Florida Bar Journal

Putting Carts Before Horses: Why the Taxpayer Failed in Connelly v. United States, and the Effect on Business Succession and Estate Tax Planning

On June 6, 2024, the Supreme Court unanimously ruled for the IRS in Connelly v. United States, 144 S. Ct. 1406, 1414 (2024), which held that when determining the value of corporate shares for estate tax purposes, the value of a corporate-owned life insurance policy on the decedent’s life is not offset by the corporation’s obligation to redeem the shares from the estate. This article analyzes the Supreme Court’s opinion, as well as the decisions of the lower two courts, for the purpose of understanding how the opinion was reached and the impact it has on business succession and estate plans. The key points of this article are as follows: 1) The Court’s decision rested on the economic interests of the shareholder pre- and post-redemption, and the mechanics of redemptions generally, to arrive at its holding; and 2) the law surrounding the effect of purchase agreements and stock restrictions on fair market value under I.R.C. §2703 and the lower courts’ analyses are still binding.^[1] This makes the Supreme Court’s decision less narrow than the opinion suggests.

Because of these points, drafters and parties of purchase agreements or stock restrictions must either meet the conditions of §2703(b) or structure the agreement — and each shareholder’s estate plan — with the assumption that such agreements or restrictions have no offsetting effect on valuation.

Summary of the Facts

Two brothers, Michael and Thomas Connelly, owned a small but successful contracting business, Crown C. Supply, Inc. (Crown). The company’s shares were split between Michael and Thomas roughly 77% to 23%, respectively.^[2] The Connelly brothers entered a stock purchase agreement that permitted each brother to buy the other’s shares upon one of their deaths. The corporation was required to redeem the deceased brother’s shares if the surviving brother declined to purchase the shares. To fund this arrangement, Crown owned and paid for a life insurance policy of $3.5 million on each of the brothers’ lives.

Upon Michael’s death, Thomas declined to purchase his brother’s 77% of shares. Crown purchased Michael’s shares using $3 million of the life insurance proceeds; the price was agreed to by Thomas (as executor of Michael’s estate) and Michael’s son (as a beneficiary of the estate).^[3] Michael’s estate tax return reported the value of his shares to be approximately $3 million, which is roughly 77% of a $3.86 million valuation of Crown, determined by offsetting $3 million of policy proceeds as a satisfaction of the liability (i.e., the redemption obligation). The IRS audited the estate tax return and assessed the estate for an additional $889,914 in taxes,^[4] based on the IRS’s position that the policy proceeds used in the redemption were not offset by the obligation, making Crown worth about $6.86 million at Michael’s death. Under this theory, Michael’s shares were worth roughly $5.3 million instead of $3 million.

Summary of the Opinion

The sole question before the Supreme Court was whether Crown’s obligation to redeem Michael’s shares offset the $3 million of life insurance proceeds used to satisfy that obligation.^[5] Roughly put, the federal estate tax is based on the value of the decedent’s taxable estate, which includes the value of all the decedent’s property, including corporate stock.^[6] Property interests are valued at the time of death at “fair market value,” which is the amount to which a reasonable, willing buyer and seller would agree when apprised of relevant facts in an arm’s length transaction.^[7] Applying that standard to the case, the question is about the fair market value of a corporation for estate tax purposes: At the time of Michael’s death, would a buyer and seller who are reasonable, willing, and unrelated have agreed to $3.86 million or $6.86 million for Crown, knowing that the corporation had an obligation to redeem the shares from Michael’s estate?

