Connelly v. United States: A Landmark Case on Estate Tax Valuation

On June 6, 2024, the United States Supreme Court issued a pivotal decision in Connelly v. United States, reshaping the landscape of estate tax valuation for closely held corporations. This ruling provides critical insights into the treatment of life insurance proceeds and shareholder agreements, with significant implications for business owners and estate planners.

Case Background

Michael and Thomas Connelly were the sole shareholders of Crown C Supply, a closely held building supply company. Their buy-sell agreement stipulated that upon the death of one brother, the surviving brother could purchase the deceased’s shares. To facilitate this agreement, Crown C Supply held a $3 million life insurance policy on each brother, with the intent of funding the share redemption.

After Michael’s death, the company used the $3 million life insurance proceeds to redeem his shares. For federal estate tax purposes, Michael’s estate reported the value of his shares as $3 million but excluded the life insurance proceeds when determining the taxable estate’s value. The Internal Revenue Service (“IRS”) challenged this exclusion, arguing that the life insurance proceeds increased the corporation’s value and, consequently, the value of Michael’s taxable estate.

The Supreme Court’s Decision

The Supreme Court unanimously sided with the IRS. The key holdings were as follows:

1. Inclusion of Life Insurance Proceeds in Corporate Value: The Court ruled that life insurance proceeds payable to a corporation should be included in the corporation’s fair market value for estate tax purposes. These proceeds are assets of the corporation and directly impact its valuation.
2. Buy-Sell Agreements and Estate Valuation: The Court clarified that a corporation’s contractual obligation to redeem shares under a buy-sell agreement does not reduce the corporation’s value for estate tax calculations. Such obligations do not offset the impact of life insurance proceeds on the company’s overall worth.

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Implications of the Ruling

The Connelly decision underscores the importance of understanding how corporate structures and agreements impact estate tax obligations. Key takeaways include:

• Reevaluation of Buy-Sell Agreements: Business owners should carefully review their buy-sell agreements to ensure they align with their estate planning goals. The use of corporate-owned life insurance to fund share redemption may result in higher estate tax liabilities than anticipated.
• Alternative Funding Strategies: Consider alternative strategies, such as cross-purchase agreements, where individual shareholders own life insurance policies on each other. This structure avoids the inclusion of life insurance proceeds in the corporation’s value.
• Importance of Expert Guidance: Estate planning professionals play a critical role in navigating the complexities of tax law. The Connelly ruling highlights the need for proactive planning to mitigate estate tax liabilities and ensure efficient wealth transfer.

Looking Ahead

The Connelly v. United States decision sets a precedent that will shape estate tax valuations for years to come. Business owners and their advisors must account for this ruling when developing succession plans and crafting estate strategies. By taking a proactive approach, they can minimize tax exposure and preserve wealth for future generations.