SCOTUS Hears Arguments in Estate Tax Life Insurance Stock Redemption Case

The Supreme Court heard oral arguments to settle a circuit court split over whether life insurance proceeds following a shareholder’s death that are intended for a closely held corporation’s stock redemption are included in its valuation for estate tax purposes.

The case, Connelly v. US (No. 23-146), revolves around a stock redemption agreement between brothers Michael and Thomas Connelly, who were both shareholders of Missouri-based Crown C Supply Co (Crown). Upon Michael’s death in 2013, Crown used $3 million in proceeds from his life insurance policy — as part of the agreement — to purchase his shares. Michael owned 77.18% of Crown, and Thomas, now the lone shareholder, is the executor of Michael’s estate.

Although the life insurance proceeds where earmarked for stock redemption, the agreement did not set the price beforehand. The estate and the IRS agree on a base valuation of Crown at $3.86 million, but the IRS contended that the $3 million should be added to the valuation for a total of $6.86 million. The 9th and 11th circuit courts ruled in similar cases that the proceeds should be left out of the valuation, but the 8th Circuit held in favor of the government’s assessment. Connelly appealed to the Supreme Court, which granted the estate’s cert petition.

At oral arguments March 27, the petitioners were represented by Kannon Shanmugam, who told the bench that “the government also will subject Thomas eventually to the capital gains tax on the increase in the value of his shares.”

“And that, in our view, is the fundamental problem with the government’s approach here, and that is why this is effectively double taxation,” said Shanmugam.

A part of the IRS’ reasoning for including the proceeds in the valuation is that a hypothetical third-party would pay the $6.86 million to buy all of Crown’s shares. Justice Amy Coney Barrett asked Shanmugam what “a stranger to the situation” like a potential outside buyer should consider, whether it’s the “whole value worth” of Crown or the per-share price.

“[D]o you assume the perspective of Thomas, someone who would buy one of Thomas’ shares or someone who would buy one of Michael’s shares or … could even pretend that you had a third brother named Ralph who only had one share?” Barrett expanded.

In response, Shanmugam answered “it is a hypothetical buyer of the same proportion of shares in the company,” as in 77.18%. The reason, he continued, “is precisely because, if we were talking about Michael’s actual shares, those shares are about to be extinguished. They’re subject to the redemption obligation.” Shanmugam added that the obligation to redeem shares is legally binding, accounted for as a liability.

“In fact, the accounting standards go so far as to specifically enumerate stock to be redeemed upon the death of the holder as giving rise to a liability.” Later, Shanmugam emphasized that the petitioner’s position is that a willing buyer would recognize the $3 million coming into the company as an amount that will immediately “go out.”

Yaira Dubin, representing the government, said it “makes no sense” to, when valuing Michael’s shares, “subtract the price that Crown paid.”

“Using the item you’re trying to value as a line item in its own valuation will never give you the correct answer, and it doesn’t give the estate the right answer here either,” she argued.

In restating the government’s “basic pitch” to the Court, Justice Elena Kagan framed the defense’s argument in saying a redemption obligation “is not any old liability. A redemption obligation is supposed to split the pie” among existing shareholders, “so you come away with a smaller pie. That’s because that’s what redemption obligations do.”

Agreeing with Kagan’s summarization, Dubin stated another component of her position is that “the price paid out for Michael’s shares is value that goes to Michael’s shares.” Petitioners, she said, cannot try to value Michael’s shares “after Crown already redeemed them.”

Justice Brett Kavanaugh expressed that it is “a little … messed up” that after Michael’s death, the net worth of the company “has dipped in half.” His point was that the life insurance policy was taken out “for this exact purpose” to “make sure that didn’t happen.”

Dubin replied in explaining that “what the parties wanted to do here was maintain Crown as a $3.86 million enterprise and give Michael $3 million. That means that there’s $6.86 million of value in the estate tax because Michael owned that $6.86 million of value.”