Grayson M.P. McCouch is the Clarence J. TeSelle Professor of Law at the University of Florida.
In this article, McCouch weighs in on how the Supreme Court in Connelly should resolve a circuit split over the estate tax valuation of a controlling shareholder’s stock that is redeemed by the corporation using the proceeds of corporate-owned life insurance, and he urges the Court to dispel lingering confusion about redemption agreements funded with life insurance.
Copyright 2024 Grayson M.P. McCouch.
All rights reserved.
Shareholders of a closely held corporation often enter into a buy-sell agreement funded with life insurance policies. Under a redemption agreement, the corporation owns policies on its shareholders’ lives and uses the proceeds to redeem a deceased shareholder’s stock from his or her estate.1 Questions concerning the valuation of the decedent’s stock for estate tax purposes have elicited conflicting decisions from the Eighth and Eleventh circuits, prompting the Supreme Court to grant certiorari in Connelly.2
Michael Connelly and his brother Thomas were the sole shareholders of Crown C Supply Inc., a building supply company. Michael owned a 77.18 percent controlling interest (385.9 of 500 outstanding shares), and Thomas owned the remaining 22.82 percent (114.1 shares). A buy-sell agreement between the brothers and Crown required Crown to redeem the stock of either brother at death if the surviving brother failed to exercise a purchase option, with the price of the decedent’s stock to be determined either by a certificate of agreed value or by an appraised value per share. To fund its redemption obligation, Crown obtained $3.5 million of life insurance on each brother, with Crown as the designated beneficiary. After Michael’s death in 2013, Crown used $3 million of the $3.5 million insurance proceeds to redeem Michael’s stock from his estate. On the estate tax return, Michael’s estate valued the stock at its $3 million redemption price, but on audit, the government valued the stock at $5.3 million and assessed additional estate tax.3 The estate paid the additional tax and sued for a refund.
The district court held that the value of Michael’s stock was not limited to the $3 million redemption price and granted summary judgment for the government, which the Eighth Circuit affirmed.4 The issue before the Supreme Court is whether the lower courts properly treated the $3 million of insurance proceeds that Crown used to redeem Michael’s stock (redemption funds) as a corporate asset in determining the fair market value of Michael’s stock for estate tax purposes.
The estate tax value of closely held stock is generally determined as a share of the corporation’s value based on its net worth, earning power, dividend-paying capacity, and “other relevant factors.”5 If the corporation owned an insurance policy on the life of a shareholder, proceeds payable to the corporation at the shareholder’s death are generally treated as a corporate asset in determining the corporation’s net worth and are therefore reflected in the value of the decedent’s stock.6 Indeed, because these proceeds are taken into account in determining the value of the decedent’s stock, the corporation’s incidents of ownership are not attributed to the shareholder for estate tax purposes. In contrast, if the proceeds of a corporate-owned insurance policy on the life of a sole or controlling shareholder are payable (other than for a valid business purpose) to a third-party beneficiary, ownership of the policy is attributed to the deceased shareholder, resulting in dollar-for-dollar inclusion in the gross estate under section 2042.7 Although Michael was a controlling shareholder of Crown, the attribution rule does not apply in Connelly because the proceeds were payable to Crown.8
In Connelly, Michael’s estate argues that the redemption funds should be disregarded in valuing Michael’s stock. More specifically, noting that Crown had an enforceable obligation under the buy-sell agreement to use insurance proceeds to redeem Michael’s stock, the estate argues that the redemption obligation was a $3 million corporate liability that offset an equal amount of insurance proceeds in determining Crown’s value. Excluding the redemption funds from Crown’s value implies that the value of Michael’s stock reflected only a proportionate share of Crown’s remaining assets.9 The estate relies primarily on Estate of Blount,10 in which the Eleventh Circuit held on similar facts that insurance proceeds received by a corporation and used to redeem the stock of a deceased controlling shareholder were “not the kind of nonoperating asset that should be included in the [corporation’s] value” because they were “offset dollar-for-dollar by [the corporation’s] obligation to satisfy its contract with the decedent’s estate.”11 The Eleventh Circuit explained that because a hypothetical purchaser would take account of corporate liabilities as well as assets in valuing the corporation, the decedent’s stock should also be valued without regard to any insurance proceeds that the corporation used to pay the redemption price.12
