Take-Away: Funding a stock or partnership buy-sell agreement with life insurance on the life of an owner may cause unexpected federal estate tax liability for a deceased owner’s estate.

Background: Many small businesses use corporate buy-sell agreements to finance the purchase of an existing business. Often that buy-sell agreement uses life insurance to fund the buy-out of the interest of a business owner who has died. The life insurance can either be implemented using a cross-purchase arrangement, where each business owner owns a life insurance policy on all of the other business owners, or the life insurance can be implemented through a redemption arrangement, where the life insurance policies are owned by the entity, e.g., where the corporation is obligated to buy-back the interest of the deceased shareholder. The cross-purchase approach, while providing tax-free liquidity to the surviving owners, is often rejected as cumbersome and confusing, particularly when there are multiple owners of the entity, since each owner’s life must be insured by each of the other owners, thus resulting in multiple life insurance policies issued and/or financed. The much more simple approach is with a redemption arrangement because the entity owns the life insurance policies on each of its owners, so far fewer policies must be purchased and maintained by the entity. Stock redemption arrangements have been in the news the past 24 months and they may soon be the topic of the United States Supreme Court.

Connelly Decision: Previously reported in these missives was the case of Connelly v. United States, United States District Court (Missouri) , No. 19-1410 (September 21, 2021), affirmed United States Court of Appeals No. 21-3682 (June 2, 2023.)

Facts: In this case two brothers owned a C corporation. Mike died owning 77.18% of the stock. Mike’s brother, Tom, owned the remaining 22.82% of the stock. The brothers had entered into a stock purchase agreement in which the surviving brother had the right to buy-out the deceased brother’s shares. If the survivor did not exercise that priority purchase right, then their corporation was obligated to redeem the decedent’s shares of stock. The stock purchase agreement provided two methods to determine the value of the corporation: (i) execute a certificate of agreed-on-value of the corporation by mutual agreement of the shareholders at the end of every year (which the brothers, like almost all other shareholders in small companies regularly fail to do;) and (ii) using at least two appraisals of fair market value (which was also ignored by the two brothers.) To finance its purchase obligation the corporation obtained life insurance on both Mike and Tom. When Mike died the corporation collected the $3.0 million in life insurance proceeds from the policy on his life and it redeemed Mike’s shares in the company. No appraisal was obtained. When Mike’s estate tax return was filed, the corporation’s value and his interest in it was based solely on the $3.0 million life insurance proceeds that were received by Mike’s estate.

Notice of Deficiency: The IRS issued the Notice of Deficiency. The IRS claimed that the corporation had significant value beyond the life insurance proceeds that were received, and thus Mike’s gross estate was worth considerably more, and thus undervalued on his federal estate tax return. Mike’s estate argued that the redemption agreement determined the value of the corporation for federal estate tax purposes, so there was no need to obtain any appraisal of the corporation or his interest in it. As an alternate argument, Mike’s estate claimed that the increase in value of the corporation caused by its receipt of the life insurance proceeds would be offset by the corporation’s redemption obligation, thus leading to the same outcome- no increase in the value of the corporation.

District Court: The District Court ruled in favor of the IRS. This Court found that the corporation’s  receipt of the $3.0 million in life insurance proceeds added to the value of the corporation for purposes of valuing the corporation and thus Mike’s 77% interest in the corporation.

District and Appeals Courts: The Eighth Circuit Court of Appeals also sustained the IRS’s position and its fair market value appraisal of the corporation..

IRC 2703: The Court noted that IRC 2703(a) requires asset valuations to ignore options, agreements or other restrictions unless they are (i) created under a bona fide business agreement, (ii) with terms that are comparable to arm’s-length transactions, and (iii) they are not a device to transfer property to a family member for less than full and adequate consideration. Here we had an agreement between family members and there was no indication that the agreement’s terms were arm’s-length.

No Fixed Price: The Court also noted that there was no restriction or fixed or determinable price in the corporation’s stock purchase agreement. In fact, the stock purchase agreement set no value or price, and equally important, the brothers did not follow the methods that had been prescribed in the agreement in any event. Instead, Tom and Mike’s son, who served as the Personal Representative of Mike’s estate, essentially sat down and mutually agreed to use the $3.0 million life insurance proceeds as the binding purchase price.

Estate of Blount: Mike’s estate argued that the exclusion of the life insurance proceeds from the value of the corporation should follow an earlier federal Court of Appeals decision, Estate of Blount v. Commissioner, 428 F.3d 1338 (11th Circuit, 2005) that had reached a contrary result. The Blount court had held that the proceeds of insurance received  by the corporation under a stock purchase agreement that is subject to a corresponding obligation for the redemption of the decedent’s shares are offset by that redemption liability, so that there is no impact on the corporation’s value due to the receipt-redemption arrangement. The Eighth Circuit Court expressly refused to follow the Blount decision. In doing, so the Connelly Court found that a willing buyer would not disregard the life  insurance proceeds that are used to redeem shares because those proceeds do actually increase the value of the corporation. A case in the 9th Circuit Court of Appeals also has held that life insurance proceeds should be excluded from the value of its recipient corporation, so that the Eighth Circuit was clearly going in a different direction than two other Circuits.

United States Supreme Court: On August 16, 2023 the Connelly Estate filed a Petition for Certiorari with the United States Supreme Court. The Estate alleges that a circuit ‘conflict’ exists as the basis for justification of a grant of its writ of certiorari by the Court. The question presented to the Supreme Court by the Estate is: “Whether the proceeds of a life-insurance policy taken out by a closely held corporation on a shareholder in order to facilitate the redemption of the shareholder’s stock should be considered a corporate asset when calculating the value of the shareholder’s shares for purposes of the federal estate tax.”  We will have to wait and see if the Supreme Court accepts the petition and later provides a decision to clarify the conflict.

Conclusion: Most small business owners, where there is more than one owner, execute buy-sell agreements in anticipation that one will become disabled, die, or later wish to retire. The obligation to purchase because  of the death of one event that is often financed with the purchase of a life insurance policy on the owner’s life. For some reason, once these buy-sell agreements are put in place, the owners then turn to running their business and frequently ignore the terms of their buy-sell agreement, including the need to annual readjust the value of their business. The Connelly decision is a helpful reminder that ignoring the agreement’s terms and obligations can generate IRS scrutiny, judicial skepticism, and in Connelly case, unexpected federal estate tax liability.