In Connelly v. U.S. (June 6, 2024), the U.S. Supreme Court ruled on the value of a closely held business for purposes of estate tax. Brothers, Michael and Thomas Connelly, were the sole shareholders of Crown C Supply, a small building supply corporation. The brothers and the company entered into a stock purchase agreement granting a surviving brother an option to purchase a deceased brother’s shares or the obligation for the company to redeem a deceased brother’s shares. To fund the redemption obligation, the company purchased life insurance on the brothers.

Michael died and Thomas elected not to purchase Michael’s shares. Michael’s son and Thomas agreed that the value of Michael’s shares was $3 million. The company used $3 million of life insurance to redeem Michael’s shares. Michael’s estate tax return reported the value of Michael’s shares to be $3 million. However, during the audit, the estate’s accounting firm valued the company at $3.86 million. The IRS asserted that the company’s true value was $3.86 million, plus the $3 million of life insurance proceeds, for a total of $6.86 million.

The estate asserted that the life insurance proceeds should be excluded from the value. The estate relied on Estate of Blount v. Commissioner, 428 F.3d 1338 (11th Cir. 2005) which ruled that in determining value, life insurance proceeds are offset by the company’s obligation to purchase the decedent’s shares. Indeed, the court in Blount wrote, to suggest that a reasonably competent businessperson, interested in acquiring a company, would ignore a purchase obligation as a liability defies any sensible construct of fair market value.

However, the Supreme Court unanimously ruled in favor of the IRS concluding that an obligation to redeem shares at fair market value does not offset the value of life insurance proceeds set aside for the redemption because a share redemption at fair market value does not affect any shareholder’s economic interest. Therefore, no willing buyer purchasing Michael’s shares would have treated the company’s redemption obligation as a factor that reduced the value of the shares. Thus, the estate was subject to additional estate tax. Further, for income tax purposes, the estate recognizes a $3.86 million loss ($3 million redemption price, less stepped-up basis in the shares of $6.86 million) which the estate may never be able to utilize.

As a result of Connelly, business owners should review the terms of any shareholders buyout arrangement. If the buyout is structured as a redemption, Connelly may apply causing the life insurance to be included in the value of the business for purposes of estate tax. Business owners may instead wish to implement a cross-purchase buyout or insurance trust which would not increase the company’s value.