Life Insurance Value Included in Value of Shares for Estate Tax Purposes
On June 4, 2024, the U.S. Supreme Court issued a unanimous opinion holding that a corporation’s obligation to use life insurance proceeds to redeem a decedent’s shares did not offset the value of the life insurance when valuing the shares for estate tax purposes. [Connelly v. U.S., No. No. 23–146 (U.S. Sup. Ct. June 4, 2024)].
Facts
Two brothers, Michael and Thomas, the only shareholders of a small corporation, Crown, Inc., agreed that if one brother died, the surviving brother could buy the other brother’s shares in Crown. If the brother decided not to buy the shares, Crown was required to redeem the shares. To ensure adequate funds for redemption, Crown took out $3.5 million life-insurance policies on each brother. Michael, who owned 77.18% of Crown’s shares, died first. Upon Michael's death, Thomas chose not to buy the shares, triggering Crown’s obligation to pay Michael’s estate for the fair market value of his shares. Thomas and Michael’s son reached an agreement that the shares were worth $3 million, and Crown redeemed the shares for that amount.
Thomas, as the executor of Michael’s estate, reported the shares' value as $3 million on the estate’s federal tax return. During an IRS audit, Thomas enlisted an outside accounting firm to value the company. After excluding the $3 million in life insurance required to redeem Michael’s shares, the firm determined that Crown was worth $3.86 million. The IRS disagreed with the valuation, determining that the company was worth $6.86 million. Because Michael owned 77.18% of the company’s shares, the IRS determined that the Michael owned $5.3 million of Crown shares at his death and underpaid $889,914 in estate taxes.
The district court determined that the $3 million in life insurance Crown used to redeem Michael’s shares had to be included in the valuation of Crown. The U.S. Court of Appeals for the 8th Circuit agreed. On review, the U.S. Supreme Court affirmed the decision.
Supreme Court Decision
When calculating the federal estate tax, the value of a decedent’s shares in a closely held corporation must reflect the corporation’s fair market value. Life-insurance proceeds payable to a corporation are an asset that increases the corporation’s fair market value. The narrow question before the court was whether Crown’s contractual obligation to redeem Michael’s shares at fair market value offset the value of life-insurance proceeds committed to funding that redemption. The Court held that the answer was no, finding that no hypothetical buyer purchasing Michael’s shares would have treated Crown’s obligation to redeem Michael’s shares at FMV as a factor that reduced the value of those shares.
At the time of Michael’s death, the Court explained that 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. A buyer would acquire a 77.18% stake in a company worth $6.86 million, along with Crown’s obligation to redeem those shares at fair market value. A buyer would therefore pay up to $5.3 million ($6.86 million x 0.7718)—for those shares. Crown’s promise to redeem Michael’s shares at fair market value did not reduce the value of those shares.
Considerations for Farm Entities
The Court stated that this was a “narrow” dispute and that in the end, the brothers were bound by the structure of their agreement. The Court also noted the terms of the buy-sell agreement were not followed. No appraisal was secured, and Thomas and Michael’s son agreed that the shares were worth $3 million. The Court also explained that there were other options for the brothers if they did not like this result. They could have used a cross-purchase agreement in which they each agreed to buy the shares of the other and they each purchased life insurance on the life of the other. Although that approach carried the risk of one of the brothers failing to renew the life insurance policy on the life of the other, it would have generally prevented the life insurance from being included in the value of the redeemed shares.