The Supreme Court has just weighed in on how gift and estate taxes apply with respect to non-cash gifts in Estate of Connelly v. United States. The Court's opinion closely follows the economics of such arrangements, but overturns an established estate planning technique. As a result, closely-held businesses should eschew corporate owned life insurance to fund redemptions of deceased shareholders in favor of shareholders holding life policies over each other to fund cross-stock purchases.
I. THE FACTS OF ESTATE OF CONNELLY
Michael Connelly and his brother Thomas Connelly operated a small business supply company named Crown C Corporation (“Crown C”), in St. Louis, Missouri. Michael owned 77.18% of the outstanding stock of Crown C and Thomas owned the remaining 22.82% of the Crown C stock. In order to finance the buy-out by the family of each of the owners when they died, Crown C purchased $3.5 million of life insurance on each of the brothers. Although the opinions are silent on whether Crown C deducted the premiums paid for the policies from its federal taxable income, life insurance premiums on the lives of employees generally are not tax deductible.1 Under the brothers' buy-sell arrangement in place, if either Michael or Thomas failed to purchase the stock of the other on the other's death, Crown C was obligated to purchase such stock.
Michael passed away in 2013. Thomas didn't exercise his right to buy the Crown C stock held by the estate of Michael. As a result, and pursuant to the buy-sell arrangement, Crown C became liable for redeeming such stock. Michael's estate agreed with Crown C to accept $3 million in redemption of the Crown C stock held by Michael. The remaining $500,000 of death benefits, paid on the insurance policy over Michael's life, were used by Crown C “to fund company operations.”
Michael's estate filed a federal estate tax return reporting that the Crown C stock owned by Michael at the date of his death was $3 million, the amount that the estate received in the redemption. This figure resulted in a total value of Crown C at $3.89 million ($3,000,000/.7718). The Internal Revenue Service (IRS) did not challenge this valuation of Crown C with respect to the period prior to when Crown C received the death benefits under the life insurance policy covering Michael's life. However, the IRS did assert that the value of Crown C should be increased by the $3 million that Crown C received upon Michael's death and not used to pay expenses.2 This addition brought the value of the stock owned by Michael's estate to $5.3 million ((3,890,000 + $3,000,000)/.7712). This assertion resulted in a significant estate tax liability for Michael's estate.
The taxpayer asserted that, since the death benefits were offset by the obligation of Crown C to redeem the stock held by the estate, there was no net any accretion to value by reason of the receipt of the insurance proceeds ($3 million in and $3 million out). The IRS countered that anyone who sought to purchase the shares held by the estate at fair market value would have inured to 77.12% of the total net value of Crown C, which included the net death benefits payable under the life insurance policy. The IRS asserted, and the Supreme Court agreed, that Thomas' stake was worth $887,017 before the redemption ($3,890,000 x .2282). Accordingly, Michael's estate made a gift of $2.2 million to Thomas, which explained how the value of the company was $3.89 million after the redemption.3 The inclusion of that $2.2 million in the estate resulted in the estate tax liability.
While the Court's math was persuasive, the taxpayer must have believed that it was on sound footing as two prior cases had considered the same issue and held that the value of the corporation should not be increased by the death benefits payable under the insurance policy. In Estate of Blount,4 the Eleventh Circuit Court of Appeals held in the taxpayer's favor on the same issue on a similar fact pattern. That Circuit Court held that the death benefits were offset by the redemption obligation made excluding the death benefits from the value of the stock “persuasive and consistent with common business sense.” In Cartwright v. Comm'r,5 the Ninth Circuit Court of Appeals also had held that insurance proceeds should not be added to the value of a corporate beneficiary of the insurance policy where the corporation had a concomitant obligation to use the proceeds to redeem the stock of a shareholder.
II. A TRAP FOR THE UNWARY
The Connelly brothers, as a practical matter, considered themselves the owners of the insurance policies on each other's lives. In other words, if the Connelly brothers had treated themselves as receiving the death benefits, then the value of their business was not affected by the stock buy-out. The facts suggest that Michael's estate did not intend to make a $2.2 million gift to Thomas. Concomitantly, Michael's estate perceived that it was receiving fair value for the stock.
The taxpayers' intention could have comported with a lower estate tax burden if they had held the insurance policies on each other's lives in their own names. In that case, the insurance policy proceeds would have been received tax-free by each brother,6 the proceeds of the policy being owned by the brother who did not die would not have been included in the estate of the brother who did die and the value of the corporation would not have been increased by the death benefits. There wouldn't have been any income tax differences because the premiums were non-deductible no matter who paid them. Thus, the Court put an extremely high price on the form of the transaction, something that neither the Estate of Blount nor Cartwright v. Comm'r courts found justifiable.
The Court's opinion acknowledges that a cross-purchase agreement in lieu of a redemption agreement would have avoided the additional estate tax burden. The opinion also states that it is “true enough” that the holding of the case will result in closely-held businesses adopting this strategy rather than redemption agreements even though it is more burdensome. In short, closely held businesses need to revisit their succession and buy-out planning to ensure that they don't get caught by unintended taxes.
Footnotes
1. Section 264(a) of the Internal Revenue Code of 1986, as amended (the “Code”); Treas. Reg. § 1.264-1(a).
2. The buy-out arrangement failed to qualify for the valuation safe-harbor of Code § 2703(b) because the buy-out arrangement did not have fixed or determinable price. The arrangement did not specify any price or formula for the buy-out.
3. The Court's decision did not make any reference to the regulations promulgated under Code § 2042 (which governs the circumstances under which life insurance proceeds are includible in the gross estate of a decedent for estate tax purposes) or Code § 2031 (which govern the valuation of businesses for estate tax purposes).
4. 428 F.3d 1338 (11th Cir. 2005), aff'g and reversing T.C.Memo. 2004-116
5. 183 F.3d 1034 (9th Cir. 1999)
6. Code § 101(a).
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