Supreme Court affirms life insurance is an asset of the corporation for estate tax purposes

In detail

As background, Michael and Thomas Connelly, sole shareholders of Crown C Corporation, had a stock-purchase agreement to maintain family control of the company after the death of either of them, funded by life insurance policies on each other. When Michael died in 2013, Crown used the $3.5 million insurance payout to buy back his shares for $3 million and put $500,000 into the business. Thomas, as executor of Michael’s estate, valued Michael’s shares at $3 million for estate tax purposes (i.e., the price that Crown paid to redeem his shares), not accounting for the insurance money as a corporate asset. The IRS contested this valuation, claiming Crown was worth $6.86 million, including the insurance proceeds as part of the company's value, leading to a $1 million tax deficiency notice to the estate, which was paid and then contested in court by Michael's estate seeking a refund. For more details regarding the facts of this case, please see our  previous Insight. 

In its unanimous opinion, the Supreme Court rejected the argument put forth by Michael's estate that Crown's obligation to redeem his shares was a liability that offset the value of the life insurance proceeds used to fulfill that obligation. According to the court, an obligation to redeem shares at fair market value does not offset the value of the life insurance proceeds set aside for redemption because a redemption at fair market value does not affect the value of the company's stock. 

To illustrate this point, the court provided an example of a corporation with two shareholders, A and B, who own 80 and 20 shares of the corporation, respectively. If the corporation had $10 million in assets, then each share of stock would be worth $100,000 (i.e., $10 million / 100 shares). If the corporation decided to redeem Shareholder B's 20 shares for fair value, then it would need to pay $2 million (i.e., $100,000 * 20), and the corporation would be left with $8 million in assets and 80 shares outstanding after the redemption (all shares being owned by Shareholder A). Thus, Shareholder A's stock would still be valued at $100,000 per share both before and after the redemption, even though the value of the corporation decreased from $10 million to $8 million. Based on this example, the court concluded that Crown's contractual obligation to redeem Michael's shares did not reduce the value of those shares for estate tax purposes. The court also emphasized that a redemption obligation could potentially decrease the value of a corporation's shares depending on the facts and circumstances. For example, if a redemption obligation required a corporation to liquidate operating assets to pay for the shares, then that obligation could decrease the company's future earning capacity. For this reason, the court declined to hold that a redemption obligation could "never" decrease a corporation's value, despite its ruling in the present case. 

Michael's estate also argued that a hypothetical buyer of Crown's stock would not consider the life insurance proceeds as an asset of the corporation because the insurance proceeds would leave the company as soon as they arrived to complete the redemption. Therefore, the relevant inquiry should be what a buyer would pay for those shares after the redemption. The court rejected this argument as well, as any valuation that took the company's redemption obligation into account (i.e., on a "post-redemption basis") would reflect Crown's value after Michael's shares had been redeemed. However, for estate tax purposes, the relevant inquiry is to assess how much Michael's shares were worth at the time of his death (i.e., before Crown spent the redemption proceeds).

Finally, Michael's estate argued that including the life insurance proceeds as an asset of the corporation without an offsetting liability would make succession planning more difficult for closely held corporations. In the present case, Crown would have needed "an insurance policy worth far more than $3 million in order to redeem Michael's shares at fair market value." The court acknowledged this reality, but also reasoned that this was simply a consequence of how the Connelly brothers chose to structure the stock purchase agreement. Had the Connelly brothers structured Crown's succession plan differently (such as through a cross-purchase agreement), Crown never would have received the life insurance proceeds and there would have been no impact on the value of Michael's shares.