Supreme Court Upholds Connelly Decision
On June 6, 2024, the Supreme Court unanimously affirmed a lower court’s ruling that upheld an IRS position regarding the case Thomas A. Connelly, as Executor of the Estate of Michael P. Connelly, Sr. v. the United States. The case revolved around a corporation’s estate value in light of life insurance proceeds received and the corporation’s redemption obligation. It has a significant impact on how small, closely held businesses are valued for estate planning purposes.
Case summary
Brothers Michael and Thomas Connelly operated and were the sole shareholders of Crown C Supply, a building supply company. As part of their estate planning efforts, they entered into a buy-sell agreement that allowed the surviving brother to purchase the deceased brother’s shares. If the survivor chose not to do so, the company would be obligated to redeem the shares using proceeds from a company-owned life insurance policy. As part of the agreement, and to ensure the company would have the money to buy the shares, it had obtained $3.5 million in life insurance on each brother.
At the time of Michael’s death in 2013, he owned 77% of Crown’s stock, and Thomas owned approximately 23%. When Michael died, the business received a $3.5 million payout from the company-owned life insurance policy. Thomas decided not to purchase Michael’s shares, which then obligated Crown Supply to purchase those shares using the money from the life insurance policy. The company used $3 million of the payout to purchase the outstanding shares, and used the remaining $500,000 to pay for general operating expenses.
When Thomas filed an estate tax return for Michael’s estate, he valued Crown Supply’s shares at $3 million. However, the IRS audited the estate and determined that the $3 million in life insurance proceeds used to purchase those shares should have been included in the business’ valuation as an additional non-operating asset. Doing so increased the value of Crown’s shares by nearly 80%, making the estate worth $5.3 million instead of $3 million, significantly increasing the amount owed in estate tax.
In an effort to receive a refund of more than $1 million in estate taxes, Thomas sued the IRS in the United States District Court for the Eastern District of Missouri on behalf of Michael’s estate. The district court ruled in favor of the IRS, and this ruling was recently affirmed by the United States Court of Appeals for the Eighth Circuit. The Supreme Court affirmed in June 2024, ruling that a corporation’s contractual obligation to redeem shares doesn’t reduce its value for estate tax purposes.
What this ruling means for business owners
This ruling has the potential to significantly impact succession planning strategies for business owners. Prior to the ruling, the precedent for business valuations for estate tax purposes was set in 2005 in the case of Estate of Blount v. Commissioner (United States Court of Appeals for the Eleventh Circuit), which established that the value of a life insurance death benefit would be offset by a company’s redemption obligation. However, the Connelly ruling overturns the Blount case’s precedent.
As a result, proceeds from corporate-owned life insurance used to fund a redemption obligation that’s part of a buy/sell agreement are now considered part of a company’s valuation, which can result in an increased tax liability for the deceased shareholder’s estate. It now becomes important for closely held business owners to reevaluate their current buy-sell agreements for tax efficiencies.
Strategies to mitigate the ruling’s tax impact
There are several strategies that can help protect your closely held business from the tax implications of this ruling:
- Consider a cross-purchase agreement. As an alternative to the business purchasing the deceased owner’s shares, it may make sense for the remaining owners to purchase the interest directly. Doing so prevents proceeds from the buy/sell agreement from being included in the decedent’s estate.
- Review and update any existing buy/sell agreements. The structure of a buy/sell agreement can greatly impact a decedent’s estate tax liabilities, which is why it’s important to carefully review any existing agreements with a focus on potential tax exposure.
- Establish business continuity plans. Your business should have a comprehensive business continuity plan in place to account for changes in estate taxes and help protect your business over the long term.
Could you use help navigating impacts of the recent Connelly ruling? Creative Planning Business Services is here for you. Our experienced wealth managers and tax advisors work side by side to help business owners navigate a wide range of estate planning challenges, tax complexities and regulatory requirements. To learn more, schedule a call with a member of our team.
