On June 6, 2024, the Supreme Court of the United States ruled unanimously that a corporation’s obligation to redeem a deceased shareholder’s shares is not a liability that reduces the corporation’s value, and the redemption obligation does not offset the value of life-insurance proceeds owned by the corporation and used to fund the redemption. Therefore, life-insurance proceeds that are used to fulfill a corporation’s obligation to redeem shares must be included in the fair market value of the redeemed shares, and as a result, may increase the potential estate tax of the deceased shareholder.
In Connelly v. United States, two brothers, as the sole shareholders of a building supply corporation, wanted to ensure the corporation would stay within the family upon the death of either brother. The brothers entered into a buy-sell agreement that provided that if either one of the brothers died, the surviving brother would have the option to purchase the deceased brother’s shares. If the surviving brother did not buy the shares, then the corporation itself would be obligated to redeem the shares. To fund the possible redemption, the corporation obtained life-insurance for each brother. Upon the death of the first brother, the corporation was obligated to redeem the deceased brother’s shares because the surviving brother opted not to purchase them. The corporation used the life-insurance proceeds to fund the redemption of the shares.
The issue for the Supreme Court was to determine if the corporation’s obligation to redeem the deceased brother’s shares funded by life-insurance proceeds was a corporate liability that decreased the value of the shares includible in the deceased shareholder’s federal gross estate. The executor for the estate of the deceased brother argued that the fair market value of the shares owned by the decedent should not include the life-insurance proceeds because the redemption obligation is an offsetting liability that reduces the corporation’s fair market value. The Internal Revenue Service argued that the corporation’s redemption obligation did not offset the life-insurance proceeds and the value of the life-insurance proceeds should be included in calculating the fair market value of the redeemed shares.
The Supreme Court held that the corporation’s obligation to redeem the shares does not reduce the value of the shares, and the life-insurance proceeds used to fund the redemption are included in the fair market value of the shares. The Supreme Court explained that a redemption of shares does not affect any shareholder’s economic interest in the corporation, as the value of the shareholder’s interest after the redemption would be equal to the value before the redemption. To avoid this result, the Supreme Court proffered that the brothers could have implemented a cross-purchase agreement, where the shareholders agree to purchase each other’s shares and fund the agreement with life-insurance policies on one another.
The Supreme Court’s decision in Connelly v. United States illustrates the importance of understanding complex valuation concepts when structuring buy-sell and redemption agreements where a deceased shareholder may face a federal estate tax.
