Supreme Court: COLI proceeds are included in business value
A recent U.S. Supreme Court ruling resolves a circuit split on a business valuation issue — and it could have a major impact on the value of many closely held companies going forward. In Connelly v. IRS (144 S. Ct. 1406, 2024), the Court held that corporate-owned life insurance (COLI) designed to fund the redemption of a deceased shareholder’s stock under a buy-sell agreement should be considered a corporate asset when calculating the value of the decedent’s shares for purposes of the federal estate tax. Here’s a summary of the case and how it may affect owners of other private companies.
IRS challenges estate’s valuation
Two brothers co-owned a building supply company. They entered into a buy-sell agreement to ensure that the business remained in the family if either brother died. Under the agreement, the surviving brother would have the option to purchase the deceased owner’s shares. If the survivor refused, the corporation would be required to redeem the interest at fair market value based on an outside appraisal. The company bought life insurance policies to fund the redemption obligation.
The brother who owned 77.18% of the company’s outstanding shares died in 2013. The surviving brother decided not to purchase the decedent’s shares, triggering a corporate redemption. The company paid the estate $3 million for the interest.
The IRS audited the federal estate tax return and claimed that the fair market value of the decedent’s shares should be $5.3 million. The IRS determined that the $3 million of COLI proceeds used to redeem the decedent’s interest should be included in the value of the entire business, increasing the value of the decedent’s shares by approximately $2.3 million ($3 million × 77.18%). As a result, the estate incurred an additional estate tax obligation of nearly $900,000.
Taxpayer files suit
The estate filed a lawsuit requesting a refund of the additional estate tax assessment. During the audit, the estate hired an accounting firm to determine the value of the decedent’s shares. The valuator determined that the corporation was worth approximately $3.86 million, and the decedent’s interest was worth roughly $3 million ($3.86 million × 77.18%).
When valuing the business, the estate’s expert excluded the COLI proceeds used to redeem the shares, based on the finding in Estate of Blount v. Commissioner (428 F. 3d 1338, CA11 2005). In this case, the U.S. Court of Appeals for the 11th Circuit affirmed that insurance proceeds should be deducted from the value of a corporation when they’re “offset by an obligation to pay those proceeds to the estate in a stock buyout.”
The IRS challenged that reasoning in Connelly. The district court sided with the IRS, and the U.S. Court of Appeals for the 8th Circuit affirmed that ruling. The Supreme Court agreed to settle the conflicting circuit court decisions. After reviewing the case facts, the Court unanimously upheld the ruling in Connelly, explaining that “a share redemption at fair market value does not affect any shareholder’s economic interest.” Instead, the Court held that a hypothetical buyer would “treat the life-insurance proceeds that would be used to redeem [the decedent’s] shares as a net asset” without an offsetting liability for the redemption obligation.
Key takeaways
The Supreme Court’s opinion notes that the Connelly decision could make succession planning more complicated for closely held businesses. And it suggests cross-purchase agreements between the shareholders (which bypass the corporation) as a possible workaround for this issue.
The opinion also explains that the Court didn’t rule that a redemption obligation can never decrease a company’s value. For example, a redemption obligation that requires a company to liquidate its assets to fund a buyout would reduce the company’s future earnings capacity. However, the Court did reject the notion that all redemption obligations reduce a corporation’s value.
No universal approach
When valuing a business, case facts matter. If you’re concerned about how COLI would be handled in a particular situation, contact us. Our business valuation professionals can help you determine the appropriate treatment for COLI proceeds and evaluate creative options to minimize federal estate and gift taxes.
© 2024