In Connelly v. United States, No. 21-3683 (8th Cir. 2023), the United States Court of Appeals for the Eighth Circuit, on the taxpayer’s appeal from an order granting summary judgment in favor of the IRS by the United States District Court for the Eastern District of Missouri, considered(i) whether a buy-sell agreement was able to fix the value of the decedent’s corporate shares for estate tax purposes (it was not), and (ii) whether life insurance proceeds payable to the corporation to help fund a corporate redemption of shares needed to be considered in determining the fair market value of the corporate shares for federal estate tax purposes. (It was so considered in determining the fair market value of the corporate shares without any offset to take into account the redemption obligation to the decedent’s estate under a buy-sell agreement.)

Facts

Brothers Michael and Thomas Connelly were the only shareholders in Crown C Supply, Inc. (“Crown”), a closely held family business that sold roofing and siding materials.  Michael owned approximately 77% of the company’s shares, while Thomas owned the remaining approximately 23% of the company’s remaining shares. The brothers entered into a stock purchase agreement that gave the surviving brother the right to buy the decedent’s shares.  If the surviving brother declined, then Crown (the company) was required to buy back the shares of the first brother to die, and the company bought $3.5 million in life insurance on the life of each brother to ensure it had enough cash to make good on the agreement.

The stock purchase agreement provided two mechanisms for determining the price for which Crown would redeem the shares. The principal mechanism required the brothers to execute a new Certificate of Agreed Value at the end of every tax year, which set the price per share by “mutual agreement.” If they failed to do so, the brothers were supposed to obtain two or more appraisals of fair market value. The brothers never executed a Certificate of Agreed Value or obtained appraisals, as required by the stock purchase agreement.

When Michael died in October 2013, the company repurchased his shares, which constituted an approximately 77% ownership interest in the company for $3 million. The rest of the life insurance proceeds ($500,000) went to fund company operations. Michael’s estate paid estate taxes on his shares in the company. The IRS assessed additional estate taxes of more than $1 million. Thomas, as executor of his brother’s estate, paid the deficiency and filed a suit in federal district court for the Eastern District of Missouri seeking a refund. At the core of the dispute was the question of the proper valuation of the company on the date of Michael’s death.

Aside from the life insurance, the company was worth approximately $3.3 million on the date of Michael’s death; on that date, the company had an obligation to repurchase Michael’s shares from his estate. Also on that date, the company became entitled to receive $3.5 million in life insurance proceeds.

U.S. District Court for the Eastern District of Missouri

The first question presented in this case (initially before the United States District Court for the Eastern District of Missouri on motion for summary judgment) was whether the buy-sell agreement was effective to fix the price of the shares for estate tax purposes under Section 2703 of the Internal Revenue Code.  The district court held that it was not.

In order for a buy-sell agreement to fix value for estate tax purposes under Section 2703, a series of requirements must be satisfied. First, under the statutory requirements of Section 2703, (i) there must be a bona fide business arrangement; (ii) the agreement must not be a device to transfer property to family for less than full and adequate consideration; and (iii) the agreement must be comparable to similar agreements negotiated at arm’s length between unrelated parties. 

In addition, there are the following additional requirements under the section 2703 regulations and the case law: (a) there must be a fixed and determinable offering price; (b) the agreement must be binding both during life and after death; and (c) there must be a bona fide business reason, and it must not be a testamentary disposition for less than full and adequate consideration.

With respect to the statutory requirements of section 2703, the district court concluded (i) that although the buy-sell agreement was a bona fide business arrangement, (ii) it was a device to transfer property to family for less than full-and-adequate consideration, in part because the parties ignored the appraisal requirement under the agreement and basically picked a $3 million redemption price for the shares, which is a different price than what the parties stipulated to in the court proceedings. In addition, (iii) the taxpayer could not show that the agreement was comparable to similar agreements entered into between unrelated parties at arm’s length.  Accordingly, the $3 million redemption price per the buy-sell agreement was not binding to fix the value of the shares for federal estate tax purposes.

