A recent U.S. Supreme Court decision may affect your closely-held business’ succession  plan in significant ways. In Connelly v. United States (No. 24-146 U.S., June 6, 2024), the Court examined the issue of determining the fair market value of a decedent’s shares in a closely-held corporation on the date of his death for purposes of estate taxation when the corporation is obligated to redeem the decedent’s shares as funded by a life insurance policy.

The federal estate tax is based on the fair market value of a decedent’s assets upon death, including any interest in a closely-held business. For many closely-held businesses aiming to maintain continuity of ownership and operations, it is common for the business and its owners to enter into an agreement where the deceased owner’s interest will be redeemed by the business.  It is also common for a closely-held business to then take out a life insurance policy to fund this obligation.

In Connelly v. United States, Michael and Thomas Connelly and their business, Crown C Supply, did just that. Their agreement provided that the corporation was to purchase the deceased’s shares at fair market value. When Michael died, his son and Thomas, as the executor, agreed not to have the corporation appraised but rather agreed that Michael’s shares were worth $3 million, and the corporation was worth $3.86 million. The corporation received $3 million dollars in life insurance proceeds.  While the corporation was obligated to redeem his 77.18% ownership interest for $3 million, the IRS determined that this obligation did not reduce the value of the corporation and the fair market value of his shares at the time of his death was $5.3 million – resulting in almost $900,000 in additional estate tax.

The fair market value of the corporation determines the value of the shares and must consider “the company’s net worth, prospective earning power and dividend -paying capacity, and other relevant factors,” “including proceeds of life insurance policies payable to…the company.” 26 CFR § 20.2031-2(f)(2). The life insurance proceeds payable to the corporation are an asset that increases the corporation’s fair market value. The Court said that the corporation’s obligation to pay for Michael’s shares did not reduce the value of the shares because “no real-world buyer or seller would have viewed the redemption obligation as an offsetting liability.”  The Court focuses on the fact that the obligation does not affect any shareholder’s economic interest and, therefore, no willing buyer purchasing Michael’s shares would have treated the corporation’s obligation to redeem Michael’s shares at fair market value as a factor that reduced the value of those shares. The Court argues that any valuation that takes the redemption obligation into account effectively values the corporation on a post-redemption basis – this is inconsistent with the provision of the Internal Revenue Code that requires an assessment of how much Michael share were worth at the time he died – before the redemption payment. 26 U.S.C. § 2033; 26 CFR § 20.2031-1(b) (“the value of every item of property includible in a decedent’s gross estate…is its fair market value at the time of the decedent’s death”).  If the value of the corporation was $3.86 million both before and after the redemption, then there must have been a disproportionate shift of the value of the corporation to Thomas immediately after the redemption, because his shares would have been worth four times what Michael’s shares were worth at redemption.

So, what does this mean for you? It may be time to evaluate your shareholder agreement and how it is funded. The proceeds of any life insurance policy on an owner will result in an increase in the fair market value of the business and could result in increased estate tax liability.  Perhaps a cross-purchase agreement may be a better fit – that comes with its own sets or pros or cons.  Our team at Smith Bukowski can help you evaluate your options.