The Supreme Court’s ruling in Connelly v. Internal Revenue Service may drive the owners of small businesses to reevaluate one of their core organizational documents. In Connelly, the Court was asked to consider the valuation and tax implications of life insurance policies used by a company to facilitate a mandatory repurchase of a deceased stockholder’s shares – a common structure in many stockholder and operating agreements.
Michael and Thomas Connelly were the sole shareholders of a small business, Crown C Supply (“Crown”), and entered into an agreement, pursuant to which Crown would repurchase a deceased brother’s shares upon his death if the surviving brother elected not to repurchase the shares himself. To ensure it could satisfy the repurchase obligations, Crown obtained a $3.5 million life insurance policy against the death of each brother.
In 2013, Michael died; upon his death, Michael’s son and Thomas agreed that Crown was valued at $3.86 million, meaning Michael’s shares, representing approximately 77% of Crown’s equity, were worth $3 million. This amount was paid to the estate by Crown, from the insurance proceeds it received upon Michael’s death. This agreed upon valuation was based on the premise that the value of life insurance proceeds was offset by Crown’s obligation to repurchase Michael’s shares and, therefore, did not serve to increase the company’s value. However, during an audit of Michael’s estate tax return, the IRS disagreed with the determination of Crown’s value, arguing that the insurance proceeds used to fund the repurchase should have served to increase the value of the company from nearly $4 million to nearly $7 million. This increased valuation, in turn, increased the size of Michael’s estate and corresponding estate tax liability. Ultimately, the Supreme Court ruled in favor of the IRS, holding that the redemption obligations are not necessarily liabilities that reduce a corporation’s value for purposes of the federal estate tax. The net result of the IRS’s decision, as affirmed by the courts, was nearly $1 million in additional estate taxes due to the government from Michael’s family.
While this was an unfortunate result for the taxpayer in this case, in its opinion, the Court noted that there remain various structures available to owners of closely held companies (such as a cross-purchase arrangement) that would not necessarily increase the value of the corporation under similar circumstances. However, these alternative structures carry their own considerations and may not be appropriate.
Ultimately, the Connelly case serves as a reminder of how business formation, succession planning, and estate planning are often intertwined, and how critical it is to have strategic counsel from seasoned professionals throughout the life cycle of your business.
For more information about how this Supreme Court ruling may impact you, your business, or your clients, please contact the Davis, Agnor, Rapaport & Skalny attorney with whom you typically work, or contact an attorney in our Business Planning & Transactions or Estate Planning Practice Groups here.