Further, the district court also noted (a) that the agreement was not fixed and determinable in determining value as the parties did not treat it as such; and (b) that the parties’ own conduct demonstrated that the stock purchase agreement was not binding after Michael’s death.  Accordingly, the district court concluded that the stock purchase agreement did not fix the company’s value for estate tax purposes.

The district court next considered the second question of whether life insurance proceeds owned by and payable to the company should be considered in valuing the company. The estate relied upon the decision of the United States Court of Appeals for the Eleventh Circuit in Estate of Blount, 428 F.3d 1338 (11th Cir. 2005), which had reversed the Tax Court below in holding that the fair market value of a closely-held corporation did not include life insurance proceeds, on the grounds that the stock purchase agreement created a contractual liability for the company which offset to that extent the life insurance proceeds.     

The district court in Connelly rejected the Eleventh Circuit’s approach in Blount, finding the decision “demonstrably erroneous” and that there “are cogent reasons for rejecting it.” The court in Connelly focused on what a hypothetical willing buyer would pay for a company subject to a redemption obligation and concluded that it would not factor the company’s redemption obligation into its assessment of the value of the company because, with the purchase of the entire company, the buyer would thereby acquire all of the shares that would be redeemed under the redemption obligation. As a result, the buyer’s redemption obligation would then be owed solely to itself. (Importantly, this however is factually incorrect, as the payment obligation was owed instead to Michael’s estate.) The court continued that the company could choose to cancel this obligation if it did not wish to change the company’s capital structure, or alternatively receive the equivalent of a distribution from the company, leaving the buyer in the same economic position as if the redemption obligation had been cancelled.   

The district court in Connelly therefore construed the redemption obligation as not constituting a corporate liability for estate tax purposes. It therefore held that the life insurance proceeds used to redeem the decedent’s shares in the company must be included in determining the fair market value of the company (and therefore in determining the fair market value of the decedent’s shares of stock in the company) without any offset relating to the company’s redemption obligation for its shares.

Eighth Circuit Court of Appeals

The estate appealed the district’s court’s grant of summary judgment in favor of the IRS, and the United States Court of Appeals for the Eighth Circuit affirmed the district court.

On the issue of the applicability of section 2703, the Eighth Circuit focused on the fact that the stock purchase agreement fixed no price nor prescribed a formula for arriving at one; it merely laid out two mechanisms by which the brothers might agree on a price. One was the Certificate of Agreed Value, which the Eighth Circuit regarded as nothing more than “an agreement to agree.” The other was an appraisal process for determining the fair market value of Crown; as to this, the Eighth Circuit noted that there is nothing in the stock purchase agreement, aside from minor limitations on valuation factors, that fixes or prescribes a formula or measure for determining the price that the appraisers will reach; instead, the agreement required only that the appointed appraisers independently determine and submit their appraisals of the fair market value of the company, and the brothers were supposed to average the results or consult a third appraiser as a tiebreaker. None of this was ever done. Thus, the buy-sell agreement was not binding to fix the value of the shares for federal estate tax purposes under Section 2703 because the agreement was not fixed and determinable in determining value due to the parties’ failure to treat it as such. (None of the other grounds raised by the district court in its Section 2703 analysis were mentioned by the Eighth Circuit.)

On the issue of the fair market value of the decedent Michael Connelly’s shares in Crown, the Eighth Circuit (similar to the district court) phrased the issue as whether the life insurance proceeds received by Crown and intended for redemption should be taken into account when determining the corporation’s value at the time of Michael Connelly’s death.

The Eighth Circuit emphasized that in valuing a closely held corporation, the regulations under Code Section 2031 require that consideration shall also be given to non-operating assets including proceeds of life insurance policies payable to or for the benefit of the company. In this regard, the Eighth Circuit stated that although not directly applicable, Section 2042 helps to illuminate what it means to take into account life insurance proceeds for Section 2031 purposes, including in valuing a corporation’s stock that is affected by the receipt of life insurance proceeds for purposes of the willing buyer / willing seller test.