Importantly, the Supreme Court did not address whether the purchase agreement set the fair market valuation at the purchase price under §2703(b), which is addressed below. Michael’s estate argued that Crown’s fair market value was $3.86 million, a value that excluded the life insurance policy because no hypothetical reasonable buyer would have been willing to buy the company for $6.86 million in light of the redemption obligation. The IRS disagreed and argued that because the value to each shareholder was the same before and after the redemption, the life insurance proceeds could not be excluded. The government also argued that the mechanics of a stock redemption leave a corporation less valuable than before the redemption, as repurchased stock is not a corporate asset.^[8] The Court provided an example of this principle: Shareholder A owns 20% of a corporation (C), which is worth $10 million. Shareholder Bowns 80% of C. To redeem A’s shares, C would have to pay $2 million, leaving B with the remaining $8 million. While C is less valuable after the redemption, A did not receive less than $2 million for A’s shares, and B maintained ownership of the same $8 million of value. Furthermore, a hypothetical buyer purchasing all $10 million of stock subject to a redemption obligation on A’s shares would receive no less than $2 million in return for A’s former shares.^[9]

The Effect of Purchase Agreements on Valuation

The precise question before the Supreme Court was whether the obligation offset the value of the life insurance proceeds in determining the fair market value of Crown. The Supreme Court did not address whether the conditions of §2703(b) applied to the Connellys’ agreement, which would have allowed the agreement and any restriction on the stock to affect the fair market value. However, the §2703(b) analysis was a key factor in the district court’s order^[10] and the Eighth Circuit’s opinion,^[11] as well as the Tax Court’s^[12] opinion and the subsequent opinion from the 11th Circuit^[13] in Estate of Blount v. Commissioner, 428 F.3d 1338, 1344 (11th Cir. 2005), which the Eighth Circuit and Supreme Court heavily used in this case.^[14]

If an agreement or a restriction satisfies the conditions of §2703(b), the agreement or restriction can influence the fair market value, including the offsetting of non-operating assets by an obligation under such agreement. Thus, an understanding of the code, regulations, and caselaw developments are integral to planning in light of Connelly.

• Inclusion of Non-operating Assets — In determining the fair market value of Crown, it is important to remember that the question before the Court was not whether the life insurance proceeds should have been included in the valuation; the estate and the government stipulated this fact.^[15] Indeed, the treasury regulations^[16] are clear that the value of life insurance proceeds and other non-operating assets of a closely held company are to be considered “to the extent such nonoperating assets have not been taken into account in the determination of net worth, prospective earning power, and dividend-earning capacity.”^[17] A key component in this determination is that Crown is a closely held company. The regulation that directs these non-operating assets to be taken into account is applicable when valuing a company where “selling prices or bid and asked prices are unavailable.”^[18]

• Obligations as Offsetting Liabilities: §2703(a) — The fact that a willing buyer and willing seller would reasonably consider a corporate liability when settling on a price is a straightforward assumption. But if liabilities and obligations affect fair market value, why would Crown’s contractual obligation not be considered under the reasonable willing buyer/seller test?

The Eighth Circuit’s decision, which adopted the Tax Court’s reasoning in Blount, gives two reasons that the Supreme Court affirms or does not address: 1) Redemptions of a corporation’s own stock are not considered liabilities in the way other corporate obligations are considered;^[19] and 2) Crown’s obligation came from a purchase agreement, and absent the conditions explained below, §2703 requires the agreement — and, thus, the obligation — to be disregarded for valuation purposes.^[20]

Another question arises from the estate’s obligation to sell the shares. If the value of an estate is determined at the time of death,^[21] and not before the decedent passes, could a buyer have bought Michael’s shares without Crown first satisfying its redemption obligation, and would the estate be free to sell the shares to such a buyer in the first place?^[22] The same points above apply to restrictions on the right to sell or use property, with some variations that are addressed later on.

