Company Owned Life Insurance and Buy-Sell Agreements
In Connelly v. U.S., USDC ED MO, Case No. 4:19-c-01410, September 21, 2021, the District Court for the Eastern District of Missouri held that company-owned life insurance on the life of a deceased shareholder that was used to redeem the deceased shareholder’s shares increased the fair market value of the company by the amount of the life insurance received. The result of this decision significantly increased the taxable estate of the deceased shareholder. This case is on appeal to the Eighth Circuit Court of Appeals.
Crown C. Supply, Inc. (“Company”) was a closely held family business that sold roofing and siding materials. The Company was owned by Michael Connelly, Sr. (77.18%) and his brother, Thomas A. Connelly (22.82%). In 2001, the Company and the two (2) shareholders entered into a Stock Purchase Agreement (“SPA”). The SPA provided that upon one brother’s death, the surviving brother had the right to purchase the decedent’s shares. The SPA further provided that the value on death would be determined by the shareholders executing a certificate of agreed upon value at the end of every tax year. In the event the shareholders failed to execute a new certificate of agreed upon value, then the SPA provided that value would be determined by securing two or more appraisals. Michael Connelly, Sr. subsequently passed away.
Thomas A. Connelly declined his option to purchase the shares of his deceased brother. The SPA required the Company to purchase the shares if the surviving brother failed to exercise his option to purchase the shares. To fund its redemption obligation, the Company purchased life insurance of $3,500,000 on both brothers, even though they were not equal owners.
When Michael Connelly, Sr. passed away, there was no executed certificate of agreed upon value. Under the SPA, the surviving brother and Company should have obtained two or more appraisals to determine the amount the Company needed to pay for the shares. This valuation method was not used by the parties, and the Company redeemed Michael’s shares for $3,000,000.
The IRS challenged the valuation, stating that the SPA did not meet the requirements of Internal Revenue Code and the valuation of the Company should include the life insurance. The inclusion of life insurance in valuing the Company increased the fair market value of the Company, resulting in a greater valuation for federal estate tax reporting.
The Estate’s position was based on the position of both the Tax Court and the Eleventh Circuit Court of Appeals in Estate of Blount, F. 3d 1338 (11th Circuit 2005), which held that life insurance used to redeem a decedent’s shares should be excluded from the valuation of a company. Unfortunately for the Estate, the court did not agree with the Estate and instead sided with the IRS holding that the life insurance proceeds received by the Company should be included when determining the Company’s fair market value.
The case has been appealed to the Eighth Circuit Court of Appeals. The Circuit Court of Appeals will either follow the Eleventh Circuit Court of Appeals’ Estate of Blount decision or create a split in the Circuit Courts. Regardless of the Eight Circuit Court of Appeals findings, this is an opportunity to review Buy-Sell Agreements and the ownership of life insurance policies used to fund redemptions of shares under these types of agreements (i.e., closely held companies with related owners).
In order to pass IRS scrutiny, a buy-sell agreement should be structured as follows:
- Be a bona fide business arrangement;
- Not be a device to transfer property to members of the decedent’s family for less than full and adequate consideration in money or money’s worth;
- Contain terms that are comparable to similar arrangements entered into by persons in arms’ length transactions;
- Contain a purchase price that is fixed and determinable under the agreement; and
- Be legally binding during the life and after death.
If all these requirements are met, the IRS will be bound by the valuation set forth in a buy-sell agreement. Failing to satisfy even one of these requirements means that the IRS can adjust the valuation determined under a buy-sell agreement to fair market value under federal estate tax valuation principals. It is important for advisors to periodically review these issues with their clients in order to ensure a cost efficient transition of the business upon a triggering event.