A case with estate planning implications is currently before the U.S. Supreme Court after split decisions at the circuit court level. The case, Connelly v. United States, will address the treatment of corporate-owned life insurance (COLI), a common way for small businesses to fund the redemption of stock from a deceased stockholder. However, this tool may be in jeopardy depending on the outcome.
In the case, two brothers owned a roofing and siding company called Crown C Supply, Inc., with Thomas Connelly holding 22.82% ownership and brother Michael the remaining 77.18%. Michael died in October 2013.
As stipulated in a stock purchase agreement, Crown C Supply, Inc. was obligated to purchase the deceased stockholder’s shares. The company and Michael’s estate agreed on a purchase price of $3 million (implying a total equity value of approximately $3.86 million). The company had maintained a life insurance policy on Michael and received approximately $3.5 million in proceeds upon his death. The money was used to pay Michael’s estate in the share redemption, with the excess $0.5 million in proceeds added to the company’s value as a nonoperating asset.
An estate tax return was filed, valuing Michael’s shares at the agreed-upon purchase price. The IRS subsequently audited the estate and determined that the $3.0 million life insurance proceeds used for stock redemption should be added to the value of the company, resulting in a total equity value (for 100% ownership) of $6.89 million. As a result, the IRS issued a Notice of Deficiency, assessing over $1 million in additional estate taxes.
The estate argued that by increasing the value of the company by the value of the insurance proceeds, the IRS effectively ignored the corresponding liability since the company was obligated to redeem the deceased stockholder’s shares and the insurance money was received into the company, then directly paid out to the estate. The estate also argued that increasing the company value by the $3 million insurance proceeds results in double taxation, first through the estate tax, then later as a capital gains tax due to the increase in the value of Thomas’s shares.
The IRS argued that there isn’t an actual liability incurred in this case that reduces the net worth of the company or the value of shares to be redeemed; in other words, the $3.5 million will not be repaid like a loan owed to a creditor would be and even though the money did go out of the company, it gained another asset in its place—the shares it redeemed from the deceased stockholder. As a result, the total “pie” is $6.89 million, and the value attributable to the estate would be the deceased stockholder’s ownership percentage times the value of this larger pie.
The Supreme Court justices questioned both sides’ arguments extensively in an attempt to understand the issues at hand. However, the justices did not tip their hand(s) on how they expect to eventually rule on the matter creating some temporary uncertainty for taxpayers who currently have COLI.
Regardless of the ultimate ruling, COLI can be a useful tool for estate and succession planning. It provides funding to ensure the continuity of the business and provides the cash flow to do so without the company potentially having to liquidate assets needed for the company’s continued operations. However, if the Supreme Court rules that the insurance proceeds increase the value of the company, the attractiveness of COLI as an estate planning tool will likely be significantly impacted. Stay tuned for updates in this case, as well as information on any ramifications for COLI and estate and succession planning.
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