Supreme Court to decide estate tax impact of life insurance in closely held businesses

The U.S. Supreme Court will decide a case this term that presents a crucial question regarding the estate tax treatment of life insurance proceeds received by a closely held business and its shareholder redemption obligations. It focuses on closely held corporations’ practice of entering into an agreement to redeem the stock of a deceased shareholder and funding the redemption with life insurance proceeds received by the company upon the shareholder’s death. The central issue is how these arrangements should be treated for federal estate tax purposes. The Court heard oral arguments in the case, Connelly, No. 23-146 (U.S. 3/27/24), on March 27.

The primary question presented in the case is whether the life insurance proceeds received by Crown C. Supply Inc. (Crown) used to satisfy an estate redemption obligation should increase the valuation of the ownership interest in Crown held by the estate of the deceased shareholder, Michael Connelly, and thus the corresponding estate tax owed.

The case has profound implications for estate planning, taxation, and the operation of closely held corporations, particularly with respect to the use of life insurance in succession planning. A decision in favor of the estate would validate the use of life insurance proceeds to fund shareholder redemption agreements without increasing estate tax liability, thus affirming a practice among small businesses for ensuring continuity.

Conversely, a decision for the government would affect how closely held corporations prepare for the estate tax impact of the transition of ownership following a shareholder’s death. The Court’s ruling is eagerly anticipated for its broader impact on estate planning, taxation, the operation of closely held corporations, and succession planning.

Oral arguments

The Supreme Court justices and the government engaged in a lively debate during the oral argument. The estate argued that the life insurance proceeds used to redeem the estate’s shares did not increase Crown’s net worth because of the contractual obligation to redeem the estate’s shares. Therefore, the estate argued, the estate tax valuation of the estate’s Crown shares was equal to the estate’s interest in Crown prior to the receipt of the life insurance proceeds.

The estate’s position is that a hypothetical buyer would not consider the life insurance proceeds as increasing the value of the Crown shares due to the obligation to redeem the estate’s shares, a preexisting corporate liability. Attorney Kannon K. Shanmugam, arguing on behalf of the estate, said that “the problem with the government’s approach is that [it] requires you to do one of two things: either to disregard the offsetting liability or to assume … that your hypothetical buyer is somehow going to be able to capture the life insurance proceeds.”

The government, represented by Assistant Solicitor General Yaira Dubin, contested the estate’s view by emphasizing that the estate’s method of valuation “contradicts basic math and valuation principles.”

“The estate’s contrary view rests on a fundamental misunderstanding of the nature of a redemption obligation,” Dubin said. “A redemption obligation is not a corporate debt that reduces the corporation’s net worth. … A debt owed to creditors reduces corporate and shareholder value. A redemption obligation divides the corporate pie among existing shareholders without changing the value of their interests.”

The government vigorously argued its position that Crown’s total net worth immediately before the division should reflect the addition of the life insurance proceeds, which would mean the estate’s valuation method significantly undervalued its estate tax obligation.

The justices probed the practical implications and logical underpinnings of both parties’ arguments, focusing on the valuation of Crown and the appropriate treatment of Crown’s redemption obligation.

Justice Clarence Thomas questioned the estate: “If a very interested buyer showed up the day after Michael died, would Thomas sell the business to him for $3.86 million?” The $3.86 million is the value of Crown treating life insurance proceeds as offset dollar for dollar against the redemption obligation. Thomas further questioned the estate: “If a buyer showed up the day after Michael died and offered to buy it at any price, what would he sell it for? … Would he ask $3.86 million or $6.86 million?”

The estate never answered Thomas’s question directly.

Several justices expressed concern about the contrast between the windfall to Michael’s surviving brother, Thomas Connelly, the executor of Michael’s estate, who owned 100% of Crown after the redemption, versus the estate’s valuation, which did not incorporate the amount of the life insurance proceeds.

Justice Elena Kagan responded to the estate and emphasized that “the fundamental problem with your approach is that Thomas’s … asset has quadrupled in value, and it’s quadrupled in value without him putting a single cent more into the company.”

The estate argued that there will be an eventual capital gain tax on the increase in value of Thomas Connelly’s shares. The government did not point out, however, that any potential capital gain tax does not affect the estate tax valuation.

The estate argued that the result the government supports would be for companies to have to “dip into operating assets” to redeem shares or “otherwise engage in some sort of transaction to ensure continuity.” Justice Sonia Sotomayor emphasized that Crown could have obtained additional life insurance.

Justice Brett Kavanaugh focused on two professors’ amicus briefs. He highlighted the fact that both briefs disagree with the position of the estate and summarized their position as “obviously, they’ve spent a lot of time thinking about this issue. They’re against you. Do you want to — maybe you just covered it in your view, but where do they get it wrong?”

— Carol Warley, CPA/PFS, J.D., is a partner at RSM US LLP and incoming chair of the AICPA Trust, Estate, and Gift Tax Technical Resource Panel. Michael Reeves, CPA, MST, is a senior manager at RSM US LLP. To comment on this article or to suggest an idea for another article, contact Paul Bonner at Paul.Bonner@aicpa-cima.com.