The Supreme Court ruled on the Estate of Michael P. Connelly Sr. today (June 6, 2024). The court sided with the government and ruled that a company’s contractual obligation to redeem shares (as a result of the death of one of the shareholders) is not a liability that reduces a company’s value for purposes of the federal estate tax. However, the court’s ruling leaves some questions unanswered.

Introduction

On March 27, 2024, the United States Supreme Court heard arguments in the Estate of Michael P. Connelly Sr. (Thomas A. Connelly, petitioner) v. Internal Revenue Service.

The case centered on valuation: Should the proceeds of a life-insurance policy taken out by a closely held corporation on a shareholder for the express purpose of facilitating the redemption of the shareholder’s stock be considered a corporate asset when calculating the value of the shareholder’s shares for purposes of the federal estate tax?

The taxpayer contended that the life-insurance proceeds should be excluded, thereby lowering the value of the decedent’s shares and lowering the tax owed. The IRS disagreed and assessed additional estate taxes of about $890,000 (the original estate tax paid was about $300,000). The estate paid the additional tax and sued for a refund.

The District Court of the Eastern District of Missouri ruled that the life-insurance proceeds should be included and that the company was worth $3.5 million more on the valuation date than the day before. The Eighth Circuit Court of Appeals concurred with the District Court.

And now the Supreme Court has essentially concurred with the District Court and the Appeals Court (although, in its decision, the Supreme Court framed the issue more properly as to whether the redemption liability should be included or excluded rather than the insurance proceeds). However, this ruling still leaves questions unanswered.

Background

Two brothers, Michael and Thomas Connelly, were the only shareholders in Crown C Supply Inc., owning 385.9 shares (77.18%) and 114.1 shares (22.82%), respectively. Crown C Supply Inc. was a closely held family business that sold roofing and siding materials. (It was sold to SRS Distribution Inc. in August 2018.)

As is typical in family businesses, the brothers entered into a stock purchase agreement that required the company to buy back the shares of the first brother to die, and the company purchased two life insurance policies to ensure that the company had enough cash to make good on the agreement.

When Michael died on October 1, 2013, Crown C subsequently repurchased his 385.9 shares for $3 million, and Michael’s estate paid estate taxes on his shares in Crown C based on this value. Thus, aside from the life-insurance proceeds, Crown C was worth roughly $3.9 million on the date of Michael’s death ($3 million divided by 0.7718).

Due to Michael’s death, Crown C now had an obligation to repurchase Michael’s shares from his estate. In addition, Crown was about to receive a cash infusion of $3.5 million from the life-insurance proceeds; without these proceeds, Crown C would have had to deplete its assets or borrow money (or both) to buy Michael’s shares.

The taxpayer contended that the stock purchase agreement created “an enforceable contractual obligation to use the life-insurance proceeds to purchase [Michael] Connelly’s stock in Crown C Supply” upon Michael’s death citing the Estate of Blount v. Commissioner (428 F.3d 1338, 1342–43 [11th Cir. 2005]).

The IRS countered that allowing the redemption obligation to offset the insurance proceeds “undervalues Crown C Supply’s equity, undervalues [Michael’s] equity interest in Crown C Supply (i.e., his shares), and violates well-established equity valuation principles because the resultant share price creates a windfall for a potential buyer that a willing seller would not accept.”

Decision

A large portion of the District Court’s ruling discusses the provisions of the stock purchase agreement and the reasons why, under the provisions of applicable law, it should be ignored. Ultimately, the District Court ruled that the stock purchase agreement could not be relied upon to determine the fair market value of the decedent’s shares.

The estate did not obtain a third-party appraisal to determine such value (as required under the agreement) and instead tried to rely on the value that was arbitrarily set between the company and the estate of $3 million. However, because both the taxpayer and the IRS agreed on the $3 million value (excluding the life-insurance proceeds), the District Court did not determine an alternative fair market value of the company. (The estate did obtain an appraisal once the audit was underway.)

Previously, the Eleventh Circuit had ruled “that the stock-purchase agreement created a contractual liability for the company, offsetting the life-insurance proceeds” (Estate of Blount).

The District Court disagreed. “The Court must determine the fair market value of Crown C on the date of Michael’s death, not the value in its post-redemption configuration,” the Court wrote in its decision. Further, “redemption obligations are different from other types of corporate obligations in that a redemption obligation both shrinks the corporate assets and changes its ownership structure.”

Ultimately, the District Court held that the life insurance proceeds should be included in the value of the company.

Appeals Decision

The estate appealed the ruling—unsuccessfully. The Eighth Circuit agreed with the District Court on both issues: the stock purchase agreement did not control how the company should be valued and the life insurance proceeds must be included. The Appeals Court cited the Fletcher Cyclopedia of the Law of Corporations, “the redemption of stock is a reduction of surplus, not the satisfaction of a liability.”

Interestingly, the Eighth Circuit references a valuation dilemma without ultimately resolving it or even seemingly being aware of the precise consequences. The dilemma valuation practitioners face is determining the exact timing of the valuation. Is it the moment prior to death, the moment of death, or the moment after death?

The Eighth Circuit states in its ruling, “We focus on this moment in time—after Michael’s death but before his shares are redeemed.” However, in making this decision (after death), the Court references a Fifth Circuit ruling (Bright’s Est. v. United States) that stated, “the valuation is to be made as of the moment of death and is to be measured by the interest that passes, as contrasted with the interest held by the decedent before death or the interest held by the legatee after death.” Presumably, that difference in wording was lost on the Eighth Circuit.

While this may sound like an insignificant difference, the implications are quite profound. If the valuation took place before or at the moment of death (and, presumably, death is a somewhat unpredictable event), then there could be no expectation of an immediate payout of the life-insurance proceeds.

If the valuation should take place after the death (as the District Court implies and the Appeals Court states outright), then should other factors resulting from the death be considered? For instance, what if most or all customer relationships were with the decedent? Should the potential loss of such customers be factored into the valuation?

Ruling

During the hearing before the Supreme Court, the taxpayer’s representative conceded that the life-insurance proceeds should be included in the value of the company and that the issue is rather whether the redemption obligation represents an offsetting liability. This is an important distinction. If a company is the beneficiary of a life-insurance policy but does not have a corresponding redemption obligation, does the value need to be included? The taxpayer conceded on this issue during oral arguments, but did the court actually rule on this particular issue?

The court did. In its opinion, the Supreme Court states, “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….”

In a footnote, the court acknowledges that a redemption liability could potentially reduce a company’s value if such a redemption obligation caused the company to liquidate assets required in the operations of the company (and therefore reduce future cash flows).

Unanswered Questions

Despite the seemingly straightforward ruling by the Supreme Court, questions remain: As mentioned above, do you factor in the death of the decedent in the valuation? Does the age and health of the insured matter in the analysis? What about the presumed value of the second life-insurance policy on the life of the second brother, Thomas? Wouldn’t it also increase the value of the company in some way?

On that note, the courts in this case only ever considered the question if the life insurance proceeds (i.e., the death benefit) should be included in the value of the company. No consideration was made whether another measure of value (e.g., cash surrender value, interpolated terminal reserve value) should be considered instead.

The life insurance proceeds were $3.5 million but only the $3 million used for the redemption seems to have been added back to the value. What about the other $500,000? Does this omission imply that proceeds not used for a redemption should be ignored (or was it simply an omission)?

Conclusion

In the rare occurrence of the U.S. Supreme Court taking up a tax issue, including a valuation question, the court sided with the IRS (and all prior courts) that a redemption obligation does not represent liability of the company and therefore does not reduce the value of the company for purposes of the federal estate tax.