An Introduction to Estate Taxes and Buy-Sell Agreements

The Federal Estate Tax is a tax on your right to transfer property to others upon your death. It consists of an accounting of everything you own or have certain interests in at the time of your death. When calculating that amount, the Internal Revenue Service (“IRS”) uses the fair market value of the assets, not what you paid for them or what the values were when you acquired them. Often, as was the case in Connelly, disputes arise when determining the fair market value of shares in a closely held business at the time of an owner’s death. For publicly traded companies, valuation is relatively straightforward; the value can be readily obtained by reference to daily stock market reports. However, determining the fair market value of a closely held business is much more difficult because the shares are not publicly traded, and the owners often want control to remain with the surviving owners.

A commonly employed way to set value and assure control remains with surviving owners is for the closely held business to enter into a buy-sell agreement providing for a “fair payment” to the deceased owner’s estate in exchange for a transfer of the deceased owner’s shares to the surviving owners or to the company. A buy-sell agreement wherein the company purchases such shares is called a “redemption agreement,” whereas a buy-sell agreement wherein the remaining shareholders purchase such shares is called a “cross-purchase agreement.” In either case, insurance policies are commonly used to fund the purchase. When an owner dies, the surviving owner(s) or the business uses the death benefit proceeds from the policy on the owner’s life to purchase or redeem the deceased owner’s shares in the company.

The critical provision under any buy-sell agreement is the method for valuing the deceased owner’s shares in the company. For the buy-sell agreement to control for estate tax purposes, the value under the buy-sell agreement must equate to the fair market value of the company. This means that the agreement must: (1) have a price that is fixed and determinable, (2) be binding throughout both life and death, (3) be a bona fide business arrangement, (4) not be a device to transfer assets to family members for less than full and adequate consideration and (5) be comparable to similar arm’s length transactions. An agreement is deemed to meet the requirements if more than 50% of the business enterprise is owned by individuals who are not members of the same family. Agreements that fail to meet these requirements could subject your valuation to an audit from the IRS and result in adverse federal estate tax consequences. This is exactly what happened in Connelly.

Overview of Connelly

Brothers Michael and Thomas Connelly were the only shareholders in a closely held building supply corporation based out of St. Louis, Missouri. To ensure ownership remained within the family, Michael and Thomas entered into a stock purchase agreement that gave the surviving brother the option to buy the deceased brother’s shares. If the surviving brother declined, the corporation would be required to buy back the deceased brother’s shares from his estate. The purchase agreement provided two methods for calculating the value by which the corporation would redeem the deceased brother’s shares. The primary method required the brothers to agree on to the value of the corporation after each year in a document called a “Certificate of Agreed Value.” If this did not occur, the brothers were supposed to obtain two or more independent appraisals calculating the fair market value of the corporation. To ensure the corporation had liquidity to fund the buy back, the corporation purchased life insurance on each brother.

When Michael died, Thomas declined to purchase Michael’s shares. The corporation then used the death benefit proceeds from the policy it held on Michael’s life to redeem Michael’s stake in the corporation for $3 million. The actual redemption transaction was part of a larger, post-death agreement between Thomas and Michael’s son resolving several estate-administration matters. The brothers never executed a Certificate of Agreed Value nor were any appraisals ever obtained pursuant to the stock purchase agreement. Instead, Thomas and Michael’s son declared they had “resolved the issue of the sale price of Michael’s stock in as amicable and expeditious a manner as is possible” and that they “have agreed that the value of the stock” was $3 million. As Executor of Michael’s estate, Thomas filed a federal tax return for Michael’s estate reporting the value of Michael’s shares at $3 million. Subsequently, the Internal Revenue Service audited the return. During the audit, Thomas obtained a valuation from an outside accounting firm that valued the corporation’s fair market value upon Michael’s death at $3.86 million (and Michael’s 77.18% stake at $3 million). Notably, the valuation excluded the $3 million in death benefit proceeds used by the corporation to redeem Michael’s shares. Relying on the Eleventh Circuit’s holding in Estate of Blount v. Commissioner, Michael’s estate took the position that the $3 million in death benefit proceeds were properly deducted from the value of the corporation because they were offset by the corporation’s contractual obligation to use the proceeds to redeem Michael’s shares from his estate.

The IRS disagreed and insisted that the corporation’s contractual obligation to redeem Michael’s shares did not offset the death benefit proceeds. The IRS viewed the $3 million in death benefit proceeds as an additional non-operating asset of the corporation, thereby increasing the corporation’s valuation to $6.86 million ($3.86 million + $3 million). In turn, the IRS valued Michael’s shares at $5.3 million ($6.86 million x 77.18%), thereby increasing the estate’s taxes by nearly $900,000. The estate paid the tax deficiency and then filed suit against the IRS seeking a refund. The district court sided with the IRS and the Eighth Circuit affirmed the district court’s ruling. The matter then proceeded to the Supreme Court.
Holding in Connelly

