Many limited partnerships have buy-sell redemption agreements with shareholders. These agreements are critical to maintaining business continuity when a key shareholder leaves the company. When the redemption agreement is triggered by the death of a shareholder, companies often buy back the shares with life insurance proceeds. A recent Supreme Court decision has raised questions about the impact of redemption agreements and company-owned life insurance policies on the stock valuation for estate tax purposes of a deceased insured shareholder.
In Connelly v. United Statesthe Supreme Court ruled that the company’s repurchase obligation did not offset the value of a company-owned life insurance policy that was used to satisfy the obligation for estate tax valuation purposes of the deceased insured shareholder. In that case, the sole shareholders of Crown C Supply – brothers Michael Connelly and Thomas Connelly – had entered into an agreement under which the company would repurchase the shares of a deceased shareholder with the proceeds of a company-owned life insurance policy. When Michael died, the company used the life insurance proceeds to buy out his shares. Michael’s estate did not include the value of the life insurance proceeds in calculating goodwill because the repurchase obligation offset the value of the life insurance policy. The estate valued the shares at $3 million.
The IRS disagreed, arguing that the surrender obligation did not reduce the value of the company for estate tax purposes. The IRS argued that the life insurance proceeds were a non-operating asset that must be included in calculating the value of a shareholder’s stock. The IRS valued the stock at $5.3 million, resulting in a significantly higher tax bill for the deceased shareholder’s estate.
In a unanimous decision, the U.S. Supreme Court sided with the IRS and held that a surrender obligation does not outweigh the value of a captive insurance policy in light of a shareholder’s economic interest. The Court stated:
“The question here is whether Crown’s contractual obligation to repurchase Michael’s shares at market value outweighs the value of the life insurance proceeds intended to fund that repurchase. The answer is no. Because a repurchase at market value has no impact on a shareholder’s economic interests, no hypothetical purchaser purchasing Michael’s shares would have considered Crown’s obligation to repurchase Michael’s shares at market value as a factor reducing the value of those shares… However, for the purposes of calculating the estate tax, the issue is determining how much Michael’s shares were worth at the time of his death – before Crown spent $3 million on the repurchase payment.”
In other words, the court considered the life insurance proceeds as an asset, but did not consider the surrender obligation as a liability at the time of the deceased shareholder’s death.
What does this mean for owner-managed corporations with redemption agreements?
The court admitted that the dispute in the Connelly The case is narrowly focused and its outcome is “a consequence of the way the Connelly brothers structured their agreement.” The decision may have far-reaching implications for limited-ownership companies. If your company has a corporate-level surrender agreement funded by life insurance, it is important to understand the implications of those agreements from an estate tax perspective. Along with legal counsel, you should carefully review your company’s shareholder agreements and insurance participations, keeping the following questions in mind:
- Is the proceeds from the life insurance policy earmarked for the purpose of fulfilling the surrender obligation?
- Is the redemption price in the agreement determined on the basis of a value other than the inheritance tax value?
- Are the company’s shareholders affiliated companies?
- Have there been any changes in ownership or management in the company since the transfer agreement was drawn up?
- Otherwise, does the agreement meet the requirements of Section 2703(b) of the Internal Revenue Code?
- Does the agreement limit the deceased’s participation in the value of the life insurance benefit?
There are various succession and estate planning options that should be discussed with legal advisors and accountants. For example, a limited company and its shareholders might consider shareholder cross-purchase agreements with life insurance policies owned by the shareholders (or trusts or a shareholder limited company).
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