Valuation Lessons from Connelly v. United States

The Role of Life Insurance in Estate Taxes

The recent U.S. Supreme Court case, United States v. Connelly, provides business valuation practitioners opportunities to a cautionary tale and also an opportunity to assist business owners structure or restructure their buy-sell agreements. The authors summarize the case and offer tips to assist business owners transition a business using life insurance.

Introduction

Does the fair market value standard require the insurance proceeds owed to a company at the date of a shareholder’s death need to be added to the value of the business for tax purposes? The Supreme Court ruled that, yes, it does.[1]

In Connelly v. United States (“Connelly”), decided in June 2024, the U.S. Supreme Court tackled a fundamental question in estate taxation: Should the life insurance proceeds payable to a company be included in the valuation of the company for estate tax purposes when the proceeds are earmarked for a stock redemption? The Court’s unanimous decision affirmed the IRS’s stance that these proceeds are assets of the company and must be included in the company’s fair market value, reshaping the assumptions underlying many estate plans.

This decision reverberated across the fields of estate planning and valuation, underscoring the necessity for precision in structuring buy-sell agreements and evaluating their tax implications.

Case Overview[2]

Two brothers, Michael and Thomas Connelly, were shareholders in Crown C Supply, a building supply company. They had a shareholder’s agreement which provided that if one died, the other could buy out the stock of the decedent. If the remaining brother did not buy the stock, then the Company would be obligated to buy the stock. In either case the purchase price would be at fair market value. The Company purchased life insurance on both owners to fund the obligation.

Michael died, and Thomas did not buy the stock, but the Company did. The only question presented to the Supreme Court could be summarized as follows: whether following the fair market value standard means that life insurance proceeds should be added to the value of the business and taxed as part of the estate or whether an offsetting obligation to buy the brothers stock should be subtracted to eliminate the gain?

The executor of the estate argued that the insurance proceeds were offset by the obligation to buy the brother’s stock. The IRS argued that the insurance proceeds should be added to the value of the business and taxed.

The Supreme Court ruled that the insurance proceeds were assets of the Company at the time of death and should be included in the estate. They argued that the obligation to buy the stock was not a liability; it was an equity obligation.

The Court’s math (simplified) was as follows:

• Business Value without Insurance: $3.8 million
• Insurance Proceeds: $3 million
• Business Value with Insurance:             $6.8 million

The Court agreed with the IRS that a fair market value buyer would pay $6.8 M for the Company paying off the equity obligation and keeping the insurance proceeds.

The Supreme Court’s Decision[3]

The Supreme Court ruled in favor of the IRS, affirming that the $3 million in life insurance proceeds should be included in Crown’s fair market value. The Court’s reasoning rested on the following principles:

1. Life Insurance Proceeds as Assets: At the time of the shareholder’s death, the life insurance proceeds were assets of Crown. A hypothetical buyer considering the company’s value would include these proceeds in their calculation, irrespective of the company’s obligation to use the funds for redemption.
2. Redemption Obligations are Not Liabilities: The Court distinguished between liabilities and equity obligations. While liabilities reduce a company’s net value, the obligation to redeem shares at a fair market value is an equity transaction, transferring economic interests without reducing the company’s value.
3. Fair Market Value Standards: The estate tax requires that assets be valued at their fair market value as of the decedent’s date of death. For Crown, this included all assets—both operational assets and the life insurance proceeds—resulting in a valuation of $6.86 million.

The Court acknowledged the potential challenges that this ruling poses for closely held businesses, but emphasized that the outcome was a natural consequence of how the Connelly brothers structured their agreement.

Key Valuation Takeaways

Valuators should consider the implications that the Connelly decision has for engagements in which life insurance proceeds, shareholder agreements, or equity obligations influence the valuation of closely held businesses, particularly in the context of estate and tax planning.

Life Insurance Proceeds Impact Fair Market Value

The inclusion of life insurance proceeds in a company’s valuation fundamentally shifts how practitioners approach buy-sell agreements. Historically, many valuation professionals offset insurance proceeds with stock redemption obligations, assuming a net-zero effect. The Court’s decision in Connelly rejects this assumption, establishing that life insurance proceeds are treated as net assets that increase the company’s fair market value.[4]

Practical Implications for Appraisers

Understanding the Connelly case results in many takeaways that have practical implications for valuation professionals:

• The proceeds must be valued as of the decedent’s date of death. Any use of the proceeds after that date, such as funding a stock redemption, does not alter their status as assets at the valuation point.
• Fair market value calculations must reflect the perspective of a hypothetical buyer. This buyer would consider the insurance proceeds a tangible asset, regardless of any equity obligation associated with their use.

Equity Obligations vs. Liabilities

One of the most critical aspects of the Court’s decision was its treatment of Crown’s obligation to redeem Michael’s shares. The Court emphasized that:[5]

• Redemption obligations are equity obligations, not liabilities.
• These obligations redistribute economic interests among shareholders rather than diminish the company’s net value.

For valuation experts, this distinction underscores the importance of accurately categorizing financial obligations. Misclassifying an equity obligation as a liability could lead to significant valuation errors and tax compliance issues.

Structuring Buy-Sell Agreements Post-Connelly

The Connelly case highlights the importance of meticulous planning in structuring buy-sell agreements. These agreements are fundamental to ensuring smooth business transitions and providing liquidity for estate obligations. However, without proper foresight, they can inadvertently trigger substantial tax liabilities.

The ruling underscores that life insurance proceeds used to fund stock redemptions are not automatically offset by redemption obligations. Consequently, structuring buy-sell agreements without considering the associated tax implications may result in inflated estate valuations and unexpected tax burdens.

To address these challenges, businesses and their advisors should evaluate alternative approaches to structuring buy-sell agreements. Below are some common strategies, along with their benefits and limitations.

