Supreme Court Rules In Favor Of IRS: Revise Redemption Plans Now

Retirement

Supreme Court Rules in Favor of the IRS

On June 6, 2024, the U.S. Supreme Court issued a unanimous opinion on a closely held business valuation case that will have significant impact on many family and closely held businesses. Connelly v. United States, U.S., No. 23-146, Opinion 6/6/24. The case addressed the valuation of stock in a closely held business and held that the obligation of an entity to buy a deceased equity owner’s shares does not reduce the value of the insurance proceeds received by the entity to fund the buyout. The Supreme Court’s ruling resolves the conflict between the Connelly case and Estate of Blount v. Commissioner which had reached the opposite conclusion.

The Case

Two brothers, Thomas and Michael Connelly, owned all of the stock in Crown C Supply, a corporation that operated a building supply business. They had planned for the risk of either of them dying by putting in place a buyout agreement that set the value of the stock and the requirement for the corporation to buy or redeem a deceased shareholder’s shares. They were even prudent enough to address the economic issue of how that requirement to buy out a deceased shareholder’s shares would be funded and had the corporation buy life insurance on each shareholder’s life. The goal was to keep the business in the family if either of them died. They were not particularly careful or prudent in adhering to the formalities of the arrangement, but that was not the critical issue in the Supreme Court’s holdings.

The key issue, which undermines many closely held and family business redemption buyout arrangements (that is when the entity owns the life insurance and buys the shares from the deceased owner’s estate) is that the life insurance the corporation owned to fund the buyout had to be included in the value of the entity’s interests being bought out. In other words, the life insurance proceeds were deemed a corporate asset that increases the value of the entity interests held in the decedent’s estate, and thereby may increase the estate tax due. This result seemed called for under Treasury Regulation 20.2031-2(f)(2), which requires that nonoperating assets, like life insurance, that are not included in the fair market value of the business worth be added to value.

The obligation the entity had to consummate the buyout is not to be treated as a liability which can be applied to reduce the value of the business interests being bought out. Many advisers had thought that the entity’s obligation to pay the deceased equity owner’s estate should be an offset to the value of the life insurance policy. No such luck for taxpayers after the Supreme Court’s holding. So, the obligation to buy out a deceased equity owner’s interests are not treated as a reduction in value as say a bank loan would be. An obligation to buy out equity is not a traditional liability and the Supreme Court held that it should not be treated as one. The Court reasoned that: “a fair-market-value redemption has no effect on any shareholder’s economic interest, no hypothetical buyer purchasing Michael’s shares would have treated Crown’s obligation to redeem Michael’s shares at fair market value as a factor that reduced the value of those shares.”

The Court reasoned further: “For calculating the estate tax, however, the whole point is to assess how much Michael’s shares were worth at the time that he died—before Crown spent $3 million on the redemption payment. See 26 U. S. C. §2033 (defining the gross estate to “include the value of all property to the extent of the interest therein of the decedent at the time of his death”). A hypothetical buyer would treat the life-insurance proceeds that would be used to redeem Michael’s shares as a net asset.”

More specifically, here’s how the above issues played out. The buyout agreement gave the surviving brother the first right to purchase the deceased brother’s shares. Thomas elected not to purchase Michael’s shares, so that the entity’s obligation to purchase the shares would be triggered. The deceased equity owner’s son and Thomas, the surviving brother/equity owner and executor, agreed that the value of the decedent’s shares was $3 million. The entity paid that amount to the deceased brother’s estate. A federal estate tax return was filed for the estate reporting the value of the decedent’s ownership interest as $3 million. The IRS audited the return. During the audit, the executor obtained an independent appraisal which set the value of the entity at $3.86 million. That calculation excluded the $3 million in insurance proceeds used to redeem the shares. The rationale for that was that the life insurance value was offset by the contractual obligation to redeem the deceased brother’s share. The IRS disagreed. It insisted that the entity’s obligation to redeem the deceased brother’s ownership did not offset the life insurance proceeds. The IRS valued the company at $6.86 million ($3.86 million enterprise value + $3 million life insurance value). That is a big valuation difference.