The Eighth Circuit then tackled head on the Eleventh Circuit’s decision in Blount. The Eighth Circuit in Connelly observed that the Eleventh Circuit in Blount had concluded that the life insurance proceeds had been accounted for by the redemption obligation, and that the Eleventh Circuit in Blount views the life insurance proceeds as an asset directly offset by the liability to redeem shares, yielding zero effect whatsoever on the company’s value.

According to the Eighth Circuit, the Blount court’s premise that an offsetting liability should be recognized due to the corporation’s obligation to redeem shares is flawed, because an obligation to redeem shares is not a liability in the ordinary business sense, but instead simply a reduction to corporate surplus. According to the Eighth Circuit in Connelly:

“Consider the willing buyer at the time of Michael’s death. To own Crown outright, the buyer must obtain all of its shares.  At that point, he could then extinguish the stock-purchase agreement or redeem the shares from himself. This is just like moving money from one pocket to another. There is no liability to be considered – the buyer controls the life insurance proceeds. (This, however, is factually incorrect as Crown [now owned by surviving brother Thomas Connelly] is redeeming shares from brother Michael’s estate and paying $3 million to brother Michael’s estate which no longer has any ownership interest in Crown.)

The court continued:

A buyer of Crown would therefore pay up to $6.86 million, having “taken into account” the life insurance proceeds, and extinguish or redeem as desired. On the flip side, a hypothetical willing seller of Crown holding all 500 shares would not accept only $3.86 million knowing that the company was about to receive $3 million in life insurance proceeds, even if those proceeds were intended to redeem a portion of the seller’s   own shares.” (This, however, is factually incorrect, as it was instead the Estate’s shares.)

On this basis, the Eighth Circuit affirmed the district court’s grant of summary judgment in favor of the IRS.

Observations

A. The critical distinction in the analysis between Blount and Connelly lies in the recognition (or non-recognition) of an offsetting liability to implement the redemption obligation under the buy-sell agreement.  The Eleventh Circuit in Blount recognized an offsetting liability for such redemption obligation, whereas the Eighth Circuit in Connelly did not.

B. But is this a complete analysis, however, or is there something else that may be missing?  The author believes that the correct analysis in a “conceptual sense” would be to allow the offset for such liability in determining the value of the corporate stock but then recognize for estate tax purposes a corresponding asset to the estate in the form of a receivable equal to the amount of the redemption payment obligation.  The Connelly court’s denial of an offsetting liability for this corporate obligation to pay out cash to the estate in connection with the redemption transaction seems to be functioning as somewhat of a proxy for this approach.  It is seemingly an imperfect proxy, however, because the value of the corporate stock attributable to the life insurance proceeds is then potentially multiplied by the estate’s ownership interest percentage in the corporation’s stock in determining the stock’s estate tax value that is attributable to it (subject to any discounts that may potentially apply depending upon the circumstances including due to lack of control or lack of marketability), while the receivable associated with the redemption payment obligation under the buy-sell agreement would not be similarly adjusted based on ownership percentage. That being said, it is also possible that a court could conclude that no discount should be applied to the cash that is earmarked for payment of the redemption obligation.

C. In any event, given the split that we have in the Circuits, this is very likely not the last we’ve heard of this issue, and indeed the taxpayer in Connelly recently filed a petition for certiorari for consideration by the United States Supreme Court. So stay tuned, as they say.

Kevin Matz, Esq., CPA, LLM, is a partner at the law firm of ArentFox Schiff LLP in New York City. He earned his JD from Fordham University School of Law, New York, N.Y. and his LL.M. in Taxation from New York University School of Law. He is a Fellow of the American College of Trust and Estate Counsel (ACTEC), where he chairs ACTEC’s Business Planning Committee and currently serves as chair of the Estate and Gift Taxation Committee of the New York City Bar Association.

He also currently serves as a Director on the NYSSCPA Board of Directors, and currently chairs both the NYSSCPA’s Professional Liability Insurance Committee and the Foundation for Accounting Education (FAE) Curriculum Committee. He may be contacted at (212) 745-9576 or  kevin.matz@afslaw.com.