US Supreme Court Affirms the Eighth Circuit’s Decision in Favor of the Government Concerning the Estate Tax Treatment of Life Insurance Proceeds Used to Fund a Corporate Redemption Obligation

The specific question presented was whether, in determining the fair market value of the corporate shares, there should be any offset to take into account the redemption obligation to the decedent’s estate under a buy-sell agreement. The Supreme Court concluded that there should be no such offset. In doing so, the Supreme Court resolved a conflict that had existed among the federal circuit courts of appeal on this offset issue.

Facts

Brothers Michael and Thomas Connelly were the only shareholders in Crown C Supply, Inc., a closely held family business that sold roofing and siding materials. Michael owned approximately 77% of the company’s shares, while Thomas owned approximately 23%. The brothers entered into a stock purchase agreement that gave the surviving brother the right to buy the decedent’s shares. If the surviving brother declined, Crown was required to buy back the shares of the first brother to die, and the company bought $3.5 million in life insurance on the life of each brother to ensure it had enough cash to make good on the agreement.

According to the lower courts’ decisions, the stock purchase agreement provided two mechanisms for determining the price for which Crown would redeem the shares. The principal mechanism required the brothers to execute a new Certificate of Agreed Value at the end of every tax year, which set the price per share by “mutual agreement.” If they failed to do so, the brothers were supposed to obtain two or more appraisals of fair market value. The brothers never executed a Certificate of Agreed Value or obtained appraisals as required by the stock purchase agreement.

Michael died in October 2013, and the company repurchased his shares, constituting approximately 77% ownership interest in the company for $3 million. The rest of the life insurance proceeds ($500,000) went to fund company operations. Michael’s estate paid estate taxes on his shares in the company. The Internal Revenue Service (IRS) assessed additional estate taxes of nearly $900,000. Thomas, as executor of his brother’s estate, paid the deficiency and filed a suit in federal district court for the Eastern District of Missouri seeking a refund.

The district court granted summary judgment in favor of the government, holding:

• First, that Section 2703 of the Internal Revenue Code applied to disregard the buy-sell agreement to determine the value of the decedent’s ownership interest in the company for estate tax purposes.
• Second, that in determining the fair market value of the corporate shares, there should not be any offset to take into account the redemption obligation to the decedent’s estate under the buy-sell agreement.

The Eighth Circuit affirmed. This produced a “split between the circuits” on this offset issue. In contrast, the US Court of Appeals for the Eleventh Circuit in Estate of Blount v. Commissioner, 428 F.3d 1338 (Eleventh Cir. 2005), held that the fair market value of a closely held corporation did not include life insurance proceeds on the grounds that the stock purchase agreement created a contractual liability for the company which offset to such extent the life insurance proceeds payable to the company. The Supreme Court, in a unanimous decision authored by Justice Clarence Thomas, resolved this circuit split in favor of the government and affirmed the Eighth Circuit.

Analysis

As stated by the Supreme Court, the sole question before it was “whether Crown’s contractual obligation to redeem [the decedent’s] shares at fair market value offsets the value of life insurance proceeds committed to funding that redemption” obligation. The Supreme Court concluded that the redemption obligation does not provide any such offset.

The Supreme Court explained its reasoning by providing an example that focused on how the per share value of a closely held corporation is generally unaffected by the corporation’s redemption obligation under a buy-sell agreement. According to the Supreme Court, no willing buyer purchasing the decedent’s shares would have treated the redemption obligation as a factor that reduced the value of those shares. It did not matter that the redemption obligation constituted an enforceable obligation under applicable state law — according to the Court, it was not the sort of liability to be given effect for valuation purposes in determining the fair market value of the corporate shares.

The Supreme Court also commented that the adverse estate tax consequences produced here were the consequence of the use of a corporate redemption obligation, and that these adverse estate tax consequences could have been avoided in their entirety had the brothers instead entered into a cross-purchase agreement and funded it with life insurance policies taken out by the brothers on the other brother’s life. In a somewhat rare occurrence of commenting upon alternate estate and business succession planning techniques, the Court surmised that such might pose the risk that each brother might fail to pay the premiums for the insurance policy on the other’s life, but suggested that such a trade-off may be warranted depending upon the circumstances to prevent the life insurance proceeds payable to the corporation from being included in the decedent’s estate without any offset to take into account the corporation’s redemption obligation.

Further Observations

Some further observations:

• We now have a final resolution of the circuit split between the Blount (Eleventh Circuit) and Connelly (Eighth Circuit) cases concerning the recognition (or non-recognition) of an offsetting liability to implement the redemption obligation under a buy-sell agreement. The Eleventh Circuit in Blount recognized an offsetting liability for such redemption obligation, while the Eighth Circuit in Connelly did not. The Eighth Circuit’s view in Connelly has now prevailed.
• But is this a complete analysis or is there something else that may be missing? The author believes that the correct analysis in a “conceptual sense” would be to allow the offset for such liability in determining the value of the corporate stock but then recognize for estate tax purposes a corresponding asset to the estate in the form of a receivable equal to the amount of the redemption payment obligation. The Connelly Court’s denial of an offsetting liability for this corporate obligation to pay out cash to the estate in connection with the redemption transaction seems to be functioning as somewhat of a proxy for this approach. This may potentially explain certain aspects of the Supreme Court’s (and lower courts’) analysis in Connelly which comes across as strained.
• From a tax planning perspective, Connelly highlights the relative estate tax benefits that may be derived from instead using a cross-purchase agreement between shareholders or partners to avoid the potential estate tax inefficiency of a corporate redemption agreement. In order for a cross-purchase agreement to work where life insurance is involved, the life insurance policies would generally need to be payable to the surviving shareholder (or to a trust or entity structured for the benefit of the surviving shareholder) instead of to the corporation as in Connelly. That, in turn, is not without some measure of complexity in its own right, as the financing of the premium payments can raise additional concerns including for income tax purposes.