Connelly v. United States: Supreme Court Ruling Overview
On June 6, 2024, the Supreme Court of the United States issued a significant ruling in Connelly v. United States, addressing how the value of a closely held corporation’s stock should be determined for federal estate tax purposes—particularly when life insurance proceeds are used to fund a stock redemption agreement.
Background of the Case
Michael and Thomas Connelly co-owned Crown C Supply, a building supply company. They had a buy-sell agreement stating that when one brother died, the surviving brother had the option to purchase the deceased’s shares. If the surviving brother declined, the corporation itself was obligated to redeem the shares—funded at least in part by life insurance policies on each brother.
When Michael Connelly died in 2013, Crown received $3 million in life insurance proceeds and used it to redeem Michael’s shares. The estate reported the value of Michael’s shares as $3 million, matching the redemption price. However, no outside appraisal was performed as required in the original agreement. Instead, Michael’s son and Thomas mutually agreed on the valuation in an “amicable and expeditious manner.”
At the time of his death, Michael held a 77% ownership interest. After redeeming his shares with the life insurance funds, Thomas became the sole shareholder of Crown.
IRS Dispute and Valuation Adjustment
The IRS challenged the estate’s valuation, arguing that the $3 million in life insurance proceeds should be considered part of the corporation’s value. Based on this reasoning, Michael’s shares were worth approximately $5.3 million, not $3 million—resulting in an additional estate tax liability of about $900,000.
Supreme Court Decision and Reasoning
The Supreme Court sided with the IRS. It held that when a corporation uses life insurance proceeds to redeem a deceased shareholder’s shares, those proceeds remain corporate assets and must be included in the overall valuation of the company. The Court emphasized that redeeming shares does not diminish the value of the remaining shares for estate tax purposes.
Implications for Business Owners
This ruling clarifies that life insurance proceeds used for corporate stock redemptions increase the value of the corporation and, consequently, the value of the deceased shareholder’s estate. Business owners should carefully review their:
- Buy-sell agreements
- Estate plans
- Life insurance policies
Understanding these implications can help minimize unexpected tax liabilities.
Cross Purchase vs. Redemption Agreements
In a cross-purchase agreement, each shareholder owns life insurance on the others. When one dies, the surviving shareholder uses the proceeds to buy the deceased’s shares. This results in:
- A change in percentage ownership among survivors
- A step-up in basis for surviving shareholders—applies to income, estate, gift, and generation-skipping taxes
In contrast, company-owned insurance used in redemption agreements does not provide a step-up in basis for other shareholders.
Tax Planning Considerations
Cross-purchase agreements may offer better tax outcomes, especially for family-owned businesses, because of the step-up in basis. However, as the business grows, the cost and complexity of maintaining cross-purchase insurance plans can become a burden—often leading companies to opt for corporate-owned insurance.
Recommended Valuation Procedure Post-Connelly
To align with the Connelly ruling, consider this valuation method:
- Appraise the Business Without Life Insurance
- Use a qualified appraiser
- Apply minority discounts or other valuation adjustments
- Add Life Insurance Proceeds
- Combine the appraised value with the insurance proceeds
- This total reflects the accurate company valuation for estate tax purposes
As a result, each shareholder (including the deceased’s estate) should receive a proportionate share of the corporation’s full value, including the life insurance.
