Monthly LRA Update: July 2024

JUDICIAL DEVELOPMENT

Supreme Court Affirms IRS Position Regarding Life Insurance Owned by a Closely Held Corporation On June 6 the Supreme Court of the United States unanimously ruled in favor of the IRS in an estate tax challenge (see Connelly v. United States). As a result, the Supreme Court determined that life insurance proceeds received by a company on the death of a shareholder must be included in determining the value of the company’s shares for estate tax purposes.

Situation

Brothers Michael (77%) and Thomas (23%) Connelly were the sole shareholders of a closely held corporation. They entered into an agreement with the corporation providing that if either brother died, the surviving brother would have the option to purchase the deceased brother’s shares. If the surviving brother declined to buy the shares, the corporation itself would be contractually required to redeem the shares. To ensure that the corporation had sufficient funds to redeem the shares if required, the corporation obtained life insurance on each brother.

Michael died in 2013 and Thomas opted not to purchase Michael’s shares. As a result, the corporation was obligated to redeem Michael’s shares. Thomas and Michael’s son agreed that the value of Michael’s shares was $3 million, and the corporation used the life insurance proceeds to redeem the shares. This left Thomas as the sole shareholder of the corporation.

IRS Audit

The IRS audited the estate tax return. During the audit, Thomas obtained a formal valuation for the corporation. That valuation excluded the value of the life insurance proceeds (based on a holding in Estate of Blount v. Commissioner) and arrived at a valuation of the corporation of $3.86 million.

The IRS counted the $3 million of life insurance that was excluded by the valuation analyst to arrive at a corporation valuation of $6.86 million. Based on the higher valuation, the IRS determined that the estate owed an additional $900k in taxes.

The estate paid the deficiency and sued for a refund.

District Court Position

The District Court granted summary judgment to the Government. The court explained that under customary valuation principles, the corporation’s obligation to redeem Michael’s shares was not a liability that reduced the corporation’s fair market value.

The Court of Appeals affirmed on the same basis.

Supreme Court Arguments

Thomas argued that a contractual obligation to redeem the shares is a liability that offsets the value of life insurance proceeds.