Written by W. Michael Wolfe, CPA/ABV, CVA and Aaron Fleitman, ASA, ABV
The Ruling
On June 6, 2024, the Supreme Court ruled on the Estate of Michael P. Connelly, Sr. v. United States, regarding a number of key estate planning issues that could impact business owners nationwide. While every case and estate have unique factors that can impact valuation, planning, and execution, the Connelly case has points that may be helpful in your planning.
Michael and Thomas Connelly owned Crown C Supply, a small building supply corporation located in Missouri, with Michael Connelly holding a majority interest (approximately 77.18%) and the balance held by his brother, Thomas. As part of their estate and corporate planning, the brothers entered into an agreement that would maintain the ownership of the company within the family in addition to the valuation requirements of an interest to be redeemed in the event one brother passed. To limit unnecessary burdens on the Company’s cash flow from future redemptions, the company purchased $3.5 million in life insurance policies for each brother as a funding source for the redemption.
Upon Michael’s death, instead of following the prescribed requirements of the agreement to obtain an outside appraisal for redemption, Michael’s son and Thomas agreed to a purchase value of $3 million for the estate’s interest and used this value to file the estate tax return.
The IRS sent a notice of deficiency to the estate, arguing that:
- The stock redemption agreement failed to set the price of the estate’s interest by not obtaining an appraisal of the stock, and
- The estate failed to include the life insurance proceeds in the value of the estate’s interest because it offset the life insurance proceeds by the redemption liability.
Issues
Fair Market Value
Instead of obtaining an outside appraisal as directed by the agreement between the Connelly brothers, Michael’s son and Thomas agreed to expeditiously value Michael’s shares in the company at $3 million. This transaction did not represent an “arm’s-length transaction” and necessitated an appraisal for both the redemption as well as the estate tax return. While implementing guidance for the value of redemption obligations may be helpful from a corporate planning perspective and going further to implement a formula to value purchase redemptions, the best method is obtaining periodic appraisals of the business to set the value for redemption obligations.
Incorrect Consideration of the Life Insurance Proceeds and Redemption
The Connellys’ estate planning considered the significant costs associated with the redemption of equity after the first brother’s death. Significant redemption “liabilities” can cause undue hardships for a small business that does not have adequate cash flow to support the redemption. However, redemptions are not a true liability of a company. In the Connelly case, life insurance proceeds increase the equity value and, accordingly, the business value of the Company. This was not considered in the value used by the estate. The Court determined that the redemption liability could not offset the life insurance proceeds.
Instead of having the company be the beneficiary of the brothers’ life insurance policies, the company could have paid the annual policy premiums and listed each brother as the direct beneficiary. This would have eliminated the taxation of the life insurance as part of the business value and saved the estate an assessment of $889,914.
Planning Tips
If your company has a redemption agreement that is funded by life insurance, review the arrangement and discuss it with your Estate Planning professional to avoid the consequences of the Supreme Court decision in the Connelly case.
Business valuation formulas used to value a business or business interests are not acceptable when it comes to gift or estate taxation. An independent appraisal by a qualified appraiser is required. A periodic appraisal should be performed to understand this value.
For any assistance needed, feel free to contact the Estate Planning or Business Valuation professionals at Trout CPA.
