Connelly v. United States – Effect on Your Estate Planning

In its recent Opinion in Connelly v. United States, 144 S.Ct. 1406 (June 6, 2024) the U.S. Supreme Court held that a corporation’s contractual obligation to use life insurance proceeds to redeem a deceased shareholder’s shares was not a liability but rather must be included when calculating the value of the decedent’s shares for estate tax purposes.

In Connelly, Michael and Thomas Connelly were the sole shareholders of Crown C. Supply, a building supply corporation. In order to keep Crown in the family, the brothers agreed that when either of them died, the other would have the option to purchase the deceased brother’s shares. If the option was declined, Crown was required to purchase the shares. In order to ensure that it would have enough money to purchase the shares if required, Crown obtained $3.5 million in life insurance on each brother.

After Michael died owning a 77.18% interest in Crown, Thomas declined the option to purchase Michael’s shares which triggered Crown’s obligation to do so. Michael’s son and Thomas agreed that the value of Michael’s shares was $3 million, which amount Crown paid to Michael’s estate using the life insurance proceeds. Thomas as executor reported the value of Michael’s shares as $3 million on the federal estate tax return. The IRS audited the tax return and assessed Crown’s total value at $6.86 million without offsetting the life insurance proceeds, and Michael’s shares at $5.3 million (6.86 million x .7718). The IRS determined that the estate therefore owed additional tax in the amount of $889,914. Thomas as executor paid the tax deficiency, then sued the U.S. for a refund.

The District Court and the 8th Circuit Court of Appeals agreed with the IRS that the $3 million in life insurance proceeds must not be counted as a liability of Crown but must be included in the valuation of Crown. The U.S. Supreme Court affirmed the 8th Circuit’s decision: “We hold that Crown’s contractual obligation to redeem Michael’s shares did not diminish the value of those shares.” The life insurance proceeds payable to a corporation are an asset that increases the fair market value of the corporation.

26 U.S.C. §2033 defines the decedent’s gross estate to include the value of all property to the extent of the interest therein of the decedent at the time of his death. The value of a decedent’s shares in a closely held corporation must reflect the corporation’s fair market value when calculating the federal estate tax.

Finally, the Supreme Court noted that this was a consequence of how the Connelly brothers structured their particular agreement. The brothers had other options, such as a cross-purchase agreement where each of them agreed to purchase the other’s shares at death and purchase life insurance policies on each other to fund the agreement. This type of agreement, however, would have its own drawbacks and tax consequences.

Please consult your tax and estate planning attorneys to learn more about structuring your business and estate plan in order to meet your needs.