The Supreme Court resolved unanimously a common estate tax issue for many closely-held companies. The issue in Connelly v. United States was “whether the corporation’s obligation to redeem [a deceased shareholder’s shares] was a liability that decreased the value of those shares.” The court concluded it was not.
Family-owned companies will often purchase life insurance on its shareholders in order to facilitate the company’s redemption upon a shareholder’s death. By doing so, the redemption helps ensure the company remains in the hands of the family.
A problem arises, however, as to how to treat the value of the death benefit that will be paid to the company immediately after the shareholder’s death. Does the policy make the company worth more than it would be without the proceeds (because company now owns the proceeds) or does the policy leave the company’s value unchanged because the proceeds are offset by the company’s obligation to pay such proceeds to the deceased shareholder’s estate to buy the shares?
The Supreme Court believed the redemption obligation is not a liability offsetting the value of the insurance: “We hold that [the company’s] contractual obligation to redeem [the deceased shareholder’s] shares did not diminish the value of those shares. Because redemption obligations are not necessarily liabilities that reduce a corporation’s value for purposes of the federal estate tax, we affirm the judgment of the Court of Appeals.” (emphasis supplied).
The high court dismissed the estate’s argument “that the redemption obligation was a liability” as something that “cannot be reconciled with the basic mechanics of a stock redemption.” The court explained that a redemption “necessarily reduces a corporation’s total value. And, because there are fewer outstanding shares after the redemption, the remaining shareholders are left with a larger proportional ownership interest in the less-valuable corporation.”
The court concedes that the decision “will make succession planning more difficult for closely held corporations.” But the court says that is simply a consequence of how the Connelly brothers chose to structure their agreement. The court notes other options were available. For example, the brothers could have used a cross-purchase agreement to fund the agreement in which the brothers, instead of the company, would have owed the policies used to buy the shares. The court notes that such a cross-purchase agreement would have allowed the surviving brother to purchase the deceased brother’s shares and keep the company in the family, while avoiding the risk that the insurance proceeds would increase the value of the deceased brother’s shares. But as the court notes, “every arrangement has its own drawbacks” because a cross-purchase agreement would have required the brothers to pay the premiums for the insurance policy on the other brother, creating a risk that one of them would be unable to do so. The court notes that the company purchased the life-insurance policies and its payment of the premiums, ensured that the policies would remain in force with the death benefit available to fund the redemption. But, as the court explained, this company-owned policy arrangement also meant that the company would receive the insurance proceeds thereby increasing the value of the deceased brother’s shares.
It is interesting to study carefully the court’s language. As noted above, the court stated that a redemption obligation by a corporation is not “necessarily” a liability that reduces the company’s value. And in footnote 2 of the opinion, the court states as follows:
We do not hold that a redemption obligation can never decrease a corporation’s value. A redemption obligation could, for instance, require a corporation to liquidate operating assets to pay for the shares, thereby decreasing its future earning capacity. We simply reject Thomas’s position that all redemption obligations reduce a corporation’s net value. Because that is all this case requires, we decide no more (emphasis in original).
Closely held business owners and their advisors will now study this decision and by contractual design try and find ways to solve this problem. Will company owners decide to use cross purchase agreements and policies (where company shareholders individually own the policy outside the company) instead of company owned policies? Or will such owners structure their redemption agreements in a manner that, at least on paper, may, upon redemption, impact “future earning capacity” of the company for valuation purposes while still purchasing “key man” insurance? All of this remains to be seen.