The Supreme Court’s recent decision in Connelly v. United States raises concerns about corporate structuring and business succession plans. Connelly v. United States, No. 23-146 (U.S. June 6, 2024). In this case, Crown C Supply (“Crown”) was a successful, Missouri-based, family corporation owned by two brothers, Michael Connelly (deceased brother) and Thomas Connelly (surviving brother). For Crown to stay within the family upon one of the brother’s deaths, the brothers entered into an agreement where the surviving brother was required to purchase the deceased brother’s shares in Crown.
If the surviving brother did not want to purchase the shares at the time of the other brother’s death, then Crown itself would be required to purchase the shares. To finance this, a life insurance policy of $3.5 million for each brother was required.
Upon one of the brother’s deaths, the surviving brother declined to purchase the deceased brother’s shares. Correspondingly, Crown was required to pay $3 million to the deceased brother’s estate, the agreed upon value of the deceased brother’s shares. When audited by the Internal Revenue Service (IRS), Crown’s fair market value was determined to be $6.86 million ($3.86 million plus $3 million from the life insurance proceeds). Thus, the IRS calculated the value of the deceased brother’s shares as $5.3 million after taxes ($6.86 million x 0.7718). As a result, the estate owed an excess of $889,914 in federal taxes to the IRS.
The question presented to the Court was whether the $3 million in life insurance proceeds should be included to value the deceased brother’s shares accurately. Despite the surviving brother’s argument that a redemption obligation is a liability that offsets the value of the life insurance proceeds, the Court held that the corporation’s redemption agreement did not affect the fair market value of the deceased brother’s shares. The Court reasoned that no buyer of the deceased brother’s shares would treat Crown’s redemption obligation as a factor that would
reduce the value of the shareholder’s economic interest. Further, since Crown would receive the insurance proceeds, the value of Michael’s shares would also increase.
The Court offered a logical comparison to explain their reasoning. When considering a corporation with a single $10 million asset and two shareholders, Shareholder A owning 80% and Shareholder B owning 20% of the corporation, a shareholder who is bought out by the other at fair market value would still have the same worth. If each share is worth $100,000 and Shareholder A redeems Shareholder B’s shares for $2 million (20 shares x $100,000), then both shareholders retain the same value. Therefore, redeeming shares at a fair market value does not affect the value of the shares.
The Court reasoned that the value of the shares is determined immediately prior to death, not after, and the life insurance policy was an asset of the company. Like Crown, closely held corporations are typically identified as those with only a few shareholders, often within the same family, and who participate in the corporation’s daily course of management. Alternatives to redemption obligations exist, such as a cross-purchase agreement, which the Court identified as an effective alternative.
In a cross-purchase agreement, shareholders buy each other’s shares at death and acquire-life insurance policies on each other to finance the agreement. This option avoids the risk that the insurance proceeds increase the value of the deceased shareholder’s shares. However, with a cross-purchase agreement, each shareholder is at risk of paying the insurance policy premium, therefore creating a mutual risk and independent tax consequences.
Accordingly, closely held companies need to take careful consideration in crafting comprehensive partnership agreements and buy-sell agreements.
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