Supreme Court affirms lower court’s ruling in Connelly v. United States

A summary of the decision

In its unanimous Connelly v. United States ruling, the U.S. Supreme Court clarified the treatment of life insurance proceeds intended for share redemption can be fully includable in an estate’s value calculation. The court affirmed 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.

Background on the case

On June 6, 2024, the U.S. Supreme Court affirmed the Eighth Circuit Court of Appeals’ decision that a closely held corporation’s contractual obligation to redeem a deceased shareholder’s shares does not diminish the value of those shares for federal estate tax purposes.

Brothers Michael and Thomas Connelly were the sole shareholders in Crown C Supply (Crown). Michael owned a 77.18% interest, with Thomas owning the remainder. In 2001, the brothers and Crown entered into a stock purchase agreement to maintain family control of the company if one of them died. Although the agreement provided that the surviving shareholder had the right to buy the decedent’s shares, if the purchase option was declined, the corporation was required to redeem the decedent’s shares.  

To ensure funds for a corporate redemption, Crown obtained life insurance on each brother. When Michael died, Crown used all except $500,000 of the life insurance proceeds to redeem his shares, making Thomas the sole shareholder.

Thomas filed a federal tax return for Michael’s estate, reporting the value of Michael’s shares based on the life insurance proceeds used for the redemption. This valuation excluded the insurance proceeds, determining Crown’s fair market value at Michael’s death and calculating the value of Michael’s shares accordingly. The IRS disagreed and assessed Crown’s total value by including the insurance proceeds, resulting in a higher valuation for Michael’s shares.

Discussion

The court affirmed that the value of the decedent’s shares must reflect the fair market value of the corporation as of the date of death, concluding that the life insurance proceeds payable to the corporation are an asset that increases the corporation’s fair market value and Crown’s redemption obligation did not diminish the shares’ economic value. “Because a fair-market-value redemption has no effect on any shareholder’s economic interest,”… “an obligation to redeem shares at fair market value does not offset the value of life insurance proceeds [earmarked] for the redemption.”

A hypothetical buyer would include Crown’s life insurance proceeds in the corporation’s valuation, the court held, as the obligation to redeem shares at fair market value does not change the overall value of a shareholder’s interest. Any purchaser of Michael’s shares would acquire his stake, along with Crown’s obligation to redeem those shares at fair market value, effectively paying the pre-redemption price.

The court maintained that the decedent’s shares must be valued before redemption and Crown’s valuation must include the policy proceeds as a nonoperating asset. For estate tax purposes, valuation is assessed at the time of death, not after a redemption payment. Thus, the court rejected the idea that Crown’s redemption obligation offsets the life insurance benefits.

As noted by the court, the use of corporate assets to pay for a stock redemption reduces the company’s value and concentrates ownership among fewer shares. Consequently, after redemption, the remaining shareholders wind up with a proportionately greater interest in a company that has a lower value. Therefore, the court disagreed with Thomas’s argument that Crown was worth $3.68 million before and after the redemption of Michael’s shares, noting that to attribute to a surviving shareholder a “larger ownership stake in a company with the same value as before redemption” would flip the “process [of valuation] upside down.”

Because Crown’s redemption obligation was not a liability for estate tax purposes, and since the redemption had no effect on any shareholder’s economic interest, the corporation’s contractual obligation did not reduce the value of life insurance proceeds. The insurance policy increased the taxable value of the decedent’s shares in the estate.

Implications

Business owners should review stock redemption plans, ensuring agreements are structured with tax implications in mind and that the plan has been implemented and is being followed properly.

Currently, the federal estate and gift tax exemption is $13.61 million and is indexed for inflation, increasing to more than $14.0 million in 2025. However, this Tax Cuts and Jobs Act exemption sunsets on December 31, 2025, returning a smaller federal estate and gift tax exemption regime that was present under Connelly. Therefore, clients with stock redemption plans financed by corporate life insurance should be aware that these policies will likely be considered in the share valuation for estate tax purposes.

As the court noted, however, tax burden impacts could be mitigated by transactional design. Consequently, taxpayers should confer with estate tax practitioners regarding the potential tax effects of using alternatives like cross-purchase agreements, life insurance trusts or smaller corporate life insurance plans to cover a redemption downpayment, with the remainder funded by a corporate note.

How Wipfli can help

The knowledgeable team at Wipfli can help you establish or review your succession plan to facilitate the protection of your business in the face of unforeseen or untimely events, with consideration for the latest tax rulings.