A case being considered by the U.S. Supreme Court could have a widespread impact on one common succession planning practice that closely held businesses often use to ensure continuity upon the death of a key shareholder.
Closely held businesses often enter into redemption agreements whereby the business agrees to redeem a deceased shareholder's shares. These agreements are typically funded with life insurance. The goal, of course, is to ensure that remaining shareholders retain control of the business after a key shareholder's death.
In the case under consideration, Connelly v. United States, 23-146, the Internal Revenue Service claims that the value of that life insurance should increase the value of the deceased shareholder's business interests for federal estate tax purposes. The Supreme Court is now contemplating how to resolve a split between how the Eighth Circuit and Eleventh Circuit have ruled on this issue.
While it remains to be seen how the justices will decide, closely held businesses that have entered into redemption-type agreements should carefully consider their funding options — and the potential estate tax impact of these arrangements.
The Connelly Case Facts
Connelly involves a situation where a closely held corporation purchased life insurance on the lives of key shareholders. The business here was jointly owned by two brothers. Upon either shareholder's death, the surviving brother had the option of purchasing the deceased brother's shares. In the event that the surviving brother did not opt to purchase the other's shares, the corporation would redeem them.
The corporation purchased $3.5 million in life insurance on each shareholder. When the first brother died, the corporation received the life insurance proceeds and, pursuant to the redemption agreement, redeemed the deceased shareholder's shares in the corporation.
The deceased brother's son and the surviving brother agreed that the value of the deceased brother's shares was $3 million. This value disregarded the valuation approaches contained in the original stock purchase agreement, which would have valued the decedent's shares at $3.89 million. After the redemption, the decedent's brother became the sole shareholder in the business and used the remaining $500,000 in life insurance proceeds to fund business operations.
The question being considered is whether the $3.5 million in life insurance proceeds received by the corporation should be considered a corporate asset that would increase the value of the ownership interest held by the deceased shareholder for federal estate tax purposes.
