Life insurance proceeds increase the estate tax value of a closely held corporation and aren’t offset by its obligation to redeem a deceased shareholder’s interest, the Supreme Court has ruled.

In a unanimous opinion June 6 in Connelly v. United States, the Court ruled that “a corporation’s contractual obligation to redeem shares at fair market value does not reduce the value of those shares” in calculating estate tax.

Until his death, Michael Connelly co-owned Crown C Supply with his brother, Thomas Connelly. The company held life insurance on each brother, with the proceeds earmarked to redeem their shares when either of them died. After Michael’s death, Crown used $3 million in insurance proceeds to redeem his 77.18% interest in the company.

Petitioner Thomas Connelly, the executor of Michael’s estate and the surviving shareholder in Crown, claimed that the company was worth $3.86 million at his brother’s death and that the $3 million in proceeds used to fund the redemption didn’t increase that value. The IRS disagreed, included those proceeds in its estate tax valuation of Crown, and argued the company was instead worth $6.86 million.

The Supreme Court sided with the IRS, affirming the Eighth Circuit’s June 2023 decision in the matter.

“At the time of Michael’s death, Crown was worth $6.86 million — $3 million in life-insurance proceeds earmarked for the redemption plus $3.86 million in other assets and income generating potential,” Justice Clarence Thomas wrote for the Court.

A willing buyer purchasing Michael’s 77.18% interest in the company would pay $5.3 million for it, so that is the value that must be included in Michael’s estate, the Court ruled.

Thomas clarified that the corporation must be valued before — not after — the redemption. “For calculating the estate tax, the whole point is to assess how much Michael’s shares were worth at the time that he died — before Crown spent $3 million on the redemption payment,” he wrote.

The petitioner’s argument that the $3 million in life insurance proceeds was offset by the company’s obligation to redeem his deceased brother’s shares “cannot be reconciled with an elementary understanding of a stock redemption,” Thomas wrote. He pointed out the logical flaw inherent in that argument — that the company couldn’t be worth $3.86 million both before and after the redemption: “That cannot be right: A corporation that pays out $3 million to redeem shares should be worth less than before the redemption” (emphasis in original).

“To the extent any parties were relying on this logical flaw to ignore the proceeds of corporate-owned life insurance when valuing a decedent’s equity interest for estate tax purposes, that opportunity is now closed. Appropriately so,” Brant J. Hellwig of New York University School of Law told Tax Notes.

‘Absolutely Delighted’

After the justices appeared to be wrestling with the valuation issues at oral argument, “the theme emanating from the unanimous decision of the Supreme Court in Connelly is that this was an easy case after all,” Hellwig said.

“This was a complete victory for the government and, I believe, the right decision based on both the legal authorities and the nature of redemption obligations,” Adam Chodorow of the Sandra Day O’Connor College of Law at Arizona State University told Tax Notes.

The petitioner relied on an Eleventh Circuit decision from 2005, Estate of Blount v. Commissioner, 428 F.3d 1338, which held that life insurance proceeds shouldn’t be included in the company’s value when they are offset by a redemption obligation.

Chodorow was critical of the ruling in Estate of Blount and said he is “absolutely delighted” with the decision overturning it. Before the Supreme Court granted review in Connelly, he wasn’t hopeful the issue would be revisited, he said.

“I assumed that would be the end of it,” Chodorow said, adding that “sometimes courts just get it wrong, and the issue seemed unlikely to be taken up by Congress.”

Hellwig said that the Tax Court got this issue right in its own 2004 decision in Estate of Blount, T.C. Memo. 2004-116, “before the Eleventh Circuit botched the issue on appeal.”

Both Chodorow and Hellwig filed amicus briefs supporting the IRS’s position in Connelly.

Spiraling Insurance Policies

This decision “creates a serious problem” for businesses that are valued based on their net liquidation value and that plan to fund a redemption with life insurance proceeds, according to Howard Zaritsky, a retired attorney who frequently lectures on estate tax matters.

“Including the life insurance proceeds in the value of the corporation creates a very steep increase in the amount of insurance required to pay for the redemption,” Zaritsky told Tax Notes. If adding the proceeds increases the value of the business, then the deceased shareholder’s interest is worth more, and “the amount of insurance required to fund the [redemption] increases, which then further raises the purchase price, and on and on,” he said.

It is now far less practical for closely held businesses to fund the entire redemption price with insurance, Zaritsky said. Instead, they will need to either accumulate earnings to fund the repurchase or buy the shares with a cash down payment coupled with a promissory note for the remainder. If it opts for the latter, a business could use a much smaller life insurance policy to fund only the cash down payment — limiting the amount of proceeds added to the company’s value, he explained.

The Connelly decision “should remind practitioners of the importance of accurate valuation” of corporate shares for purposes of redemption and buy-sell agreements, Zaritsky said. He noted, however, that those clauses are difficult to draft and administer.

Limited Impact

Estate tax lawyers generally agree that the use of life insurance-funded redemptions and buy-sell agreements by closely held businesses is a common practice. But the Supreme Court’s decision isn’t likely to affect a large swath of those businesses because most of the life insurance policies at issue aren’t large enough to tip an estate over the minimum estate tax filing threshold, they told Tax Notes.

For taxpayers who die in 2024, that threshold is $13.61 million. It will drop to about half of that when a provision from the Tax Cuts and Jobs Act that increased it in 2018 expires at the end of 2025.

The threshold was $5.25 million when Michael Connelly died in 2013.

Petitioner’s counsel declined to comment for this article.

The petitioner in Connelly v. United States, Sup. Ct. Dkt. No. 23-146 (2024), was represented by Kannon K. Shanmugam and other attorneys from Paul, Weiss, Rifkind, Wharton & Garrison LLP and by Robert Devereux and Mary Devereux of AEGIS Law.