The Supreme Court will consider a dispute about whether life insurance payouts should be deemed to be corporate assets in calculating federal income taxes payable on a deceased person’s estate.
The case concerns two brothers’ closely-held corporation. After one of the brothers died, tax authorities and the estate failed to agree on the value of stock.
Closely-held corporations often 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. Corporations that enter into such agreements often purchase life insurance on the shareholder to make sure the transaction is funded.
The appeal of Thomas Connelly, executor of the estate of the late Michael Connelly, was rejected by the U.S. Court of Appeals for the 8th Circuit in June.
The IRS said the estate owed close to $1 million after it found that St. Louis-based Crown C Corp., a building materials business, did not 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 Supreme Court will look at 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 should not 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 that person’s 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.”
She wrote that the U.S. Court of Appeals for the 10th Circuit ruled in 2004 that every U.S. citizen or resident who dies is subject to tax under federal law. The value of the dead person’s gross estate is “the starting point for the calculation of the amount of [estate] tax to be paid” and “includes ‘the value of all property to the extent of the interest therein of the decedent at the time of his death,’” the 3rd Circuit ruled in 1987.
“[T]he valuation is to be made as of the moment of death and is to be measured by the interest that passes,” the brief states, citing a 1981 ruling by the 5th Circuit.
Treasury Department regulations state that the value of a gross estate is figured out according to the “fair market value” of the property, which “is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.”
The willing buyer and willing seller in the legal test are not the actual parties but are instead a hypothetical buyer and seller who must agree to a transaction. The willing buyer-willing seller test of fair market value “is nearly as old as the federal income, estate, and gifts taxes themselves.”
When it is difficult to ascertain the value of the stock, the law provides that a deceased person’s shares are valued by considering the company’s net worth, prospective earning power and dividend-paying capacity, and other factors. Consideration is also given to nonoperating assets, including the proceeds of life insurance policies benefiting the company, the brief states.
The executor filed an estate tax return reporting the value of his late 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 8th Circuit “correctly rejected” the executor’s argument that “for purposes of the federal estate tax, the value of Michael Connelly’s shares in a closely held corporation must exclude the value of the life-insurance proceeds to which the corporation was entitled on the date of Michael’s death,” the brief stated.
And the executor “overstates the extent of any disagreement in the lower courts.”
“No further review is warranted. As the court of appeals recognized … the federal estate tax applies to the transfer of the decedent’s gross estate[,]” Ms. Prelogar wrote.
The executor’s attorney, Kannon Shanmugam of Paul, Weiss, Rifkind, Wharton, and Garrison in Washington, declined to comment.
The Epoch Times reached out to the U.S. Department of Justice but had not received a comment as of press time.
An oral argument has not yet been scheduled in the case.
