Connelly vs. United States Decision: What It Is

After Michael Connelly died, his family got an unexpected bill from the IRS for $889,914.

Why? An auditor reviewing Michael’s estate tax return disagreed with the stated value of the shares in Crown C Supply, the company he owned with his brother. Although his estate was bought out for $3M, the government claimed they were worth $5.3M, resulting in the nearly $900K tax bill.

The family paid the bill but went to court, hoping to get it refunded. On June 6, 2024, the Supreme Court ruled unanimously that when a company redeems shares using life insurance proceeds, the obligation to redeem shares is not a liability. The IRS kept the money.

The court essentially affirmed that a company’s fair market value increases by the amount of the death benefit received. As a result, when calculating the value of shares for estate tax purposes, those shares can be worth significantly more than what is actually paid to the estate, potentially leading to an unexpected estate tax bill.

The court used an example: Imagine a construction company with one asset ($10M in cash), 100 shares, and two shareholders. Shareholder A owns 80 shares ($8M at $100K/share) and Shareholder B owns 20 shares ($2M at $100K/share). If the company redeems Shareholder B’s shares for $2M, Shareholder A’s 80 shares remain worth $100,000 each because $8M is left after the buyback.

However, if Shareholder B dies, the company receives $2M in life insurance proceeds, and then it redeems B’s shares for $2M, Shareholder A’s 80 shares are now worth $10M ($125K each). Thus, the company’s value increased after B’s death.

To the government, Shareholder B’s shares weren’t worth the $2M the family received; they were worth $2.4M (20% of $12M). If B had a taxable estate, this would result in an extra $160K in estate tax.

This issue could significantly impact many business owners’ estate planning and tax liabilities.

What It Isn’t

The Connelly decision is narrow. It specifically addresses whether a corporation’s obligation to redeem shares is a liability. It does not invalidate all buy-sell agreements or make all company-owned life insurance problematic.

What We Don’t Know

The court dodged many implications of this decision. Due to the decision’s narrow scope, only Congress or future court cases can fully clarify its applicability.

In Connelly, Crown C Supply had an operating agreement calling for an appraisal of fair market value if shares were redeemed by the company. It’s unclear how the court would rule with a fixed price or valuation formula.

Additionally, the scrutiny of share value may differ if the owners aren’t related. For instance, if a $30M company is transitioned to an heir for $10M, the government could miss out on $8M in estate taxes, so the IRS heavily enforces family attribution rules.

What You Can Do About It

Review your operating agreement and company-owned life insurance policies. If your situation is similar to the Connelly case, consider revising your plan.

– Buy-Sell Provisions: Determine if it is a stock redemption plan (company must purchase), “wait and see” (company buys shares if partners don’t), or cross-purchase (partners must buy, not the company).

– Valuation Provisions: Check if the value is fixed, determined by an appraiser, or set by a formula.

– Life Insurance: Verify if the company is the owner and beneficiary of the policy.

Compare these details with the Connelly case: a “wait and see” plan where the living brother chose not to purchase the shares, with the purchase price set to fair market value determined by an appraisal, and the company being the owner and beneficiary of the deceased brother’s policy.

If your situation closely resembles Connelly, consider establishing an Insurance-Only/Buy-Sell LLC or Cross-Purchase Trust. These strategies add complexity to a succession plan but effectively remove the life insurance proceeds’ value from the company’s value. Given the particularities of each company and strategy, seeking professional assistance is essential.

Avoiding doing so could very well end up costing your family significant wealth after you’re gone, and without proper planning, it could demolish your estate plan.

By Paul Elmendorf