The general rule under §2703(a) and regulations is that the value of property for estate tax purposes disregards: 1) any option, agreement, or other right to acquire or use the property at a price less than the fair market value of the property (without regard to such option, agreement, or right); or 2) any restriction on the right to sell or use such property.^[23]

The plain meaning of §2703(a)(1) highlights the importance of determining whether a particular agreement contemplates a transfer for full consideration before diving into the exceptions of §2703(b). If the purchase agreement is for less than fair market value, then the agreement is to be disregarded. The estate repeatedly argues that it satisfies the testamentary substitute and comparable transaction conditions in the §2703(b) analysis below because purchase price was for fair market value (i.e., the obligation affects the value to which a willing buyer and seller would agree).^[24] This argument is the key failure of the estate because the time to argue fair market value would be in considering §2703(a)(1); to argue a price fixes fair market value when analyzing §2703(b) is a foregone conclusion. The district court explains this principle when determining the testamentary substitute requirement: “[T]he $3 million redemption price is only equivalent to the fair market value of the shares if the Court were to find that the $3 million in life-insurance proceeds are not included in Crown C’s value.”^[25]

The estate cannot claim that the redemption price reflects fair market value in order to satisfy a condition of §2703(b) when the analysis under §2703(a)(1) requires the determination that the agreement is for less than fair market value and requires that the source of the redemption obligation be disregarded. Section 2703(a)(1) and the regulations specifically identify the right to acquire property for less than fair market value is “determined without regard to the option, agreement, or right.”^[26] The logic of §2703 applied here is as follows: 1) The estate (in both Blount and Connelly) argue that fair market value is affected by the redemption obligation; 2) the obligation arises from a purchase agreement; 3) the Court decides the redemption is not an offsetting liability, so the agreement is for less than fair market value, triggering §2703(a)(1); 4) §2703(a) and the pertinent regulations disregard the agreement for fair market valuation purposes unless §2703(b) applies; 5) both Blount and Connelly failed §2703(b); and 6) therefore, for purposes of calculating the value of the company to determine the taxable estate, there was no agreement, so there was no obligation, so there is offsetting liability.

The Tax Court’s opinion in Blount, which was adopted by the Eighth Circuit, makes an important point on this issue. The Tax Court reasoned that “the willing buyer/seller analysis would be distorted if we disregarded the buy-sell agreement for purposes of fixing the value of the subject stock yet allowed provisions in the agreement to be taken into account when determining the stock’s fair market value.”^[27] Thus, for purposes of determining fair market value under the reasonable buyer/seller test, the price is not the only part of the purchase agreement disregarded; “the hypothetical willing buyer/seller construct necessarily requires that the corporation’s actual obligation to redeem shares be ignored.”^[28]

The Supreme Court did not specifically reference the Tax Court’s line of reasoning, but it did not need to because it was not analyzing §2703(b), and its determination was that the obligation did not offset any assets. The Eighth Circuit also reasoned that such a buyer would purchase the shares and “then [could] extinguish the stock-purchase agreement or redeem the shares from himself.”^[29] This argument assumes that the redemption obligation would have been disregarded or even considered as a benefit to a willing buyer.

• Requirements of §2703(b) —Buy-sell agreements fall under the disregarded agreements or restrictions contemplated by the statute. The exception to the general rule in §2703(a) is satisfied if the agreement meets three conditions outlined in §2703(b) and three conditions developed by regulation and caselaw.^[30]

1) Bona Fide Business Arrangement: The first statutory requirement is that the agreement must be a bona fide business arrangement.^[31] It is well established that an agreement meets this requirement if the parties entered the agreement for a bona fide business purpose.^[32] It is also well established that the maintenance of family ownership and control of a business is a bona fide business purpose.^[33] The courts throughout the Connelly decisions do not treat this condition as an issue.

2) Device to Transfer to Family for Less than Full Consideration: The second statutory requirement is that the agreement “is not a device to transfer such property to members of the decedent’s family for less than full and adequate consideration in money or money’s worth.”^[34] This is understood to mean that the agreement should not be a substitute for a testamentary disposition, and that the parties to the agreement must ensure that transactions between family members are for full and adequate consideration.^[35] Agreements that include family members, which are ubiquitous in closely held corporations, are given greater scrutiny in this analysis.^[36] There are two implications in this requirement. First, we look to see if the agreement transfers a property interest to the natural objects of the decedent’s bounty. Second, we look to see if this transfer is for less than fair market value.

