Let’s Talk About Tax

On June 6, 2024, the U.S. Supreme Court unanimously held that, for federal estate tax purposes, a company’s obligation to redeem shares from a deceased shareholder’s estate does not offset life insurance proceeds used by the company to satisfy that obligation. The case, Connelly vs. United States, 602 U.S. ___ (2024), was closely watched by the business community because redemption agreements backstopped by life insurance on the owners are common strategies for closely held businesses preparing for an ownership transition. The taxpayer argued that the portion of the life insurance proceeds used for the redemption were offset by the corporation’s contractual obligation to redeem the shares. The government rejected this position and asserted that “no real-world buyer or seller would have viewed the redemption obligation as an offsetting liability.” The Supreme Court agreed with the government in the case of a redemption obligation of a company paid using life insurance proceeds.

For federal estate tax purposes, property is valued at the time of the decedent’s death, so the deceased shareholder’s shares in Connelly must be valued when the company was guaranteed to receive the life insurance proceeds but before the company had used those proceeds to fulfill the redemption obligation. The taxpayer contended that treating the redemption obligation as an offsetting liability of the company would reflect the value a willing buyer and willing seller would agree to pay for the company at the time of the deceased shareholder’s death. The Supreme Court rejected this approach because a fair market value redemption, by definition, cashes out the redeemed shareholder without affecting the value of any shareholder’s interest. A willing buyer of a company’s shares therefore would not reduce their price because of a redemption obligation. Further, the Supreme Court emphasized that a redemption requires the company to give up value to cash out the redeemed shareholder—i.e., a redemption should decrease a company’s value and maintain the per share value of the remaining shares—but the taxpayer’s position would leave the company with the same value both before and after the redemption.

While the Supreme Court acknowledged that its decision would increase insurance costs for redemption obligations funded by life insurance, it treated this as an unavoidable effect of such structures and offered a cross-purchase agreement as one alternative structure that trades off this consequence for others. A cross-purchase agreement would prevent insurance proceeds from increasing the value of the redeemed shares but (i) would require the shareholders to maintain the life insurance policies instead of the company, (ii) may have different tax consequences, and (iii) might be complicated by the policy on each shareholder having a different premium. The government also raised this and two other alternatives in its briefs: first, bequeathing the shares as part of an estate plan to an agreed upon recipient, or second, using a trust or other entity to hold the insurance policies separate from the company. The former is only useful if the shareholders can agree on who should receive the shares, and the latter could have more administrative costs.

Whether these or any other alternative to redemption insurance arrangements is appropriate will depend on the circumstances of each company. Following the Connelly decision, owners of closely held businesses and their advisors should look at the consequences of any existing or contemplated redemption arrangements and whether a different ownership transition plan is necessary.