Legal Blogs and Updates

The Supreme Court last week heard arguments in the appeal of a Circuit Court opinion resolving a million-dollar dispute with the IRS that owners of closely held businesses should heed.

The case on appeal, Thomas Connelly v. United States, 70 F. 4^th 412 (8^th Circuit, June 2, 2023), involves two brothers who owned a building materials business in corporate form in the St. Louis area. The business took out life insurance on each brother. The brothers had agreed that, if one of them died, the business would collect the insurance proceeds and buy back (“redeem”) the shares held by the decedent’s estate.

First salient fact: The business owned the insurance policy and was the policy’s beneficiary.

One brother died. The Company became $3.5 million wealthier on his date of death.

Second salient fact: When the brother died, there was no fixed price at which the corporation would redeem the shares from the deceased brother’s estate. The brothers had not agreed on a price. There was no formula for calculating a price. The corporation did not seek a third-party appraisal.

Instead, the estate’s executor and the surviving brother used some of the death benefit to pay corporate expenses and spent the balance to redeem the deceased brother’s shares for an after-the-death-date-agreed $3 million.

In determining the value of the corporation for purposes of the deceased brother’s estate tax, the IRS said that, on the date of death, the $3 million was a corporate asset, but the agreement to redeem the shares was not a corporate obligation that offset the $3 million in the corporation’s bank account. Why? Because, at the date of the brother’s death, there was no established price for his shares. The impact of this difference equaled nearly $1 million in additional estate tax.

Basic corporate law treats a redemption not as a corporate liability; a redemption simply reduces “surplus” on the balance sheet. The Eighth Circuit opinion held, “The proceeds were simply an asset that increased shareholders’ equity.”

Both the federal district court and a panel of the Eighth Circuit Court of Appeals upheld the IRS’ view. The Supreme Court apparently granted certiorari on the grounds that the Eighth Circuit allegedly treated this issue differently from the way two other Circuit Courts had treated similar circumstances previously. We’ll see how the Supreme Court views the situation.

The owners of the business (and their advisors) could have avoided this situation.

First, business owners typically are well advised to set themselves up personally to purchase the shares from a decedent’s estate. That way, the survivors get a “stepped up” basis in the holdings purchased from the deceased owner’s estate, which benefits them down the road if they sell. Also, if the business’s owners own the insurance, the proceeds never go into the entity. The death benefit does not go into the decedent’s estate until the other owners buy the decedent’s shares in a transaction treated as a capital transaction, not as ordinary income.

Second, because the premiums on life insurance purchased for this purpose are not “ordinary and necessary” business expenses, neither the entity nor the owner may deduct the premiums for federal income tax purposes. The entity may have more access to cash than the owners, but the entity does not get a deduction for paying the premiums.

Third, to save out-of-pocket costs, business owners often resist having an outside appraiser periodically assess the business’s value. Instead, business owners often choose to promise to agree periodically (usually annually) on a value for their own equity interests using a document often called a “certificate of agreed value.” In this case, the brothers promised to agree from time to time on a certificate of agreed value, but they never did. In a New Jersey case, the doctors in a busy medical practice similarly agreed to make a new certificate of value every year, but they didn’t. In that case, the retiring doctor was limited to a two-decades-old certificate of value. A backup provision requiring an appraisal if no certificate is agreed upon within a two year period prior to death avoids these issues.

The owners of closely-held businesses should consult their lawyers to help ensure that they don’t make million-dollar mistakes.