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Company-Owned Life Insurance Included in Estate

U.S. Court of Appeals grants summary judgment to IRS.

In Connelly v. IRS, No. 21-3683 (8th Cir. 2023), the taxpayer, the estate of Michael P. Connelly argued that the proceeds from a life insurance policy payable to Crown C Corporation (the Corporation) and intended to be used (and, in fact, substantially used) for the redemption of the taxpayer’s interest in the Corporation shouldn’t be included for purposes of valuing the Corporation. Conversely, the Internal Revenue Service argued that the proceeds should be included for purposes of valuing the Corporation.

Stock-Purchase Agreement

Prior to his death, Michael Connelly and Michael’s brother, Thomas Connelly, were the sole shareholders of the Corporation, with Michael owning 77.18% of the shares and Thomas owning the remaining 22.82% of the shares. Michael, Thomas and the Corporation entered into a stock-purchase agreement, whereby on the death of a shareholder, the remaining shareholder had the opportunity to purchase the deceased shareholder’s shares, and in the absence of that purchase, the Corporation would redeem the deceased shareholder’s shares.

For purposes of determining the buy-out value, Michael and Thomas were to annually set the buy-out value for the year, and if this wasn’t done, then Michael and Thomas were to obtain two or more appraisals. Neither Michael nor Thomas ever took any formal action to set the buy-out price (that is, no agreed value and no appraisals). The Corporation purchased $3.5 million of life insurance on each brother to fund the anticipated redemption.

Agreed Redemption Value Used

On Michael’s death, Michael’s estate’s interest in the Corporation was redeemed by the Corporation for $3 million, which represented a value for the Corporation of about $3.89 million, a figure (not accounting for the life insurance proceeds) that the IRS more or less agreed with. No appraisal was ever completed for the Corporation or Michael’s estate’s interest in the Corporation; the $3 million figured was used based on agreement among the parties. Michael’s estate tax return valued Michael’s estate’s interest in the Corporation at $3 million using the agreed redemption value, and the IRS claimed that this value was incorrect and should essentially be increased by the amount of the life insurance proceeds.

The District Court sided with the IRS on its motion for summary judgment on the two main points in question: (1) is the stock-purchase agreement controlling with respect to how the Corporation should be valued; and (2) what’s the value of Michael’s interest in the Corporation for purposes of Michael’s estate tax return? The U.S. Court of Appeals for the Eighth Circuit agreed with the District Court in  granting summary judgment to the IRS.

No Fixed Price for Stock

The court first analyzed whether Internal Revenue Code Section 2703(a) requires the stock-purchase agreement to be disregarded for purposes of valuing Michael’s interest in the Corporation. The court recited the three criteria of IRC Section 2703(b) and then pivoted to a more fundamental element—that the stock-purchase agreement must contain some fixed or determinable price. After all, the shareholders failed to abide by the terms of the stock-purchase agreement requiring them to determine the value of the stock annually, and the stock-purchase agreement lacked specificity with regard to how the appraisals were to be prepared. The court reasoned that neither mechanism constituted a fixed or determinable price for valuation purposes, and therefore the general rule in Section 2703(a) prevails, and the Corporation’s value must be determined without regard to the stock-purchase agreement.

Value of Michael’s Interest

The court then tackled the second question—what’s the value of Michael’s interest in the Corporation for purposes of Michael’s estate tax return, and, specifically, whether the proceeds received from the life insurance policy should be taken into account.

The seminal case involving this issue is Estate of Blount v. Commissioner, 428 F.3d 1338 (11th Cir. 2005), which  both parties cited—Michael’s estate claiming Blount was correctly decided and the IRS claiming that Blount was incorrectly decided. In Blount, the 11th Circuit found that, in a case involving a similar issue, the life insurance proceeds should be accounted for and then immediately offset by the company’s “liability” to redeem the shares—effectively yielding zero effect on the company’s value.

The court didn’t buy the reasoning in Blount and, rather, sided with the IRS’ position that the reasoning in Blount “defies common sense and customary valuation principals.” The court reasoned that any purchaser of Michael’s interest in the Corporation would certainly account for the $3.5 million windfall it received immediately after Michael’s death. The “liability” generated from the anticipated redemption of stock isn’t a real “liability” in the ordinary business sense. Therefore, the court affirmed the District Court’s grant of summary judgment in favor of the IRS.

Circuit Court Split

As a result of Connelly (8th Circuit) and Blount (11th Circuit), there’s now a split in the Circuit Courts of Appeal.

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