Thomas H. Ward

“Pity me not, but lend thy serious hearing to what I shall unfold.”[i]  With its grant of certiorari late last December, the Supreme Court crossed the river Styx and resurrected a question that estate planners had thought was laid to rest long ago:  whether the proceeds of a life insurance policy held by a closely held corporation on a shareholder’s life and used for redemption of said shareholder’s stock increases that stock’s value for estate tax purposes?[ii]  Last June, the Eighth Circuit answered this question in the affirmative,[iii] a decision that now stands in juxtapose to the Eleventh Circuit’s ancient decision in Estate of Blount v. C.I.R.[iv]  And now, estate planners desperately await for the Supreme Court to unearth what will constitute taxable estates henceforth.

I. Connelly v. United States.

Michael and Thomas Connelly were brothers and the sole shareholders of Crown C Corporation, a building materials company in St. Louis, Missouri.[v]  Anticipating the inevitable, the two brothers entered a stock repurchase agreement, whereby the surviving brother or Crown would redeem the shares of the other brother upon his death.[vi]  To fund the redemption, Crown purchased $3.5 million life insurance policies on both Michael and Thomas.[vii]  When Michael died in 2013, Crown redeemed his shares for $3 million and kept the remaining life insurance proceeds ($500,000) to fund its operations.[viii]  The IRS audited the return, claiming that Michael’s estate undervalued his shares in Crown by relying on the redemption payment rather than determining the fair market value of Crown—which the IRS asserted included the value of the life insurance proceeds.[ix]  Both the District Court and the Eighth Circuit agreed.[x]

II. What is a Taxable Estate?

Start at square one, with what a taxable estate is.  The Internal Revenue Code dictates that every estate is subject to taxation.[xi]  And every estate begins as a gross estate whose value consists of “all property whether real or personal, tangible or intangible, wherever situated” of the decedent at her time of death.[xii]  This “gross estate” eventually transforms into a “taxable estate” as the decedent’s estate subtracts certain deductions allowed by the Internal Revenue Code.[xiii]  A taxable estate—and therefore the estate’s total tax liability—accordingly hinges on the value of the property of the decedent at the time of her death—the value of her gross estate.[xiv]

The end of Connelly is ultimately a question of the beginning: what was Michael’s gross estate?  In general, the value of stock held in said corporations is to be determined “without regard to any option, agreement, or other right to acquire . . . the property at a price less than the fair market value” or to “any other restriction on the right to sell or use such property.”[xv]  But if a redemption agreement (1) is a bona fide business arrangement, (2) is not a device to transfer property to members of the decedent’s family for less than full and adequate consideration, and (3) contains terms that are comparable to other similar arrangements entered into in arm’s length transactions, then the agreement can offset some of the value of the property.[xvi]  Unfortunately, the redemption agreement in Connelly fell short of this exclusion because it neither mentioned an amount nor prescribed a formula to calculate the amount to be paid at redemption.[xvii]

III. The Issue Before the Supreme Court.

Because the redemption agreement failed to fix a price for Michael’s shares in Crown, the Supreme Court must decide what the fair market value of Michael’s shares were at the time of his death for estate tax purposes.  As the pertinent regulations lay forth, the value of a property in an estate is the price at which said property would change hands between a willing buyer and a willing seller (the “willing buyer, willing seller test”).[xviii]  And when it comes to shares in closely held corporations, the willing buyer, willing seller test takes into account various factors, including the company’s net worth, its prospective earning power, and its dividend-paying capacity—as well as its non-operating assets like its proceeds from life insurance policies payable for the benefit of the corporation.[xix]   However, the IRS and Michael’s estate ultimately disagree as to whether the redemption obligation acts as a liability that offsets the life insurance proceeds that Crown received.

