Eric J. Sachtjen, Attorney, and Carolyn Powers, Summer Associate
In Connelly v. United States, No. 23-146 (U.S. June 6, 2024), two brothers served as the exclusive shareholders of a closely held corporation. Under a contractual arrangement, each brother had an option to purchase the other’s shares in the event of death, the value of which would be determined by an outside appraisal. If the surviving brother declined to exercise his option, the corporation was obligated to redeem the deceased shareholder’s shares. To help fund this obligation, the corporation acquired life insurance policies on each shareholder.
Following the death of one shareholder, the surviving shareholder declined to exercise his purchase option, thereby obligating the corporation to purchase the shares. In lieu of obtaining an appraisal, the decedent’s Estate and the surviving shareholder agreed to the fair market value of the decedent’s shares. The corporation then acquired the shares using the insurance proceeds.
The Court considered two narrow issues. First, whether the life insurance proceeds ought to be included in the fair market value of the decedent’s shares. Second, whether the corporation’s redemption obligation necessitated a deduction in the shares’ value.
The Court determined that the life insurance proceeds payable to the corporation indeed constituted an asset increasing the corporation’s fair market value. However, the Court also held that because a shareholder’s economic interest is not affected by a corporation’s fair market value redemption of shares, the redemption obligation would not be a factor considered by a hypothetical buyer of the decedent’s shares.
The Court illustrated its reasoning with a simple example. Consider a corporation with $10 million in assets and 100 shares held by two shareholders: shareholder A owns 80 shares worth $8 million and shareholder B owns 20 shares worth $2 million. If shareholder B dies, and the corporation uses $2 million in cash assets to redeem shareholder B’s 20 shares, the transaction has no effect on shareholder A’s 80 shares which are still worth $80 million. Therefore, the corporation’s redemption obligation is not a liability reducing the corporation’s fair market value or offsetting the life insurance proceeds.
While the Estate contended that such a ruling would complicate succession planning for closely held corporations, the Court acknowledged this potential outcome as an inherent consequence of the shareholders’ chosen contractual structure. The Court suggested alternative approaches, such as establishing a cross-purchase agreement, where each shareholder commits to purchasing the other’s shares and acquires life insurance on the other accordingly. Although this strategy has its own potential tax implications, such an arrangement would preclude the increase of the deceased shareholder’s shares by the value of the life insurance.
Finally, tucked in a footnote at the end of the opinion, the Court noted that it was not holding that a redemption obligation can never diminish a corporation’s value because such an obligation might require the liquidation of operating assets to facilitate share repurchase, thereby decreasing future earning capacity.
Entities owing life insurance should contact their Paine Hamblen advisor to discuss the impact of Connelly on their buy-sell agreements.
