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The Supreme Court unanimously <a href="https://www.supremecourt.gov/opinions/23pdf/23-146_i42j.pdf" target="_blank" rel="noreferrer noopener">ruled in favor of the IRS</a> in Connelly v. United States, holding that company-owned life insurance acquired to fund a redemption obligation arising upon the death of an owner must be included in the value of the business and is not offset by a liability equal to the obligation to redeem the interests of the deceased owner. In doing so, the Court upended a planning structure business owners and practitioners alike believed was long settled. However, life insurance can remain a key element of succession planning.

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Unique Facts Lead to a Widely Applicable Ruling

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Brothers Michael and Thomas Connelly were the only shareholders in Crown C Supply (“Crown”). Michael owned 77.18% of the shares in Crown and Thomas owned the rest. The Connelly brothers and Crown entered into a buy-sell/redemption agreement (“Agreement”) that provided if either brother died, the other brother would have the opportunity to purchase the deceased brother’s shares, and if the survivor elected not to purchase them, Crown was required to redeem those shares. To ensure Crown would have sufficient cash to fund a potential redemption, the company acquired a $3.5 million policy on the life of each brother.

When Michael died in 2013, Thomas declined to purchase Michael’s shares, triggering Crown’s obligation to purchase them. Without following the mechanisms for determining value in the Agreement or obtaining an appraisal, the parties agreed Michael’s shares were valued at $3 million; that value was used for the redemption transaction and Michael’s federal estate tax return.

During the audit of Michael’s estate tax return, the estate obtained an appraisal stating Michael’s Crown shares were worth $3 million. The appraiser relied on the Eleventh Circuit’s 2005 ruling in Blount v. Commissioner, increasing Crown’s enterprise value by the life insurance proceeds receivable upon Micheal’s death and decreasing it by the $3 million redemption obligation. The IRS’s position, on the other hand, was that the estate was not entitled to the offsetting obligation.

The sole question for the Supreme Court was whether a redemption obligation is properly considered a corporate liability that reduces the enterprise value for estate tax valuation purposes. Ruling in favor of the IRS, the Court said “no.” Writing for the entire Court, Justice Thomas stated that “Because a fair-market-value redemption has no effect on any shareholder’s economic interest, no willing buyer purchasing Michael’s shares would have treated Crown’s obligation to redeem [his] shares at fair market value as a factor that reduced the value of those shares. … Crown was worth $6.86 million—$3 million in life-insurance proceeds earmarked for the redemption plus $3.86 million in other assets and income-generating potential. … a buyer would therefore pay up to $5.3 million for Michael’s shares.” He went on to say that coming to the result Michael’s estate posits would “turn this ordinary [valuation] process upside down” if a redemption “left [the surviving owner(s)] with a larger stake in a company with the same value as before the redemption. … That cannot be right.” As a result, Michael’s estate paid about $890,000 in additional estate taxes.

For those interested, hidden within this case but only mentioned with a single citation by the Court, is a very technical rule in Section 2703 of the Internal Revenue Code (“Code”) that essentially says an agreement to acquire an asset for less than fair market value (determined under the Code and related Treasury Regulations) is ignored unless the agreement is a bona fide business arrangement, not a device to transfer property to family members, and is comparable to similar arrangements among unrelated parties. In this case, the IRS determined the Agreement was defective under Section 2703, the district court granted summary judgment to the IRS, the Eighth Circuit agreed and, perhaps because the Supreme Court does not generally consider alternative arguments or because the parties agreed the enterprise value included the life insurance proceeds, the Section 2703 element was not considered in the final appeal.

Life Insurance Planning Is Still on the Table, It’s Just a Bit Smaller Table

As the Court pointed out, there are other structuring options to consider, one being a cross-purchase arrangement which involves owners directly owning insurance on the life/lives of other owners whereby death benefits are payable to the surviving owner(s) and no funds flow to the company or the deceased owner’s estate. Other structures could involve trusts or LLCs owning the policy(ies). There are pros and cons to any planning structure and there is no one-size-fits-all approach.

While it’s always good practice to review your business governance documents and succession plan, the Connelly case offers a ripe reason to do so now. You should consult an experienced attorney and accountant to complete the review and to outline options for structuring (or restructuring) life insurance and purchase/redemption agreements that may work for your business.

* Jake Horton (Capital University Law School, ’25) contributed significantly to this article as a Thompson Hine summer associate; he is not admitted to the practice of law. Please contact <a href="mailto:Julia.Zerman@thompsonhine.com?subject=Thompson%20Hine%20Summer%20Associate%20Program">Julia Zerman</a> to learn more about our summer program.

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Life Insurance-funded Succession of Closely Held Businesses After Connelly

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