The sole question before the Supreme Court was whether the corporation’s contractual obligation to redeem a deceased owner’s shares in a company offsets the value of the death benefit proceeds committed to funding that redemption. The Supreme Court unanimously held that the corporation’s contractual obligation does not offset the value of the death benefit proceeds and therefore must be included in the value of the corporation for purposes of calculating the deceased owner’s federal estate taxes. The Supreme Court reasoned that because a fair-market-value redemption does not affect the value of any shareholder’s economic interest, no willing third-party buyer acquiring the shares would have treated the corporation’s obligation as a factor that diminished the value of the shares. To illustrate this point, the Supreme Court noted that, although there is a lower company value after the redemption, there are also less shares, so the value per share remains the same before and after the redemption. Finally, the Court noted that, for estate tax purposes, the point is to assess the value of the deceased’s shares at the time of his death. At the time of Michael’s death, the Supreme Court noted that the corporation had the death benefit proceeds but had not yet spent the proceeds to redeem Michael’s shares. As such, the Supreme Court held that the death benefit proceeds increased the value of the corporation, and in turn, the value of Michael’s shares in the corporation.

Impact of Connelly

1. Reassess Insurance Funded Redemption Arrangements to Avoid Increased Estate Taxes
Connelly makes clear that the full value of life insurance proceeds under a redemption agreement must now be included in the valuation of the company for estate tax purposes. Thus, because redemption obligations no longer offset the value of life insurance proceeds, closely held businesses will need to reassess insurance funded redemption arrangements to avoid increased estate taxes. Given the Supreme Court’s decision, owners of closely held businesses should consider alternative structures for buy-sell agreements to mitigate the potential increase in estate taxes. Some of these options include:

a. Cross-Purchase Agreements. A cross-purchase agreement, where owners agree to buy each other’s shares, can mitigate the risk of increasing share value due to corporate-held life insurance. However, this approach requires that the owners maintain their policies and can introduce other challenges, such as funding premium payments and making sure that premium payments are made. This method does allow the surviving owners to acquire shares with a basis equal to the date-of-death purchase price.

b. Insurance LLC. An insurance LLC buy-sell arrangement is a strategy in which a separate special purpose LLC (“Insurance LLC”) purchases life insurance policies on the lives of each owner, and the proceeds on the insured-owner are specially allocated to the other owners. Upon the death of the insured-owner, the Insurance LLC collects and distributes the proceeds to the surviving owners, who are then contractually obligated (via the buy-sell agreement of the operating business) to purchase the ownership interest of the insured in the operating business. Because the insured decedent will be an owner of the LLC, the question arises whether the Connelly decision could be applied to the Insurance LLC, and somehow treat the insured-owner’s LLC membership interest as having value attributable to the life insurance proceeds, even though those proceeds are specially allocated away from the insured. While the Insurance LLC seems to be a true cross-purchase arrangement, the insured’s ownership in the LLC creates some uncertainty.

c. Trust-Owned Life Insurance. Trust-owned life insurance (“TOLI”) is also an option. TOLI allows for greater control of policy ownership and prevents the insurance proceeds from being included in the value of the decedent’s estate.

2. Ensure Valuations Under Buy-Sell Agreements Are Defensible
Connelly now provides the IRS with ammunition to challenge valuations of redemptions that involve entity-owned life insurance. As such, it is crucial that closely held businesses establish defensible valuation methods within buy-sell agreements. The buy-sell agreement in Connelly ultimately did not control the value of the business for estate tax purposes. While the Supreme Court did not address whether the methods prescribed under the purchase agreement could’ve withstood the fair market value requirements of Section 2703 of the IRC, merely using a redemption payment amount as the value, especially given the conflicts of interests Thomas has in that determination was likely never going to be acceptable. By not following either method prescribed under the purchase agreement, the parties in Connelly were inviting an audit from the IRS. The parties were supposed to obtain appraisals of the company’s valuation prior to reporting the value of the shares for estate tax purposes, not after, as Thomas did once Michael’s estate was audited. As such, it is critical that owners of closely held businesses ensure that their buy-sell agreements contain defensible methods for valuing the business upon an owner’s death, and further, that owners follow these methods. Some best practices for establishing valuation for closely held businesses include the following:

a. Methods or Formulas. Ensure that buy-sell agreements contain clear, fixed valuation methods or formulas to determine the price of shares in the company.
b. Professional Appraisals. Using qualified professionals can provide a more accurate and defensible valuation.
c. Regular Review. Regularly review and update buy-sell agreements to ensure they reflect current business values and comply with evolving laws.
d. Compliance with Section 2703. Remember that a buy-sell agreement must pass the muster of Section 2703 of the IRC, which will disregard the valuation under the buy-sell agreement unless it is a bona fide arrangement, is not a device to transfer property to members of the decedent’s family for less than full and adequate consideration, and contains terms that are comparable to similar arrangements entered into by persons in arm’s length transactions.

Conclusion

Connelly will have ripple effects for both valuing ownership in closely held businesses and the use of insurance to fund redemptions under buy-sell plans. As such, closely held businesses would be wise to reassess their succession plans to avoid unintended tax consequences. Failure to do so could lead to an audit from the IRS and higher estate taxes.