Corporate share obligation does not reduce estate tax

The Supreme Court, in a unanimous opinion (S Ct, 6/6/2024) ruled on June 6 that a corporation’s obligation to redeem shares is not a liability that reduces a corporation’s value for federal estate tax purposes. 

The case, Connelly v. United States, centered around two brothers, Michael and Thomas Connelly, who were the only shareholders in a building supply corporation. The brothers and the company entered into an agreement for the purchase or the redemption of the first brother to die shares so that the business would stay in the family. The agreement provided that the surviving brother would have the option to purchase the deceased brothers shares. If the surviving brother declined the company would be obligated to redeem the shares of the deceased brother. The company also held life insurance on each brother’s life in the amount of $3.5 million each in order to fund the possible redemption.

After the death of the first brother the surviving brother did not exercise their purchase option, so the company was obligated to redeem the shares of the deceased brother. Ignoring the agreements provision for an appraisal to determine the redemption price there was an agreement amongst the parties that the stock would be redeemed for $3 million. The estate tax return of the deceased brother was filed with the value of the deceased brother’s shares being reported as $3 million. The estate tax return was audited and during the audit a third-party appraisal was obtained that valued the deceased brother’s interest in the company as $3.86 million. This appraisal did not include $3 million in insurance proceeds used to redeem the stock of the deceased brother. The appraisal did not include value of the insurance proceeds that were used to redeem the shares based on the case of Estate of Blount v. Commissioner, which held that insurance proceeds should be deducted from the value of a corporation when they are to be used to pay an obligation in a stock buyout. The IRS disagreed with this analysis that the buyback obligation reduced the value of the business and valued the stock at $5.3 million.

The Supreme Court agreed with the IRS’s position holding that the obligation to redeem the shares did not reduce the value of the company for estate tax purposes. The court held that a hypothetical buyer purchasing the deceased brother’s shares would not have treated the company’s obligation to redeem the shares as a factor that would reduce the value of the shares in question. 

Additionally, the court went on to suggest that if the brothers had entered into a cross purchase agreement and that they held the life insurance on each other outside of the business the value of the business would not have been increased by the life insurance proceeds.

Based on the holding of this case all taxpayers who’s closely held business holds life insurance in the business to redeem a shareholder on their death, should consult with their tax advisor to determine if a restructuring of this redemption is in order.