The case

Brothers Michael and Thomas Connelly were the sole shareholders in Crown C Supply (“Crown”). The brothers entered into an agreement to ensure that Crown would stay in the family when either brother died. Under the agreement, the surviving brother had the option to purchase the deceased brother’s shares. If he declined, Crown would redeem the shares of the deceased brother. Crown obtained a life insurance policy on each brother to fund its redemption obligations. 

Following Michael's passing, an accounting firm valued Michael's shares of Crown by excluding the life insurance proceeds. The theory was that the value of the life insurance proceeds was offset by Crown’s obligation to redeem Michael's shares¹.  

In siding with the IRS, the Supreme Court held that a closely held corporation’s value increases from the proceeds of a life insurance policy on one of its shareholders, even if there is an obligation to redeem the shares held by such shareholder in an amount equal to those proceeds.

The Supreme Court focused on the fact that the life insurance proceeds increased the value of the corporation. The Court determined that the price a hypothetical buyer of Michael's shares would have paid for the shares at his death would not have been reduced to reflect the corporation's obligation to redeem those shares.

Estate tax and succession planning implications

All business owners need to plan for business succession. Even more so for owners of significant family businesses due to the confluence of family, business, legal, and tax dynamics. 

Connelly stands for the proposition that life insurance proceeds paid to a corporation for the purpose of funding a buyback of a deceased shareholder is includible in the value of the shares for estate tax purposes. The brothers could have structured their arrangement differently to prevent this outcome. Potential alternatives are described below. 

Cross-purchase agreements

The brothers could have instead used a cross-purchase agreement. This is a buy-sell structured so that the surviving shareholder (rather than the company) purchases the decedent's shares².  In this case, the brothers would have each purchased life insurance on the other to fund the obligation to purchase the shares. This arrangement would have kept the life insurance proceeds out of the company. 

However, the premiums paid by the brothers on such policies would not have been deductible for income tax purposes. Although premiums paid by Crown for life insurance on its shareholders were likely also not deductible for corporate income tax purposes, paying those premiums before the shareholder-level taxes would have a tax benefit. 

Buy-sell with valuation mechanism

A buy-sell agreement can have a mechanism to set the valuation of the shares subject to the buy-sell. An agreement or right to acquire property at less than its fair market value is generally disregarded for estate tax purposes. The general rule disregarding such agreements does not apply if the agreement is part of a bona fide business arrangement, is not a device for making a below-market transfer and has arm's length terms. 

The planning in Connelly involved a buy-sell agreement which did not appear to include a valuation mechanism that met these requirements. Structuring a buy-sell that specifies a valuation formula that meets these requirements could have benefitted the shareholders.

Conclusions

Owners with a buy-sell agreement need to revisit the agreement regularly to confirm that the agreement continues to meet each of its intended purposes. Agreements become outdated due to changes in the business, changes in the family, or changes in the tax law. Connelly is a good reminder to look at those agreements again, especially where the plan involves life insurance. 

1 See Estate of Blount v. Commissioner, 428 F. 3d 1338 (11th Cir. 2005), concluding that insurance proceeds should be deducted from the value of a corporation when they are offset by an obligation to pay those proceeds to the estate in a stock buyout.

2 Their actual plan contemplated a cross-purchase option by giving the surviving brother an election to purchase the shares.