Despite its disarming simplicity, the Eleventh Circuit’s appeal to “common business sense” is misplaced.13 Section 2703(a) requires that property be valued “without regard to” any agreement to acquire the property at a below-market price, unless the agreement comes within the safe harbor of section 2703(b).14 In treating the redemption agreement as an offsetting liability of the corporation, the Eleventh Circuit circumvented section 2703 by giving effect to an agreement that should have been disregarded in valuing the decedent’s stock for estate tax purposes.15 Moreover, the Eleventh Circuit’s reasoning in Estate of Blount — and by extension, the estate’s position in Connelly — rests on a fallacy. The corporation’s obligation to redeem the decedent’s stock undoubtedly affects the price that a hypothetical purchaser would pay for the surviving shareholder’s stock (representing a share of the corporation’s value after the redemption), but it does not affect the value of the decedent’s stock (representing a share of the corporation’s value before the redemption).16
A simple hypothetical example shows why a “redemption obligation should not be treated as a value-depressing corporate liability when the very shares that are the subject of the redemption obligation are being valued.”17 Suppose A and B are equal 50 percent shareholders of X Corporation, which has assets worth $100. Each shareholder’s stock is presumably worth $50, the price a hypothetical purchaser would pay in an arm’s-length transaction.18 The result is the same if the corporation is obligated to redeem A’s stock at death for its fair market value. The redemption price should be $50, regardless of whether the corporation uses life insurance or other corporate assets to fund the redemption.19 Treating X’s redemption obligation as a $50 corporate liability — as urged by the estate in Connelly — implies that X has a net value of $50 and A and B each own stock worth only $25. But that would be inconsistent with the assumed redemption price of $50 for A’s stock (leaving B as the sole shareholder of a corporation worth $50). Nor can it be true that A’s stock should be redeemed for $25 (leaving B as the sole shareholder of a corporation worth $75).20
Instead, the value of A’s stock should not be affected by the redemption obligation since the redemption is merely an exchange of the stock for corporate assets of equal value, and a hypothetical purchaser should pay $50 for A’s stock whether or not that stock is to be redeemed.21 B’s identical stock should also be worth $50 both before and after the redemption because a hypothetical purchaser would take account of A’s rights either as a shareholder (pre-redemption) or a distributee (post-redemption). In Connelly, if the estate tax value of Michael’s stock is a proportionate share of Crown’s assets, those assets should include the full $3.5 million of insurance proceeds and should not be offset to any extent by the $3 million of proceeds that Crown used to satisfy its redemption obligation.
The Supreme Court’s grant of certiorari in Connelly provides a long overdue opportunity to review the Eleventh Circuit’s reasoning in Estate of Blount.22 Despite a superficial appearance of logic and symmetry, the Eleventh Circuit’s holding encourages the use of buy-sell agreements funded with life insurance to artificially depress the estate tax value of closely held stock. In valuing a decedent’s stock, there is no persuasive reason to treat life insurance proceeds differently from any other corporate nonoperating assets, nor does the existence of a redemption agreement justify a special valuation reduction for closely held stock.23 While welcomed by some observers, the Eleventh Circuit’s analysis has been roundly criticized for misapplying applicable statutes and regulations, violating basic valuation principles, and facilitating tax avoidance.24 Moreover, reputable practitioners have warned taxpayers to proceed with caution in relying on Estate of Blount.25 To resolve any lingering uncertainty, the Supreme Court should seize the opportunity to affirm the Eighth Circuit’s decision in Connelly and reject the Eleventh Circuit’s misguided decision in Estate of Blount.
FOOTNOTES
1 By contrast, a cross-purchase agreement provides for purchase of a decedent’s stock by the surviving shareholders. A redemption agreement is administratively simpler because the corporation maintains a single insurance policy on the life of each shareholder and avoids the need for each shareholder to maintain multiple policies. The two types of buy-sell agreements may have materially different tax consequences.
2 Connelly v. United States, 70 F.4th 412 (8th Cir. 2023), cert. granted, No. 23-146 (U.S. Dec. 13, 2023); see also Estate of Blount v. Commissioner, 428 F.3d 1338 (11th Cir. 2005).
