Estate of Connelly vs. US Shapes Estate and Tax Planning

In a unanimous decision issued on June 6, 2024, Justice Thomas ruled in favor of the Internal Revenue Service (IRS) on Estate of Connelly v. United States. The ruling held that life insurance proceeds received by a corporation to facilitate the repurchase of a deceased shareholder’s stock interest must be included in the corporation’s value for federal estate tax purposes. This value is not offset by the corporation’s obligation to repurchase the deceased shareholder’s stock.

Michael and Thomas Connelly were the sole shareholders of Crown C Supply, a small building supply company. They had an agreement to keep the business within the family if either brother passed away. According to this agreement, the surviving brother had the option to buy the deceased brother’s shares. If he chose not to, Crown was obligated to buy the shares. To ensure Crown could fulfill this obligation, the company took out $3.5 million in life insurance on each brother. When Michael passed away, Thomas decided not to purchase Michael’s shares, resulting in Crown’s obligation to buy them. Both parties agreed that Michael’s shares were worth $3 million, which Crown paid to Michael’s estate. As the executor of Michael’s estate, Thomas filed a federal tax return, reporting the shares’ value as $3 million. The IRS audited the return and obtained a valuation from an independent accounting firm, which assessed Crown’s fair market value at $3.86 million, excluding the $3 million insurance payout for share redemption. The analyst determined Michael’s 77.18% ownership interest was worth about $3 million.

The IRS disagreed, arguing that the life insurance proceeds should be included in Crown’s value, assessing it at $6.86 million. Consequently, the IRS calculated Michael’s shares at $5.3 million, leading to an additional $889,914 in taxes owed by the estate. After paying the deficiency, Thomas, as executor, sued for a refund. The District Court sided with the government, ruling that the $3 million in life insurance proceeds must be included in Crown’s valuation. The Eighth Circuit upheld this decision.

The court held that a corporation’s obligation to redeem shares does not reduce its value for federal estate tax purposes. The value of a decedent’s shares in a closely held corporation must reflect the corporation’s fair market value, which includes life insurance proceeds payable to the corporation. The question was whether Crown’s obligation to redeem Michael’s shares at fair market value offset the life insurance proceeds used for the redemption. The court concluded it did not. A fair-market-value redemption does not affect any shareholder’s economic interest, and a buyer would not consider Crown’s redemption obligation as reducing the value of Michael’s shares.

At Michael’s death, Crown’s value was $6.86 million—comprising $3 million in life insurance proceeds and $3.86 million in other assets. A buyer would pay up to $5.3 million for Michael’s shares, reflecting the value of a 77.18% stake in Crown. The court found that Thomas’s arguments, including his view that the shares should be valued post-redemption, were inconsistent with the principles of estate tax valuation. The court also dismissed concerns that this decision would complicate succession planning for closely held corporations, noting it was a consequence of how the Connelly brothers structured their agreement.

Agreements like these are often complex and it is wise to get professional guidance, especially as it relates to tax planning. Your team at Haefele Flanagan can help you navigate the nuances and offer suggestions to ensure that your agreements are structured wisely.