A recent case demonstrates the impact that a stock-purchase agreement and life insurance can have (or not have) on the valuation of a closely held company for estate tax purposes.
Before diving into the case, some context is helpful. It is not uncommon for closely held businesses to have buy-sell agreements. In many instances, the other owners are the main market to sell your shares when you exit, and that exit may include death. Thus, these agreements can provide for a “cross-purchase” option, which means that the other owners purchase the exiting owner’s interest. Another option is a redemption, which means that that the business purchases (redeems) the exiting owner’s interest.
As part of these agreements, there is typically a price setting mechanism (to determine the buyout price). For estate tax purposes, if the decedent owned an interest in the business, that value is included in the gross estate. A critical issue then arises of whether the price set by the buyout agreement is binding for estate tax purposes. That issue is resolved by § 2703 and is discussed more below. Practically, the owners also want a liquidity source to help pay for the buyout; that may be accomplished by life insurance.
In particular, this case explores when a court will respect an agreement under § 2703, and how the presence of life insurance proceeds affect the valuation of the company for estate tax purposes.
With that context, let’s get to the case.
In the case, two brothers were the sole shareholders of a corporation; one brother owned about 77% of the company and the other brother owned the rest. The brothers had a stock-purchase agreement. Under the agreement, upon the death of a brother, the surviving brother could purchase the shares. If the surviving brother opted not to, the company had to redeem the shares. As well, the corporation purchased life insurance on the brothers so that the policy proceeds could be used to fund such a redemption. The purpose of this planning, of course, was to ensure that control would stay within the family. Moreover, according to the court, the brothers intended the company to effectuate the redemption, rather than a surviving brother effectuating the cross-purchase option.
Under the stock-purchase agreement, there were two ways to determine the redemption price. The first method was that, at the end of each tax year, the brothers would agree to price per share in a “Certificate of Agreed Value.” And, if such annual agreement did not occur, the agreement required two or more appraisals. However, the brothers did not do either of these options. Despite that, the company purchased $3.5 million of life insurance on each brother.
The majority-owner brother died in 2013. After his death, the company received the life insurance proceeds and redeemed his shares for $3.0 million, the price of which was resolved by the family without any appraisal. The remaining life insurance proceeds ($500,000) was used for corporate operations.
On the brother’s estate tax return, the shares in the company were valued at $3 million—the price of the redemption payment. Upon an audit, the Service concluded that the estate undervalued the company by relying on the redemption payment instead of valuing the company and including the value of the life insurance proceeds as a corporate asset. The IRS determined that the company was worth about $6.86 million. In particular, the IRS valued the deceased brother’s shares at $2,982,000, exclusive of the life insurance. Given his 77.18% ownership, this represents a company value of $3.86 million. It then added the $3 million in proceeds for the redemption. Importantly, the court noted that the estate did not challenge the “sans-proceeds” valuation on appeal, and thus accepted it for purposes of the appeal.
Based on the IRS’s valuation, then, the deceased brother had a 77.18% interest in a $6.86 million company, meaning the interest was worth about $5.3 million. The IRS sent a notice of deficiency for the additional tax. After paying the deficiency, the estate sued for a refund. The district court granted summary judgment for the government, which the estate appealed to the Eighth Circuit.
The estate advanced two arguments. The first was that the redemption transaction, under the stock-purchase agreement, set the price for estate-tax purposes, and therefore no valuation was needed. The second argument was that the valuation should not include the life insurance proceeds because although the proceeds may have represented an asset, they were offset by the redemption obligation, which was a liability. For its part, the government countered that the stock-purchase agreement should be disregarded. It also argued that any calculation of fair market value must account for the insurance proceeds.
Undoubtedly, the brother’s gross estate included his corporate shares (see § 2033). Thus, the real issue in the case is the proper valuation of those shares. And, more acutely, the issue is about the inclusion of the life insurance proceeds as part of that valuation.
