Connelly v. US impacts inheritance tax assessment for companies

In Connelly vs. the USA (June 6, 2024), the U.S. Supreme Court ruled on the value of a family-owned business for estate tax purposes. Brothers Michael and Thomas Connelly were the sole shareholders of Crown C Supply, a small building materials company. The brothers and the company entered into a stock purchase agreement that gave a surviving brother the option to purchase a deceased brother’s stock or the company’s obligation to repurchase a deceased brother’s stock. To finance the repayment obligation, the company took out life insurance on the brothers.

Michael died and Thomas decided not to buy Michael’s stock. Michael’s son and Thomas agreed that the value of Michael’s stock was $3 million. The company used a $3 million life insurance policy to buy back Michael’s stock. On Michael’s estate tax return, the value of Michael’s stock was reported as $3 million. However, upon audit, the estate’s accounting firm valued the company at $3.86 million. The IRS claimed that the true value of the company was $3.86 million, plus the $3 million from the life insurance, for a total of $6.86 million.

The estate claimed that the life insurance benefits should be excluded from the value. The estate relied on Estate of Blount against Commissioner, 428 F.3d 1338 (11th Cir. 2005), which requires that in determining value, life insurance proceeds be offset by the company’s obligation to purchase the decedent’s stock. In fact, the court in Blount wrote that a reasonably competent businessman interested in acquiring a company would ignore an obligation to purchase because an obligation contradicts any reasonable construction of fair market value.

However, the Supreme Court unanimously ruled in favor of the IRS, concluding that because a stock redemption at market value does not affect the economic interests of shareholders, an obligation to redeem stock at market value does not outweigh the value of the life insurance proceeds set aside for the redemption. Therefore, no willing purchaser of Michael’s stock would have considered the company’s redemption obligation as a factor reducing the value of the stock. Thus, the estate was subject to additional estate tax. In addition, for income tax purposes, the estate reports a $3.86 million loss ($3 million redemption price less the $6.86 million stepped-up basis of the stock) that the estate may never be able to utilize.

As a result Connelly, Entrepreneurs should review the terms of any shareholder compensation. If the compensation is structured as a buyback, Connelly may apply, so the life insurance is included in the business value for estate tax purposes. Business owners may instead want to pursue a cross-purchase buyout or an insurance trust, which would not increase the business value.