• Cross-Purchase Agreements[6]

Under a cross-purchase arrangement, shareholders directly purchase life insurance policies on each other. Upon the death of a shareholder, the surviving shareholders use the proceeds from their policies to buy the deceased shareholder’s interest directly from the estate. This approach bypasses the company, keeping the insurance proceeds out of the corporate valuation.

Pros:

• Simplifies estate tax outcomes by excluding life insurance proceeds from the company’s balance sheet.
• Provides surviving shareholders with direct ownership of the redeemed shares.
• Aligns shareholder interests by requiring each owner to fund the policies on their peers.

Cons:

• Becomes unwieldy in companies with numerous shareholders, as each shareholder must own a policy on every other shareholder.
• Potential disparities in insurance costs if shareholders differ significantly in age or health.

• Trust-Owned Insurance[7]

Placing life insurance policies in a trust that owns shares can offer a practical solution for mitigating estate tax implications. In this arrangement, the trust holds the insurance proceeds and uses them to fund the buyout of the deceased shareholder’s interest.

Pros:

• Keeps insurance proceeds separate from the company, minimizing their impact on corporate valuation.
• Provides flexibility in distributing ownership interests according to the terms of the trust.

Cons:

• Requires careful drafting and compliance to ensure the trust arrangement does not inadvertently trigger unfavorable tax treatment.
• Adds administrative complexity and potential costs associated with maintaining the trust.

• Defined Purchase Prices[8]

Clearly defining the purchase price in the buy-sell agreement may help reduce valuation disputes among shareholders. However, the IRS is not obligated to accept the contractually defined price for estate tax purposes if it does not reflect fair market value.

Pros:

• Offers clarity to the parties involved and helps avoid conflicts during execution.
• Reduces the administrative burden of conducting a valuation upon a triggering event.

Cons:

• The IRS may disregard the agreement’s terms if they do not meet the fair market value standard, potentially leading to disputes and higher tax liabilities.
• Adjustments to the defined price may be necessary over time, requiring regular updates.

Broader Implications for Valuation Practices

The Connelly decision sends a clear message: form matters. This principle extends beyond buy-sell agreements to other aspects of valuation and estate planning.

Regular valuations are essential for closely held corporations. They provide a realistic understanding of potential tax liabilities and highlight areas where planning adjustments are necessary. For example, companies can use interim valuations to evaluate whether their existing insurance policies provide sufficient coverage to meet obligations without inflating the company’s valuation excessively.

Succession plans must account for the interplay between corporate structures, contractual agreements, and tax laws. A one-size-fits-all approach is no longer viable. Instead, planners should conduct scenario analyses to project the tax outcomes of different structures and revisit plans periodically to ensure they align with the company’s growth and evolving tax regulations.

Business owners, especially those unfamiliar with complex valuation concepts, should be educated about the tax implications of their agreements. Transparent communication and proactive planning can prevent costly disputes with tax authorities.

Conclusion

Planning ahead not only counts, but now, it is even more likely to provide an even higher return on investment.

The Connelly v. United States ruling reshapes the valuation landscape for closely held businesses, especially those that rely on life insurance to fund buy-sell agreements. By affirming that life insurance proceeds are assets that increase a company’s fair market value, the Supreme Court has created new challenges for estate planners and valuation experts.

Ultimately, Connelly reinforces the need for meticulous planning and the value of sound professional advice. In a landscape where form can outweigh substance, thoughtful preparation can yield significant returns; protecting businesses, heirs, and legacies alike.

[1] Connelly v United States, 70 F. 4th 412, affirmed, Argued March 27, 2024, Decided June 6, 2024. Source: https://www.supremecourt.gov/opinions/23pdf/23-146_i42j.pdf

[2] Ibid.

[3] Ibid.

[4] Ibid.

[5] Ibid.

[6] Hayes, A. “Cross-Purchase Agreement: What It Means, How it Works,” updated on January 31, 2023. Source: https://www.investopedia.com/terms/c/cross-purchase-agreement.asp

[7] Flood, R. “Trusteed Cross-Purchase Buy-Sell Agreements,” dated April 15, 2021. Source: https://blbb.com/trusteed-cross-purchase-buy-sell-agreements/

[8] Up Counsel. “Cross Purchase Buy Sell Agreement: Everything You Need to Know,” updated on September 19, 2022. Source: https://www.upcounsel.com/cross-purchase-buy-sell-agreement

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Disclaimer: The authors of this article are not providing legal advice, and the suggestions and information presented herein are for informational purposes only. This article is not a substitute for professional legal counsel. Readers should consult with a qualified attorney for advice tailored to their specific legal needs and circumstances.

Greg Caruso, JD, CPA, ABV, CVA, manages Harvest Business, LLC, DBA The Art of Business Valuation, an accredited valuation firm that performs business valuations such as ESOP business valuations for ESOP trustees, estate and gift tax valuations, exit planning business valuations, and SBA business valuations. Mr. Caruso combines real-world business experience with valuation experience. He speaks extensively on exit planning and business valuation and wrote a valuation book published by Wiley, “The Art of Business Valuation, Accurately Valuing a Small Business.”

Mr. Caruso can be contacted at (609) 664-7955 or by e-mail to gcaruso@artofbv.com.

Miranda Kishel, MBA, CVA, CBEC, MAFF, supports the completion of business valuations, business calculations, forensic accounting, economic damages, and asset tracing engagements, focusing on in-depth financial analysis including modeling, forecasting, research, and report preparation. Her previous experience lies in small business consulting, commercial lending, accounting, real estate development, and economic development.

Ms. Kishel can be contacted at (218) 404-4877 or by e-mail to mkishel@litcpa.com.

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