The court first considered whether the stock-purchase agreement controlled the valuation of the company for estate-tax purposes. Under § 2703(a), the value of property is determined without regard to “any option, agreement, or other right to acquire or use the property at a price less than the fair market value of the property (without regard to such option, agreement, or right)” and “any restriction on the right to sell or use such property.” In other words, § 2703(a) essentially says to ignore the stock-purchase agreement, unless certain criteria are met, which are set forth in subsection (b). Under subsection (b), the agreement must meet three requirements. First, it must be a “bona fide business arrangement.” Second, it must not be a “device to transfer such property to members of the decedent’s family for less than full and adequate consideration in money or money’s worth.” And third, “[i]ts terms are comparable to similar arrangements entered into by persons in an arms’ length transaction.”
The estate argued that its stock-purchase agreement satisfied these criteria. The court, however, disagreed. The court noted that the agreement was missing a critical component, namely a fixed or determinable price to consider for valuing the shares. As explained by the court, “if § 2703 tells us when we may ‘regard’ agreements to acquire stock ‘at a price less than the fair market value,’ we naturally would expect those agreements to say something about value in a definite or calculable way.”
Here, the court emphasized that the stock-purchase agreement set forth no fixed price or even prescribed a formula for determining a price. Rather, the agreement set forth two ways in which the brothers may have agreed to a price. And, the court, rejected the estate’s entreaty to fix the price by the redemption transaction because it linked back to the stock-purchase agreement. In this vein, the court noted that the price was chosen after the death, and, moreover, that price came not from the purchase agreement, but rather the family’s agreement to resolve estate-administration matters.
In sum, for the first issue, the court determined that the corporation’s value must be determined without regard to the stock-purchase agreement under § 2703(a).
The court then turned to the second issue, which it framed as “whether the life insurance proceeds received by [the company] and intended for redemption should be taken into account when determining the corporation’s value at the time of [the brother’s] death.”
Among other things, the court noted that, in valuing a closely held corporation, the Treasury Regulations provide that “consideration shall also be given to nonoperating assets, including proceeds of life insurance policies payable to or for the benefit of the company, to the extent such nonoperating assets have not been taken into account in the determination of net worth, prospective earning power and dividend-earning capacity.” 26 C.F.R. § 20.2031-2(f)(2)
As mentioned earlier, the estate argued that the life insurance proceeds did not augment the company’s value because the proceeds were offset by the redemption liability. The court, however, explained that “[a]n obligation to redeem shares is not a liability in the ordinary business sense.” To do so, it continued, would distort the nature of the ownership interest. In an example, the court noted that, at the brother’s death, a willing buyer could obtain all the shares and then just extinguish the agreement or redeem the shares from himself. The court said this “is just like moving money from one pocket to another.” In other words, the court explained “[t]here is no liability to be considered—the buyer controls the life insurance proceeds.” As applied here, the court explained that a buyer would pay $6.86 million, which takes into account the life insurance proceeds, and then could extinguish or redeem. The court furthermore noted that “a hypothetical willing seller of [the company] holding all 500 shares would not accept only $3.86 million knowing that the company was about to receive $3 million in life insurance proceeds, even if those proceeds were intended to redeem a portion of the seller’s own shares.” Only accepting $3.86 million, the court continued, would be to ignore the anticipated life insurance proceeds.
Finally, the court considered another thought experiment. To value the company without the life insurance proceeds, each share would be worth $7,720 before the redemption. But, after the redemption and the redeemed interest is extinguished, the shares would be about $33,800 each, representing full control of the company. Thus, “[o]vernight and without any material change to the company, [the surviving brother’s] shares would have quadrupled in value.”
In sum, the court determined that “[t]he proceeds were simply an asset that increased shareholders’ equity. A fair market value of [the deceased brother’s] shares must account for that reality.”
In reaching this decision, the court disagreed with the Eleventh Circuit’s decision in Estate of Blount v. Comm’r, 428 F.3d 1338 (11th Cir. 2005), which held that corporate insurance proceeds to fund an obligatory purchase obligation were offset by that liability and therefore need not be included in the company’s value.
The case is Connelly v. United States, No. 21-3683 (8th Cir. June 2, 2023). You can read the case here.
This is only a summary of the case and some portions—including facts, issues, or analysis—may have been omitted or edited; if you need advice in this area, please review the case in its entirety and consult an attorney.