The district court held that the estate failed to prove that the Connellys’ agreement was not a device to transfer wealth to Michael’s family members.^[37] This finding comes as no surprise. Firstly, the redemption price agreement benefited the natural objects of Michael’s bounty, as the parties to the agreement were his brother and son. The only remaining issue was whether this transfer was for less than fair market value (without consideration to the agreement). This issue is determined before we enter the §2703(b) analysis: The estate cannot consider the obligation as an offsetting liability.

This conclusion significantly complicates the agreements of any family-owned business in satisfying §2703(b), as the only reason we look to §2703(b) is because the agreement is already determined to be below fair market value.

3) Comparable to Arm’s Length Transactions: The third statutory requirement is that the agreement’s “terms [must be] comparable to similar arrangements entered into by persons in an arm’s length transaction.”^[38] This means that a restriction or an agreement for less than fair market value must have similar terms to which unrelated parties would agree. The estate’s only argument was that the redemption price was for fair market value, and it failed to provide evidence of similar business arrangements at arm’s length.^[39] The estate in Blount also failed to produce evidence of similar transactions.^[40] If the rest of the estate’s arguments succeeded, this factor alone would result in the agreement being disregarded. As discussed above, the fact that the obligation was disregarded for this part of the analysis has already been determined.

4) Fixed and Determinable Offering Price: In order for the price under a purchase agreement to be considered in the valuation, the price must be fixed and determinable.^[41] The district court quickly determined that the redemption price in Crown’s agreement failed to meet this standard. The Connelly brothers failed to follow both pricing mechanisms in their agreement.^[42] The first mechanism was for the brothers to agree upon a price. This was no more than an agreement to agree, which is a far cry from “fixed and determinable.” The second mechanism was for the brothers to obtain two or more appraisals of fair market value, which they never did.

5) Binding During Life and After Death: The final condition addressed in this article is that the agreement must be binding during the parties’ lifetimes and after their deaths in order to fix fair market value to the price of an agreement.^[43] As already addressed in the “fixed and determinable price” analysis, the Connelly brothers failed to follow the provisions of their agreement. This and the previous requirement addressed above show the perils of failing to follow the pricing mechanisms of a purchase agreement. No matter how airtight a business succession plan may be, if the parties disregard its terms, so will the IRS and the courts.

• Alternative Approaches — 1) Restriction on Property Analysis vs. Right to Property Analysis: The estate argued that the redemption obligation (which is a “right to acquire property”) affected fair market value. However, the estate failed to address the second half of a “right or restriction.” Section 2703(a)(2) and the definition in the regulation apply neither the “less than fair market value” language, nor the “without regard to such” language when addressing whether a restriction on property affects fair market value. Does the analysis change when, instead of accounting for the corporate right to purchase or redeem shares, an estate accounts for its restriction on selling the property? Footnote 3 of the circuit court’s opinion explained, “The estate does not argue that the stock-purchase agreement otherwise controls the fair market value of Crown by virtue of its restriction on the transfer of shares (i.e., through non-price-related means)…. And even if we understood the estate to make this argument, we find it indistinguishable from the estate’s fair-market-value argument that we address in Part II.B below [which holds that the obligation is not an offsetting liability in determining fair market value outside of the [§]2703(b) analysis].”^[44]

Because this analysis was not required for the Eighth Circuit’s holding, the court’s footnote is persuasive authority. Whether the Supreme Court would have entertained the unaddressed argument is a matter of speculation. However, the absence of the “less than fair market value” and “without regard to such” language acts as a double-edged sword. Any restriction on stock would have been subject to a §2703(b) analysis, even if the restriction on the estate ended with a fair market value selling price. The estate’s hypothetical restriction argument would fail on two grounds under the Supreme Court: 1) The restriction would still have to pass a §2703(b) analysis, which the Connellys’ agreement does not; and 2) The Court determined that the obligation was not an offsetting liability, so even without the §2703(b) analysis, the estate’s argument would fail based on the economic interest and redemption mechanics reasoning the Court used.

