Legal Update: September 2024

Connelly v. United States—Do Redemption Agreements Create a Business Liability?

Most have some form of agreement and financing in place to address sudden changes in ownership. In Connelly v. United States, a unanimous U.S. Supreme Court may have turned many of those plans on their heads. The question before the Court was whether a redemption agreement created a liability to the company. The author discusses the decision and impact it may have on succession planning.

One of the great challenges for privately held businesses is dealing with the unexpected departure of an owner, whether by disability or death. Most have some form of agreement and financing in place to address those sudden changes in ownership. In Connelly v. United States, 144 S. Ct. 1406, 2024 U.S. LEXIS 2485 (June 6, 2024), a unanimous U.S. Supreme Court may have turned many of those plans on their heads.

Background

Brothers Michael and Thomas Connelly owned Crown C Supply, Inc. (the “Company”). Michael owned 77.18% of the Company and Thomas owned 22.82%. The shareholders and the Company executed an agreement that, among other things, dealt with the death of a shareholder. Upon one brother’s death, the other brother would have the option to purchase his shares. If the brother decided not to exercise that option, the Company was obligated to purchase the deceased shareholder’s position at fair market value as determined by an independent appraisal. To help fund this potential obligation, the Company purchased $3,500,000 of life insurance on each brother.

In 2013, Michael died, and Thomas declined to exercise his option to purchase Michael’s shares from his estate. This triggered the Company’s obligation to redeem the shares. Rather than obtaining the valuation required under the agreement, Thomas and his nephew negotiated a purchase price of $3,000,000. The Company paid Michael’s estate from the insurance proceeds, leaving it with $500,000 in extra cash.

Thomas, as executor for Michael’s estate, filed a federal estate tax return that reported the value of Michael’s shares at the $3,000,000 purchase price. The Internal Revenue Service audited the return and valued the Company at approximately $6,860,000, which included the proceeds of the life insurance policy. The IRS concluded that the taxable value of the estate’s shares was approximately $5,300,000 (77.18% of $6.86 million) and assessed $889,914 in additional tax.

During the audit process, the estate hired its own appraiser who determined that the life insurance proceeds were partially offset by the Company’s $3,000,000 obligation to redeem the shares from the estate. The estate paid the deficiency and sued for a refund.

The trial court granted summary judgment in favor of the government, which the Eighth Circuit Court of Appeals affirmed, finding that the Company’s obligation to redeem Michael’s shares was not a liability that reduced the corporation’s fair market value.

Court Findings

The sole issue before the Supreme Court was whether the obligation to redeem a deceased owner’s interest offsets the insurance proceeds designated to fund that obligation. The Court found that the redemption obligation did not reduce the value, relying on a simplified example. The Court hypothesized that a company with a single asset, $10 million in cash, and no liabilities would have an equity value of $10,000,000. If this hypothetical corporation had two shareholders, one owning 80% and the other owning 20% of the shares, one shareholder would have an interest worth $8 million and the other would own an interest worth $2 million. If the 20% shareholder dies and the corporation redeemed their stock for $2 million, the majority owner would become a 100% owner of a company worth $8 million. From the Court’s perspective, since the “value of the shareholders’ interests after the redemption—A’s 80 shares and B’s $2 million in cash—would be equal to the value of their respective interests in the corporation before the redemption, a corporation’s contractual obligation to redeem shares at fair market value does not reduce the value of those shares in and of itself. ”[1]

The Court dismissed the estate’s position that the redemption obligation creates a liability reducing the value of the business. The estate argued that the Company was worth approximately $3,860,000 before Michael’s death, making his 77.18% interest worth approximately $3,000,000. Following the redemption, the Company was the same as it was before Michael’s death, and therefor worth the same $3,860,000. The Court disregarded this analysis without meaningful explanation concluding, “That cannot be right: A corporation that pays out $3 million to redeem shares should be worth less than before the redemption.”[2]

The estate also raised the issue that the Court’s affirmation of the earlier rulings would make succession planning for closely held businesses more difficult since the proceeds of the funding vehicle would increase the value of the subject interest and simultaneously increase the amount of insurance required to fund a redemption. This would, in turn, require even more insurance and on and on and on. The Court also dismissed these concerns, suggesting alternatives exist for dealing with the death of a shareholder that would not implicate the value of the business. For example, citing Shannon Pratt’s Valuing a Business, the Court suggested a cross-purchase agreement that obligated the shareholders to purchase the shares of a deceased owner with each shareholder purchasing life insurance, outside the company, on the other owner(s) to fund those purchases.

Conclusion

In an eight-page opinion, the Court has turned succession planning for millions of closely held businesses upside down and raised additional challenges for families trying to keep their privately owned businesses in the family. Succession planning and estate administration, along with business valuations in both of those areas, will need to consider the proceeds of company-owned life insurance policies on the principals as part of the value of the business itself.

[1] 144 S. Ct. at 1412, 2024 U.S. LEXIS 2485 at ***13

[2] 144 S. Ct. at 1413, 2024 U.S. LEXIS 2485 at ***16

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Michael J. Molder, JD, CPA, CFE, CVA, MAFF, applies 30 years of experience as a Certified Public Accountant and litigator to help investigate and analyze cases with complex financial and economic implications. He has acted as both counsel and accounting expert in pending and threatened litigation as well as participating in internal investigations of financial misconduct. As a litigator, Mr. Molder helped co-counsel understand complex financial and accounting issues in dozens of cases. In 2006, Mr. Molder returned to public accounting applying his unique skills to forensic engagements. He has also performed valuations of business interests in a wide variety of industries.

Mr. Molder has served as valuation expert for both plaintiffs and defendants in commercial litigation matters and owner and non-owner spouses in matrimonial dissolutions. He has participated in the valuations of businesses in a wide variety of industries, including: food service, wholesale and retail distribution, literary development and production, healthcare, manufacturing, and real estate development.

Mr. Molder has also investigated and valued damages in a wide variety of litigation contexts ranging from breach of contract claims to personal injury cases, and from employment disputes to civil fraud. He has consulted on many matters which have not involved the issuance of a report for litigation or resulted in deposition or trial testimony. Accordingly, the identity of these matters is protected by attorney client privilege.

Mr. Molder has also lectured widely on a variety of accounting and litigation related topics including business valuation, financial investigations in divorce proceedings, accountant ethics, financial statement manipulation and “earnings management.”

Mr. Molder can be contacted at (610) 208-3169 or by e-mail to Molder@lawandaccounting.com.