In May, I wrote about a case before the U.S. Supreme Court with potential estate tax planning implications.
The case, Connelly v. United States, was recently decided unanimously in favor of the IRS. See below for a summary description of the case and the Supreme Court’s ruling:
- Background: Michael and Thomas Connelly were sole shareholders in Crown C Supply, Inc. A stock purchase agreement was in place that obligated the company to purchase a stockholder’s shares upon death. The company had maintained a life insurance policy on each of the brothers to fund a redemption of shares. In October 2013, Michael Connelly died. The company received $3.8 million in insurance proceeds. The company also recorded a $3 million liability based on the company’s obligation to purchase the shares, largely offsetting the asset on the books.
- IRS Dispute: The IRS audited the estate’s tax return. During the audit, Thomas Connelly’s valuation expert concluded that the fair market value of the equity of the company was $3.86 million, which included a $3 million liability for the redemption obligation. The IRS’s expert determined a fair market value for the company’s equity of $6.86 million, differing from the taxpayer’s expert in that the IRS did not include a liability for the redemption obligation, effectively increasing the company’s value by the amount of the insurance proceeds received. As a result, the estate was assessed additional taxes of $889,914. The estate paid and sued for a refund, arguing that the insurance proceeds should not be included to the extent that the proceeds were used to redeem Michael Connelly’s shares.
- Supreme Court Ruling: The Supreme Court held that a company’s contractual obligation to purchase shares does not reduce the value of the company for federal estate tax purposes. The Court reasoned that the redemption obligation does not affect any shareholder’s economic interest and thus does not offset the value of the insurance proceeds.
- Implications: The decision clarifies that life insurance proceeds received by the company from the death of a shareholder must be included in the company’s value when determining estate taxes. This ruling impacts how closely held entities plan for succession and structure agreements. As a result, business owners should review any buy-sell agreements and life insurance policies that are in place and consult with legal or tax experts to consider any tax ramifications, in light of the Connelly decision. In some cases, a cross-purchase agreement may be beneficial. (In a cross-purchase agreement, life insurance is held at the individual or trust level, not at the company level, in which case, insurance proceeds will not be included in the company’s value and will not be subject to the estate tax, such as it was in this case.) Additionally, seeking estate planning and business valuation services may allow you to prepare for a tax-efficient wealth transfer and to plan for any future tax liabilities in advance. Taking proactive steps is essential for smart estate planning and smooth business succession.
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