circuit affirmed the Tax Court, and the Supreme Court now unanimously affirmed the 8th Circuit, thus negating the decision of the 11th Circuit in Blount.
The two Connelly brothers founded a small building supply company, Crown C Supply. Michael owned a 77.18% interest in Crown. The brothers had entered into an agreement whereby the surviving brother would have the right to purchase the stock of the deceased brother. If he declined, then Crown would be required to redeem the shares. Insurance on each brother totaling $3.5 million was purchased to insure the liquidity of the redemption payment. Thomas declined to purchase the shares at Michael’s death, and Thomas and Michael’s son agreed the value of the shares was $3 million. Crown paid that amount to Michael’s estate. Michael’s brother, Thomas, executor of Michael’s estate, filed an estate return showing the value of Michael’s shares at $3 million. A valuation of Michael’s shares arrived at a value of $3.86 million, which excluded the $3 million in insurance proceeds.
The IRS disagreed and insisted that Crown’s redemption obligation did not offset the insurance proceeds. “The IRS then calculated the value of Michael’s shares as $5.3 million ($6.86 million × 0.7718).… 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.”
“Held: A corporation’s contractual obligation to redeem shares is not necessarily a liability that reduces a corporation’s value for purposes of the federal estate tax.” The question here was whether the obligation to redeem Michael’s shares at fair market value offset the life insurance proceeds. No! The fair market value redemption had no economic impact on any shareholder. At Michael’s death, Crown was worth $6.86 million. For calculating the estate tax, the point was to assess how much Michael’s shares were worth when Michael died—before Crown paid the $3 million redemption amount. Thomas argued that the stock was worth $3.86 million before the redemption and $3.86 million after the redemption. Both cannot be right.
Opinion.
“The central question is whether the corporation’s obligation to redeem Michael’s shares was a liability that decreased the value of those shares. We conclude that it was not and therefore affirm.”
Michael owned 77.18%, or 385.9 out of 500 shares, of Crown. Thomas owned the remaining shares. They entered into an agreement providing that the surviving shareholder would have the option to buy the deceased brother’s shares. If the survivor declined, then Crown would be required to redeem the shares. The redemption price would be based on an outside appraisal of the fair market value of Crown. To insure liquidity to pay the redemption, Crown obtained a $3.5 million life policy on each brother.
When Michael died in 2013, Thomas opted not to purchase his shares. Crown was obligated to purchase the shares. Rather than get an appraisal, Thomas (Michael’s executor) and Michael’s son agreed that the shares were worth $3 million. The tax return for Michael’s estate reported the share value at $3 million. Thomas obtained a valuation of Crown during the IRS audit of Michael’s estate tax return from an accounting firm. He was told that the insurance proceeds need not be included in the value of Crown to the extent they were offset by the payment obligation. (Estate of Blount v. Commr.). Thus, the $3 million in proceeds used to redeem Michael’s shares were excluded from the value. Crown was valued at $3.86 million.
The IRS contended that the $3 million should be included in the value of Crown and, thus, arrived at a value of Crown of $6.86 million, resulting in an estate tax deficiency of $889,914.
The district court awarded a summary judgment to the government, ruling that the $3 million of proceeds must be included in the value of Crown. “It explained that, under customary valuation principles, Crown’s obligation to redeem Michael’s shares was not a liability that reduced the corporation’s fair market value.” (2021 U.S. Dist. LEXIS 179745) (Editor’s note: In the district court case, the court opinion stated that “[t]he IRS contends that the Eleventh Circuit’s approach violates customary valuation principles, resulting in a below-market valuation for Crown C and a windfall for Thomas at the expense of Michael’s estate.” There is no support for this statement noted in the district court opinion. It appears that the district court accepted on its face the veracity of this comment by the IRS expert. Many BV professionals do not agree with this.)
The estate did not explain why it believed the 11th Circuit decision in Blount should hold in this case. The estate argued that Crown’s redemption liability would offset the inclusion of the life-insurance proceeds. “The only question is whether Crown’s contractual obligation to redeem Michael’s shares at fair market value offsets the value of life-insurance proceeds committed to funding that redemption.”
Thomas argued that a buyer would view the obligation as an offset to the proceeds. The government, on the other hand, argued that “no real-world buyer or seller would have viewed the redemption obligation as an offsetting liability.” The Supreme Court agreed with the government. The Supreme Court offered an example to prove the point:
Consider a corporation with one asset—$10 million in cash—and two shareholders, A and B, who own 80 and 20 shares, respectively. Each individual share is worth $100,000 ($10 million ÷ 100 shares). So, A’s shares are worth $8 million (80 shares × $100,000) and B’s shares are worth $2 million (20 shares × $100,000). To redeem B’s shares at fair market value, the corporation would thus have to pay B $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). Economically, the redemption would have no impact on either shareholder. The value of the shareholders’ interests after the redemption—A’s 80 shares and B’s $2 million in cash—would be equal to the value of their respective interests in the corporation before the redemption. Thus, a corporation’s contractual obligation to redeem shares at fair market value does not reduce the value of those shares in and of itself.
There was no change in the economic interest of any shareholder. No willing buyer would consider the obligation as reducing the fair market value of the shares. “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.” The Supreme Court concluded that the redemption obligation did not reduce the fair market value of the shares.
A hypothetical buyer would treat the life-insurance proceeds used for the redemption as a net asset per Thomas. That the redemption obligation was a liability cannot be reconciled with the mechanics of a stock redemption. The transaction reduced the value of the corporation, but there were fewer shares. “Thomas argues that Crown was worth only $3.86 million before the redemption, and thus that Michael’s shares were worth approximately $3 million ($3.86 million × 0.7718). But he also argues that Crown was worth $3.86 million after Michael’s shares were redeemed. See Reply Brief 6. That cannot be right: A corporation that pays out $3 million to redeem shares should be worth less than before the redemption.”
Thomas also argued that affirming the decision will make estate planning more difficult. The Supreme Court found this argument to be misplaced. The Supreme Court affirmed the decision of the Court of Appeals.