3 In valuing Michael’s stock, the government included the $3 million of insurance proceeds that Crown used to redeem Michael’s stock as a corporate asset, increasing Crown’s value from $3.86 million to $6.86 million. Michael’s proportionate 77.18 percent share of $6.86 million is $5,294,548. The parties stipulated that the unrestricted fair market value of the stock would be $3.1 million if the insurance proceeds were excluded from Crown’s value.
4 See Connelly, No. 4:19-cv-01410 (E.D. Mo. Sept. 21, 2021), aff’d, 70 F.4th 412. The district court found that the buy-sell agreement fell outside the safe harbor of section 2703(b) and therefore should be disregarded under section 2703(a) in valuing Michael’s stock for estate tax purposes. See id. (holding that the agreement was a “testamentary device” and “not comparable to similar arrangements negotiated at arms’ length”).
5 Reg. section 20.2031-2(f)(2).
6 See Huntsman v. Commissioner, 66 T.C. 861 (1976), acq., 1977-2 C.B. 1 (noting that reg. section 20.2031-2(f) “calls for life insurance proceeds to be treated in the same manner as other nonoperating assets of the corporation in determining the value of the stock”); and Rev. Rul. 82-85, 1982-1 C.B. 137.
7 See reg. section 20.2042-1(c)(6).
8 See id. (noting that attribution rule applies only to proceeds that “are not payable to or for the benefit of the corporation, and thus are not taken into account in valuing the decedent’s stock holdings in the corporation for purposes of section 2031”); see also T.D. 7312, 1974-1 C.B. 277 (“Where a corporation is the beneficiary of any portion of the proceeds of a life insurance policy, there is no need for that portion to be included in the gross estate under section 2042 because it directly affects the value of the stock that is included in the decedent’s gross estate.”).
9 Crown received $3.5 million of insurance proceeds and redeemed Michael’s stock for $3 million. The remaining $500,000 of proceeds is “undisputedly” included in Crown’s value. Connelly, 70 F.4th at 419.
10 In Estate of Blount, as in Connelly, the decedent’s stock was valued as a share of the corporation’s value, without regard to the redemption price specified in a buy-sell agreement that fell outside the safe harbor of section 2703(b). See Estate of Blount, 428 F.3d at 1344-1345; and Connelly, 70 F.4th at 416-418.
11 Estate of Blount, 428 F.3d at 1346. The court cited Estate of Cartwright v. Commissioner, 183 F.3d 1034 (9th Cir. 1999), an income tax case in which the Ninth Circuit observed that a corporate-owned insurance policy “would not necessarily affect what a willing buyer would pay for the firm’s stock because it was offset dollar-for-dollar by [the firm’s] obligation to pay out the entirety of the policy benefits to [the deceased shareholder’s] estate,” without mentioning that $4 million of the $5 million payment in Cartwright was allocable to the decedent’s contractual claim for work in process and only $1 million to the redeemed stock. Estate of Blount, 428 F.3d at 1345 n.5.
12 See Estate of Blount, 428 F.3d at 1346 (“To suggest that a reasonably competent business person, interested in acquiring a company, would ignore a $3 million liability strains credulity and defies any sensible construct of fair market value.”). Although the regulations require that “nonoperating assets, including proceeds of life insurance policies payable to or for the benefit of the company” must be considered in valuing the decedent’s stock “to the extent that such nonoperating assets have not been taken into account in the determination of net worth,” reg. section 20.2031-2(f), the court asserted that the latter quoted phrase “precludes the inclusion of the insurance proceeds in this case.” Estate of Blount, 428 F.3d at 1345.
13 Id.
14 See section 2703(a) and (b).
15 See John A. Bogdanski, “Stock Buyouts Funded by Life Insurance: The Blount Conundrum,” 33 Est. Plan. 40, 42 (June 2006) (“The plain language of [section 2703(a)] requires that the buyout liability be completely ignored in valuing the stock. The Eleventh Circuit violated that precept by taking the liability into account in valuing the issuing corporation’s assets and operations, on the way to valuing its stock.”); and Adam S. Chodorow, “Valuing Corporations for Estate Tax Purposes: A Blount Reappraisal,” 3 Hastings Bus. J. 1, 26-27 (2006) (“One must ignore the fact that the shares will be redeemed at a price set in the buy-sell agreement. It makes little sense to ignore this fact, yet assume at the same time that the corporation will indeed incur the expense.”).