2) Agreements To Redeem from Operating Stock: The Court makes an interesting speculation in footnote 2 of its opinion. It clarifies that there may be circumstances where a redemption obligation may be considered in determining fair market value, such as a requirement that the redemption be funded from “liquidat[ing] operating assets…thereby decreasing its future earning capacity.”^[45] This clarifying dictum, while not binding, raises interesting possibilities.

If Crown was worth $6.86 million at the time of Michael’s death because of the life insurance proceeds, Crown would need $5.3 million to redeem the estate’s shares, which is $1.8 million more than the $3.5 million policy proceeds; Crown would be required to use its operating assets or to incur new debt to redeem the shares. This was a concern raised by the estate, which the Court dismissed as “misplaced.”^[46] If the $1.8 million difference were funded — or were required to be funded — from operating assets, the court speculates that portion of the obligation may have decreased the fair market value to roughly $5.06 million, making the estate’s shares worth approximately $3.9 million. That would require the purchase price to have been $3.9 million, but if that were the case, then the agreement would not have been disregarded in the first place. Furthermore, the Tax Court (adopted by the Eighth Circuit) reasoned that even without disregarding the agreement, “[t]o treat the corporation’s obligation to redeem the very shares that are being valued as a liability that reduces the value of the corporate entity, thus, distorts the nature of the ownership interest represented by those shares.”^[47] The speculation would require further development. This type of arrangement would also come with significant risks, as many states restrict a corporation’s ability to redeem its own shares with operating assets.

Conclusion: Effects on Business Succession and Estate Tax Planning

The Supreme Court’s decision and the still-relevant §2703 analyses of the Eighth and 11th circuits create a potent throughline: When considering the potential value of a corporation in an estate, don’t put your cart before the horse. The primary question when determining whether an agreement should be considered in the estate tax valuation is whether that agreement’s price is for full and adequate consideration. If you fail to start there, the rest of the analysis will become murky. Connelly provides that the redemption obligation satisfied by non-operating assets of a closely held corporation does not offset the value of the non-operating assets when determining the value of a decedent’s shares. This means that in the hypothetical buyer/seller test, such parties would not consider the redemption as a liability. Even if the buyer/seller would consider the redemption as a liability, the agreement and obligation could still be disregarded without first passing §2703(b) analysis.

While the question before the Court seems narrow, the structure of the Connellys’ business succession plan is an extremely common method of restricting stock purchases for closely held corporations, which value continuity of ownership. Allowing or requiring the corporation to redeem the shares reduces the risks and complexities associated with individual shareholders holding life insurance policies on each other’s lives.

Another important takeaway from Connelly, including the lower courts’ decisions prior to coming before the Supreme Court, is that buy-sell agreements are generally not binding on valuation for estate tax purposes unless certain conditions are met, and the buy-sell agreements of family-owned closely held corporations are highly scrutinized for this purpose. This case increases the need for sophisticated and informed advice when making a buy-sell agreement, so the parties of those agreements understand the benefits and drawbacks of each option.

For estate tax planning purposes, this case will affect a greater number of taxpayers if the lifetime exemption from estate taxes is reduced from $13.61 million to roughly $7 million per person in 2026, as it is set to do. Because a person’s taxable estate includes such a broad range of property interests, a $7 million estate is a reasonably attainable figure for many middle-class American business owners. Whether these business owners decide to structure a purchase agreement that is either for fair market value or satisfies §2703(b), or whether the owners account for Connelly in their estate plans, depends on a number of priorities and considerations of each business and each owner. While the fictional willing buyer and seller would disregard the purchase agreement in this case, business owners should certainly not disregard the fact that life insurance proceeds may indirectly inflate their estates.

This column is submitted on behalf of the Tax Section, Mark Scott, chair, and Charlotte A. Erdmann, Daniel W. Hudson, and Angie Miller, editors.