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  • Michael Sawicki

The Supreme Court Rules on How Life Insurance Proceeds and Redemption Obligations Should be Treated for Federal Estate Tax Purposes

The U.S. Supreme Court recently considered whether the proceeds of a life insurance policy taken out by a closely held corporation on a shareholder in order to facilitate the redemption of the shareholder’s stock upon death should be considered a corporate asset when calculating the value of the shareholder’s shares for purposes of the federal estate tax. On June 6, 2024, in a landmark decision, the Court unanimously confirmed a decision of the U.S. Court of Appeals for the Eighth  Circuit siding with the Internal Revenue Service (IRS) that a corporation’s contractual obligation to redeem shares is not necessarily a liability that reduces a corporation’s value for purposes of the federal estate tax.

In Connelly as Executor of the Estate of Connelly v. United States, two brothers were the sole shareholders of a corporation. The corporation obtained a $3.5M life insurance policy on each brother so that if one died, the corporation could use the proceeds to redeem his shares. When one brother died, the IRS assessed taxes on his estate, which included his stock interest in the corporation. According to the IRS, the corporation’s fair market value included the life insurance proceeds intended for the stock redemption. The estate argued otherwise and sued for a tax refund.

The corporation assessed the value of the decedent’s shares at $3M ($3.86M times the decedent’s percentage of ownership). The IRS determined the fair market value of the shares was $5.3M ($3.86M plus the $3M in life insurance proceeds times the decedent’s percentage of ownership) adding an additional tax liability of $889,914.

The Court reasoned that any valuation that takes the redemption obligation into account effectively values the corporation on a post-redemption basis (after the decedent’s shares have been redeemed). However, for the calculation of the estate tax, the value of the decedent’s shares must be calculated at the time of death before the redemption payment which would include the life insurance proceeds.

The Court ruled in favor of the IRS that when calculating federal estate tax, the value of a decedent’s shares in a closely held corporation must reflect the corporation’s fair market value. Accordingly, the life insurance proceeds payable to the corporation are an asset that increases the corporation’s fair market value. The corporation’s contractual obligation to redeem the decedent’s shares at fair market value does not offset the value of the life insurance proceeds committed to funding that redemption.

This decision highlights the importance of strategic estate planning for business owners, the selection of insurance, and the potential tax implications of corporate agreements. A cross-purchase agreement, where shareholders or trusts for the shareholder’s benefit, purchase insurance on each other, can avoid complications by ensuring insurance proceeds go directly to purchasing shares without inflating estate tax values. Companies should regularly obtain professional valuations to understand potential tax implications and ensure compliance with current market values and tax regulations. Careful planning with estate planning attorneys and tax advisors can help avoid unforeseen tax liabilities.

If you would like to speak to an attorney about your estate planning needs, please contact Batoff Associates, P.A. at 410-864-6211.


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