The Supreme Court ruled unanimously in favor of the IRS on June 6 in a dispute over taxing shareholders’ life insurance policies.
The case concerns two brothers’ closely held corporation. After one of the brothers died, tax authorities and the estate didn’t agree on the value of the stock.
Closely held corporations commonly enter into agreements that require the redemption of a shareholder’s stock after the shareholder dies to preserve the closely held nature of the business. Under such routine estate-planning devices, corporations purchase life insurance on the shareholder to make sure the transaction is funded.
The Supreme Court held that life insurance proceeds that will be used to redeem a decedent’s shares must be included when calculating the value of those shares for purposes of the federal estate tax.
The appeal of Thomas Connelly, executor of the estate of Michael Connelly, was rejected by the U.S. Court of Appeals for the Eighth Circuit in June 2023.
The IRS said the estate owed close to $1 million after it found that St. Louis-based Crown C Corp., a building materials business, failed to report life insurance proceeds after Michael Connelly died in 2013.
Michael Connelly, who was president and CEO of the corporation when he died, owned 77.18 percent of the company’s shares, while Thomas Connelly owned 22.82 percent.
The executor filed an estate tax return reporting the value of his brother’s shares as $3 million, but the IRS conducted an audit in which an accounting firm valued the shares at more than $3.8 million at the time of the brother’s death.
The IRS determined that the life insurance proceeds needed to be included in the valuation of the corporation, which meant the company had a value of $6.8 million at the date of death. The IRS found that the estate owed an additional $890,000. The estate paid the amount and then sued the tax agency in federal court in Missouri.
The Supreme Court examined whether a life insurance policy obtained to finance the company’s repurchase of the deceased co-owner’s shares should be factored into the valuation of the stock.
The estate argued the stock shouldn’t be taxed because the proceeds were to be used to repurchase the outstanding shares. The IRS countered that the shares were subject to tax based on the fair market value as measured by what they could be sold for when the co-owner died.
The case concerns an important question of federal tax law on which the federal courts of appeal disagree, according to the surviving brother’s petition.
Under the Internal Revenue Code, when an individual dies, his or her estate is subject to federal estate tax calculated, based on the fair market value of the estate’s holdings at the time of the death.
“In many cases, fair market value can be determined through a straightforward analysis of public markets. But when a particular type of asset is not freely traded, fair market value must be determined on the basis of assessment and evaluation,” the petition states.
“Under applicable Treasury regulations, life-insurance proceeds payable to a corporation may be relevant to determining the value of a decedent’s stock in the corporation in some circumstances but not others.
“The question presented is whether the proceeds of a life insurance policy taken out by a closely held corporation on a shareholder in order to facilitate the redemption of the shareholder’s stock should be considered a corporate asset when calculating the value of the shareholder’s shares for purposes of the federal estate tax.”
In his new opinion, Justice Thomas recounted that the Connelly brothers entered into an agreement to make sure the company would stay in the family if either brother died. In that pact, the corporation could be forced to purchase the deceased brother’s shares.
To finance the possible share redemption, the corporation took out life insurance on each brother. After Michael Connelly died, there was a dispute over how to value his shares for calculating the estate tax.
“The central question is whether the corporation’s obligation to redeem Michael’s shares was a liability that decreased the value of those shares,“ Justice Thomas wrote. ”We conclude that it was not and therefore affirm [the decision of the Eighth Circuit].”
The justice explained that when Michael Connelly died, the corporation was worth almost $4 million and the family valued his shares at about $3 million. However, the tax agency took the view that the corporation’s value was closer to $7 million because of the $3 million in insurance proceeds. This made the decedent’s shares worth a little more than $5 million.
“Because a fair-market-value redemption has no effect on any shareholder’s economic interest, no willing buyer purchasing Michael’s shares would have treated Crown’s obligation to redeem Michael’s shares at fair market value as a factor that reduced the value of those shares,” Justice Thomas wrote.
The justice wrote, “Redemption obligations are not necessarily liabilities that reduce a corporation’s value for purposes of the federal estate tax.”
