Taxes in Your Practice: 8th U.S. Circuit Court of Appeals includes redemption insurance proceeds in taxable estate
Vol. 79, No. 4 / July - August 2023
Scott E. Vincent
Scott E. Vincent is the founding member of Vincent Law, LLC in Kansas City.
The 8th U.S. Circuit Court of Appeals recently affirmed a district court decision that included insurance proceeds received by a company for redemption of a decedent’s shares in valuing the shares for purposes of the decedent’s estate. In Connelly v. U.S.1, the 8th Circuit rejected the reasoning of an 11th Circuit decision that did not include insurance proceeds when valuing decedent’s stock for estate tax purposes.
Michael and Thomas Connelly were the sole shareholders of Crown C Corporation, a building-materials corporation in St. Louis (Crown). The brothers entered into a stock purchase agreement providing that if one brother died, the surviving brother had the right to buy his shares. Under the agreement, if the survivor declined to make this purchase, Crown was obligated to purchase the decedent’s shares. The court noted that the brothers always intended that Crown would complete this redemption, and Crown obtained life insurance on each brother for redemption of a decedent’s shares.
The stock purchase agreement had two valuation mechanisms for a possible redemption. The principal approach was for the brothers to execute a certificate of agreed value every year to set the price by mutual agreement. If a certificate was not executed, the brothers were to obtain two or more appraisals to establish fair market value. The brothers never executed a certificate of agreed value or obtained appraisals, but Crown did purchase $3.5 million of life insurance on each brother.
Michael Connelly died in 2013, and Crown received life insurance proceeds of $3.5 million. Crown then redeemed his shares for $3 million as part of post-death agreement between Thomas Connelly and Michael Connelly’s son. The parties did not obtain appraisals, and Thomas Connelly (as executor) used $3 million as the value of Michael Connelly’s shares when filing the deceased brother’s estate tax return. Thomas Connelly did not include the insurance proceeds as an asset that would have increased the corporation’s value.
The Internal Revenue Service (IRS) audited the estate tax return and concluded that the fair market value of Crown should have included, and been increased by, the life insurance proceeds. The IRS sent a notice of deficiency for additional tax liability; the estate paid the deficiency and sued for a refund in district court.
The estate argued that the redemption pursuant to the stock purchase agreement conclusively determined the value of Crown for estate tax purposes. Alternatively, the estate argues that even if the life insurance proceeds were considered an asset, they were offset by Crown’s obligation to make the redemption. The IRS countered that the stock purchase agreement should be disregarded.
The district court granted summary judgment to the IRS, concluding that the stock purchase agreement did not affect valuation and that a proper valuation of Crown must include the life insurance proceeds. The district court declined to follow Estate of Blount2, which did not include life insurance proceeds in a valuation under similar facts. The estate then appealed to the 8th Circuit Court.
8th Circuit Court analysis and decision
The 8th Circuit Court noted that under Code §§ 2031 and 2033, a decedent’s gross estate includes the value of all real, personal, tangible, and intangible property, wherever situated, in which the decedent had an interest at the time of their death. This property includes stocks under applicable Treasury Regulations, and the only issue before the court on appeal was the value of Michael Connelly’s Crown shares.
The court first addressed whether the stock purchase agreement controls how Crown should be valued. Code § 2703(a) provides that property is generally valued without reference to options, agreements, or rights to acquire the property at less than fair market value or to other restrictions on sale or use of the property, unless such agreements meet the requirements of Code § 2703(b). To affect valuation under § 2703(b), an agreement must (1) be a bona fide business arrangement; (2) not be a device to transfer property to family members for less than full and adequate consideration; and (3) have terms comparable to similar arm’s-length transactions. The estate in this case argues that the requirements of § 2703(b) are met, and that the life insurance proceeds should not be included in valuing Michael Connelly’s Crown shares.
The court, however, found that the Crown stock purchase agreement did not adequately fix a price or prescribe a formula for determining a price. Instead, the agreement had two possible mechanisms for setting the price: a certificate of agreed value, which the court rejected since it would merely be a mutual agreement, and a mechanism including an appraisal process to establish fair market value. The court noted that the appraisal provision did not fix or prescribe a formula for determining the price of the shares, and instead just required that the appraisers determine the fair market value of Crown; the court also noted that none of the appraisal process was completed in this case. As a result, the court determined that nothing could be gleaned from the stock purchase agreement, and that a fair market value analysis was needed.
The key question the 8th Circuit Court addressed in determining fair market value was whether the life insurance proceeds intended for redemption of Michael Connelly’s shares must be included in valuing Crown at the time of his death. The court noted that the value of property in an estate is usually the price a willing buyer and willing seller would reach when under no compulsion to buy or sell and having reasonable knowledge of relevant facts. For establishing fair market value of closely held businesses, Treasury Regulations under § 2031 identify factors including net worth, prospective earnings and dividends, good will of the business, economic outlook for the industry and the company’s position in that industry, management, and the degree of control represented by the shares being valued. Treasury Regulations § 20.2031-2(f)(2) specifically provides that the valuation of a closely held company must consider nonoperating assets, including life insurance policies payable to the company.
The 8th Circuit Court noted that the 11th Circuit Court, in Estate of Blount, had determined that although life insurance proceeds should be considered in a similar situation, the value of the insurance proceeds was offset by a stock purchase agreement redemption obligation. The 11th Circuit Court concluded that this offset resulted in zero effect on the company’s value. The 8th Circuit Court found the reasoning in Estate of Blount flawed and notedthat a willing buyer of Crown would be purchasing the life insurance and could either extinguish the redemption agreement or ultimately receive the benefit of the proceeds. Similarly, the court reasoned that a willing seller of Crown would want to be compensated for the value of the life insurance proceeds. The 8th Circuit Court concluded that a willing buyer and seller would include the life insurance in valuing Crown.
The 8th Circuit Court also concluded that the estate’s position, supported by Estate of Blount, would result in a windfall for the remaining shareholder, Thomas Connelly. Not considering life insurance, before the redemption, each Crown share was worth $7,720. After the redemption, Michael Connelly’s shares were extinguished, leaving Thomas Connelly with all remaining shares and a corporation worth $3.86 million, resulting in a new value for Thomas Connelly of about $33,800 per share. This significant increase in the value of Thomas Connelly’s otherwise unchanged shares without any material change to Crown further persuaded the court to conclude that the brothers’ redemption agreement did not establish a normal corporate liability that should be considered in the valuation of Michael Connelly’s estate. The court viewed the life insurance proceeds as simply an asset that increased shareholder equity, which had to be accounted for in valuing Michael Connelly’s shares at the time of his death.
Based on this analysis, the 8th Circuit Court disregarded the Crown stock purchase agreement, found that a fair market value analysis of Crown had to include the life insurance proceeds used for redemption of Michael Connelly’s shares, and affirmed the district court’s summary judgment in favor of the IRS.
The 8th Circuit Court decision in Connelly conflicts with the analysis and decision in Estate of Blount. As a result, Connelly appears to create a conflict among circuit courts that may require a U.S. Supreme Court decision for clarity on these issues. Until this conflict is resolved, taxpayers and practitioners will have to carefully consider how redemption agreements funded by life insurance may impact estate tax valuation for the company owners.
1 Connelly v. U.S., 2023 PTC 154 (8th Cir. 2023).
2 Estate of Blount, 428 F.3d 1338 (11th Cir. 2005).