What this Means to Family and Closely Held Businesses

Take action immediately. Review the structure and terms of your buyout arrangement. If you have a buyout structured as a redemption, where the entity buys the deceased equity owner’s interests, you may be tagged by the new Supreme Court holding.

· If the value of each equity owner’s estate is safely under the estate tax exemption you might choose to leave the insurance funded redemption agreement in place. The extent to which the life insurance adds to the entity value would not trigger and federal estate tax. However, be careful. If any owner lives in a state with a lower estate tax threshold, or an inheritance tax, there may in fact be a tax incurred. Further, evaluate with counsel how the Supreme Court’s ruling might affect the formula and terminology used in the buyout documentation. Also, continue to monitor the redemption agreement in the event of tax law changes, valuation changes, etc. You might even consider purchasing additional insurance to cover the estate tax cost if one might be incurred post-Connelly.

· If including the value of the entity owned insurance will trigger estate tax it might be preferable to restructure the buyout arrangement as a cross-purchase arrangement. With a cross-purchase the equity holders own life insurance on each other to be used to fund the buyout. In that type of structure, the value of the insurance will not affect the entity value. Also, with a cross-purchase, the surviving equity holders will get increased tax basis in the equity purchased. Before undertaking such change, business owners will have to consider the costs of all new documentation for the new cross-purchase arrangement, the costs of unwinding the existing redemption agreement (you don’t want to leave a duplicative repurchase obligation on the entity) and the costs and availability of new life insurance. Also, consider the different economic implications. In a cross-purchase arrangement each equity owner must pay for insurance premiums on the lives of other equity owners. Will they do so? How will that be monitored? Some business owners feel more secure that the life insurance will in fact be in force when needed knowing that the entity is paying for these premiums. It may not be simply a change in the policies owned by a company to a cross-purchase structure. Additional or even different coverage may be required. Also, if the redemption agreement has been in effect for some time, review the valuation of the business and the economics of the buyout to see if changes in coverage amounts are warranted.

· If the amount involved in quite large, review the potential estate tax implications of the cross-purchase agreement and discuss with your advisers the potential advantages of using a special LLC to own the life insurance policies earmarked for the cross-purchase buyout.

For more background discussion on the history of the Connelly case see: “Business Owned Buyout Life Insurance Raises Tax Issues,” forbes.com Jun 28, 2023.

Reality Check: Value of Typical Family Business

The mean value of a closely held business is about $1.5 million. The reality is that most closely held businesses are not valuable enough, and their owner’s estates likely not valuable enough, to trigger any estate tax even after the Connelly case ruled for the IRS and against taxpayer business owners on this matter. So, for many, retaining a simpler redemption agreement might be satisfactory. However, even in such cases it makes sense to review the overall arrangement, evaluate the loss of basis step up the surviving equity owners, and adherence to the formalities of the arrangement.

Limits on the Connelly Decision

The Court stated in footnote 2: “We do not hold that a redemption obligation can never decrease a corporation’s value. A redemption obligation could, for instance, require a corporation to liquidate operating assets to pay for the shares, thereby decreasing its future earning capacity. We simply reject Thomas’s position that all redemption obligations reduce a corporation’s net value. Be- cause that is all this case requires, we decide no more.”

Conclusion

The Supreme Court’s holding in Connelly is an IRS favorable decision that creates yet another challenge for closely held businesses. Just this year the FTC issued a ban on almost all non-compete agreements which are integral to the succession planning for many closely held businesses. The Corporate Transparency Act filing requirements are due for most closely held entities that existed before 2024 by the end of this year. And, planning for the reduction in the estate tax exemption by half after 2025 requires immediate planning. The burdens on closely held and family businesses are burdensome and growing. Get all of these items on your planning radar.

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