A. The IRS’s Argument.

On the one hand, the IRS argues that a hypothetical buyer would have paid up to $6.89 million for Michael’s shares of Crown by accounting for the $3 million in life insurance proceeds that Crown used to redeem Michael’s shares—but not the redemption obligation itself.[xx]  This is because a hypothetical buyer (according to the IRS) could either (1) cancel the redemption obligation, leave the $3 million in Crown, and own a company worth $6.86 million; or (2) have Crown redeem the shares for $3 million, receive $3 million in cash, and own a company worth $3.86 million post-redemption.[xxi]  Similarly, the IRS argues that a hypothetical seller would not sell her shares in Crown for only $3 million because of the value of the life insurance proceeds.[xxii]  Accordingly, the IRS maintains that Michael’s estate undervalued the fair market value of Michael’s shares.[xxiii]

B. Michael’s Estate’s Argument.

On the other hand, Michael’s estate argues that a hypothetical buyer would account not only for the life insurance proceeds—but also for the redemption obligation.[xxiv]  This is because a corporation’s net worth (according to Michael’s estate) involves a mathematical computation that considers the corporation’s assets and liabilities.[xxv]  And a corporation’s liabilities (according to the estate) should include its redemption obligations as they offset any life insurance proceeds.[xxvi]  Thus, Michael’s estate maintains that it did not undervalue Michael’s shares in Crown for estate tax purposes.[xxvii]

C. The Chamber of Commerce Weighs in.

On January 31, the Chamber of Commerce joined the fray and voiced its arguments in favor of Michael’s estate.[xxviii]  In its brief, the Chamber of Commerce urges the Supreme Court to consider the vital role that closely held corporations play in the economy and maintain the well-established practice of funding redemption obligations with life insurance proceeds.[xxix]  Further, the Chamber of Commerce attacks the IRS’s efforts to maximize tax liability, stating that it has consistently shifted its position through litigation of this issue rather than creating a valid rule.[xxx]

IV. So what, who cares?

With the cards on the table, the Supreme Court must now decide whether the life insurance proceeds used for redemption increase the value of a corporation for estate tax purposes.  If the Supreme Court sides with the IRS, closely held corporations may cease funding their redemption obligations with life insurance policies altogether—and instead elect to liquidate their core asset and diminish their overall productivity to avoid increasing their valuations for estate tax purposes.[xxxi]  It is now up to the Supreme Court to decide whether such an undesirable result is truly the purpose of estate taxation.

[i] William Shakespeare, Hamlet act. 1, sc. 5, l. 9–10 (Ghost).

[ii] Brief for Petitioner at 2–3, Connelly v. United States, No. 23-146 (U.S. Jan. 24, 2024).

[iii] Connelly v. United States, 70 F.4th 412, 421 (8th Cir.), cert. granted, No. 23-146, 2023 WL 8605743, at *1 (U.S. Dec. 13, 2023).

[iv] 428 F.3d 1338, 1346 (11th Cir. 2005).

[v] Connelly, 70 F.4th at 414.

[vi] Id.

[vii] Id.

[viii] Id.

[ix] Id. at 414–15.

[x] Id. at 415, 420–21.

[xi] See 26 U.S.C. § 2001(a).

[xii] See 26 U.S.C. §§ 2031(a), 2033.

[xiii] See 26 U.S.C. §§ 2001, 2051.

[xiv] See 26 C.F.R. § 20.2031-2 (stating that the value of a stock is the fair market value of said stock); Estate of Bright v. United States, 658 F.2d 999, 1006 (5th Cir. 1981) (“[T]he valuation is to be made as of the moment of death and is to be measured by the interest that passes.”).

[xv] 26 U.S.C. § 2703(a).

[xvi] 26 U.S.C. § 2703(b).

[xvii] Connelly v. United States, 70 F.4th 412, 417–18 (8th Cir.), cert. granted, No. 23-146, 2023 WL 8605743, at *1 (U.S. Dec. 13, 2023).

[xviii] See 26 C.F.R. § 20.2031-1(b).

[xix] See 26 C.F.R. §§ 20.2031-2(a), 20.2031-2(f)(2).

[xx] Brief for Respondent at 10, Connelly v. United States, No. 23-146 (U.S. Oct. 30, 2023).

[xxi] Id.

[xxii] Id. at 11.

[xxiii] Id. at 12.

[xxiv] Brief for Petitioner at 20–21, Connelly v. United States, No. 23-146 (U.S. Jan. 24, 2024).

[xxv] Id. at 21.

[xxvi] Id.

[xxvii] Id. at 23–24.

[xxviii] Brief for the Chamber of Commerce of The United States of America et al. as Amici Curiae Supporting Petitioners, No. 23-146 (U.S. Jan. 31, 2024).

[xxix] Id.

[xxx] Id.

[xxxi] Id.