16 See Chodorow, supra note 15, at 25 (“Any valuation that takes the redemption obligation into account effectively values the corporation on a ‘post-redemption’ basis, i.e., after the decedent’s shares have been redeemed. . . . The value derived by taking the redemption obligation into account actually reflects the value of all the outstanding shares other than the decedent’s.”); James M. Delaney, “Estate Taxation of Redemption Agreements: The Treasury Loses ‘Control,’” 84 Denv. U. L. Rev. 491, 519 (2006) (noting that in valuing the stock to be redeemed a shareholder would “seek to receive his or her ratable share of the value of the company previous to the redemption” while value of remaining stock would be based on “the value of the shares that remain after the redemption”).
17 Estate of Blount v. Commissioner, T.C. Memo. 2004-116 at 69-70, rev’d on this issue, 428 F.3d 1338; see also Connelly, 70 F.4th at 420 (“An obligation to redeem shares is not a liability in the ordinary business sense.”); and Robert Willens, “Redemption Obligation Is Not a Corporate Liability,” DTR (Nov. 16, 2021).
18 The hypothetical in text, based on the Tax Court’s “simplified example” in Estate of Blount, assumes that the value of stock is a proportional share of corporate value, without regard to other factors (e.g., control and lack of marketability) that might support upward or downward adjustments. Estate of Blount, T.C. Memo. 2004-116, at 69-70; see also Chodorow, supra note 15, at 21 (Scenario 2).
19 If the redemption agreement provides for a below-market price, the agreement is likely to be disregarded under section 2703(a), as occurred in Estate of Blount and Connelly. See supra note 10. Nevertheless, the estate tax value of the decedent’s stock should be unchanged. See Chodorow, supra note 15, at 27-28 (scenarios 4 and 5).
20 See Delaney, supra note 16, at 518-519.
21 To see why a corporation’s redemption obligation should not reduce the corporation’s value in valuing the redeemed stock, imagine a hypothetical transaction in which a purchaser acquires all of X’s stock. The purchaser would pay $100 for the combined stock of A and B, equal to the value of X’s assets; the value of the stock purchased from A would be $50 whether or not that stock was redeemed, and the value of the stock purchased from B would also be worth $50 both before and after the redemption of A’s shares. See Connelly, 70 F.4th at 420.
22 The government failed to petition for certiorari in Estate of Blount, and the Eleventh Circuit’s decision has been largely ignored — neither followed nor challenged — for nearly 20 years, aside from one approving citation by the Eleventh Circuit. See Estate of Jelke v. Commissioner, 507 F.3d 1317, 1331 n.41 (11th Cir. 2007), cert. denied, 555 U.S. 826 (2008).
23 See Chodorow, supra note 15, at 28-29 (“Allowing one to offset life insurance proceeds (but not other assets) with redemption obligations would create an unwarranted preference for funding redemption obligations with life insurance.”).
24 See id. at 37 (concluding that “as a matter of regulatory interpretation, valuation theory and tax policy” the decision is “wrong”); Bogdanski, supra note 15, at 41-42 (noting that “the Eleventh Circuit erred” and “the Tax Court got it right”); see also David Berke, “Family Values: An Evaluation of Internal Revenue Code Sections 2703 and 2704(b),” 41 ACTEC L.J. 197, 226-227 (2015) (“The 11th Circuit’s reasoning falls apart in simple application.”); and Delaney, supra note 16, at 535 (criticizing the “apparent loophole”).
25 See Howard M. Zaritsky, “Another Court Considers When Life Insurance Proceeds Increase the Value of the Corporate Beneficiary,” 49 Est. Plan. 37, 40 (Jan. 2022) (noting that taxpayers outside the Eleventh and Ninth circuits “may have a more difficult time” relying on Estate of Blount).
END FOOTNOTES