An estate tax case before the US Supreme Court underscores the importance of stock-purchase agreements and life insurance arrangements, Goulston & Storrs’ Michelle Porter and Emily Berlin say.

The US Supreme Court on Dec. 13 agreed to hear arguments in Connelly v. United States, wading into a circuit split on the proper estate tax valuation of a decedent’s shares in a closely held business.

The case highlights the importance of two actions that can help practitioners protect their business-owning clients.

Stock-Purchase Agreements

To the extent clients have executed or intend to execute stock-purchase agreements, practitioners should think about the terms and performance of such agreements.

A threshold issue in Connelly was whether a stock-purchase agreement fell within the statutory exception that allows such an agreement to set the estate tax value of a decedent’s stock. In that case, the decedent and his brother, who were co-owners of a family business, had executed an agreement under which the business agreed to redeem the shares of the first brother to die.

Although the agreement required the brothers establish a redemption price for their shares by agreement or appraisal, they never did. Instead, when the decedent died, the decedent’s brother simply agreed with the decedent’s son (and heir) on a price. The decedent’s estate reported that price as the value of the decedent’s shares for estate tax purposes.

Practitioners should remember that under Section 2703 of the tax code, a stock-purchase agreement may be used to determine the estate tax value of closely held stock only if such agreement is:

• A bona fide business arrangement
• Not a device to transfer such [stock] to members of the decedent’s family for less than full and adequate consideration
• Comparable to similar arrangements entered into by persons in an arms’ length transaction

Courts also have stressed the importance that a “fixed and determinable” price be included in the agreement—something the Connellys neglected to do.

Life Insurance

The issue at the heart of Connelly is how, when calculating the fair market value of a closely held business for estate tax purposes, to account for the proceeds of a life insurance policy on the decedent taken out by the business to fund an obligation to redeem the decedent’s shares at their death.

While the personal circumstances of a client should always control the situation, practitioners generally should encourage clients to avoid arrangements like the one that landed the Connellys in court. This case highlights the downside of a closely held business itself having redemption obligations and owning life insurance policies on its shareholders to support such obligations.

Clients and other shareholders should consider taking out life insurance policies on one another, held individually or in irrevocable trusts or other entities, to ensure they have sufficient liquidity to purchase a deceased shareholder’s stock and retain the interests in the business themselves.

Note that under Section 2042 of the tax code, life insurance policies not owned by the decedent aren’t included in the decedent’s taxable estate. And if the proceeds of those policies don’t flow to the decedent’s business, the risk that the proceeds indirectly increase the value of the decedent’s estate by increasing the value of the decedent’s business is minimized.

Practitioners also may wish to suggest that clients execute stock-purchase agreements among shareholders to ensure these insurance proceeds are used as planned and guarantee their loved ones a payout on their deaths.

Looking Ahead

The Supreme Court is facing a circuit split in Connelly: The US Court of Appeals for the Eighth Circuit directly took on and rejected reasoning from Ninth and Eleventh Circuit decisions.

All three courts started from the same place, agreeing the proceeds of an insurance policy owned by a closely held business on a shareholder’s life are an asset of the business.

But the courts diverged on the treatment of a corresponding redemption obligation. The Ninth and Eleventh Circuits each held that a redemption obligation was a liability, offsetting insurance proceeds such that the business’s fair market value shouldn’t increase.

The Eighth Circuit, however, held there is no such offsetting liability, reasoning that a prospective buyer could buy the entirety of the business, extinguish the redemption obligation (since such obligation would now be owed by the buyer to himself), and thus keep the business holding all the insurance proceeds.

Should a fair market valuation of a business rely on the assumption that a buyer would buy the entire business and have the power to extinguish an otherwise considerable outstanding obligation? The Ninth and Eleventh Circuits seem persuasive in their characterization of a redemption obligation as an offsetting liability. But is their analysis incomplete?

As the Eighth Circuit seems to recognize (or at least hint at), under these circumstances, a decedent’s estate effectively passes on the value of their closely held shares twice: once to the other shareholders, in the form of increased equity, and once to the decedent’s heirs, in the form of a payout from the business.

The case is Connelly v. United States, U.S., No. 23-146.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

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