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SuraLinkWritten by Dalton Hopper, CFE, CVA
Two brothers, Michael and Thomas Connelly, were owners of Crown C Supply, a building supply company in St. Louis, Missouri. The two brothers entered into a redemption agreement that gave the surviving brother the option to purchase the deceased brother’s stock. If the surviving brother declined, the company itself (Crown C Supply) would be required to redeem the deceased brother’s shares. To fund the redemption of shares, the company had a $3.5M life insurance policy on each brother. However, when the two signed the redemption agreement, they never could have imagined it would have ended up at the U.S. Supreme Court.
Many closely held businesses have redemption agreements in place, which allow for, or require, the redemption or repurchase of shares[1] from a deceased shareholder. Oftentimes, these agreements are funded by the business purchasing life insurance for the company’s owners with the proceeds to be used to fund the eventual redemption. However, the recent Supreme Court decision Connelly v. United States, changes the tax and business valuation implications of this arrangement.
For closely held businesses and their owners, redemption agreements serve an important role. For the business and the surviving shareholder(s), it means the business can continue to operate and will remain in the same hands, and often, the same family. For the estate and the family of the decedent, it provides liquidity for an otherwise unmarketable asset (ownership in a closely held business). Now, with the unanimous Connelly v. United States ruling, company-owned life insurance proceeds used to redeem a deceased shareholder’s stock should be included in the valuation of the business and the company’s redemption obligation is not a liability that reduces the company’s value for estate tax purposes.
When Michael passed away in 2013, Thomas did not purchase the shares himself, which obligated the company to redeem the shares. The company paid Michael’s estate $3M for his interest in Crown C Supply. However, the IRS disagreed with how the life insurance proceeds were treated within the valuation for estate tax purposes and the case made its way to the U.S. Supreme Court.
The question confronting the Supreme Court was, if a company has an obligation to redeem shares at fair market value, is this offset with the value of the life insurance proceeds that are committed to funding the redemption? When valuing a privately held company for estate tax purposes, the value of the deceased’s shares should reflect the fair market value of the underlying company. While it’s clear that the value of life insurance proceeds is an asset that increases a company’s value, the Supreme Court has determined that the obligation to redeem the shares using the life insurance proceeds does not represent a liability to the company.
Specifically, the Court found that “an obligation to redeem shares at fair market value does not offset the value of life-insurance proceeds set aside for the redemption because a share redemption at fair market value does not affect any shareholder’s economic interest.” This means that while a stock redemption reduces the value of the company overall, each remaining shareholder is left in the same economic position as before. Because the redemption of a deceased shareholder’s stock reduces the total number of shares outstanding, along with the total value of the company (due to the redemption obligation), the remaining shareholders in the company are left unchanged.
In its opinion, the Supreme Court gave an illustration of a company worth $10M with two shareholders, Shareholder A who owns 80% of the company and Shareholder B who owns 20% of the company. Each share is worth $100,000 (assuming 100 shares). To redeem Shareholder B (with a value of $2M), the company would pay $2M. Shareholder A is left with a less valuable company, now worth $8M, but also owns all the outstanding stock (80 of 80 shares). Therefore, on a per-share basis, Shareholder B, the remaining shareholder, has the same per-share value as before the redemption ($8M divided by 80 shares equals the original $100,000 per share). When life insurance proceeds are introduced to the equation, the proceeds increase the value of the company overall. From the company’s now higher value (which includes the life insurance proceeds), the former shareholder is redeemed.
It’s clear that the treatment of life insurance proceeds can have a dramatic impact on the shareholder who is being redeemed, the company’s remaining shareholders, and the company’s ability to fund the buyout of the shareholder. In the Connelly case, the company’s redemption obligation would have been underfunded by over $2M and it would have been on the hook to finance the remainder of the redemption on its own. Ultimately, the shareholders and the company should decide how to fund and value a shareholder redemption or buy-sell agreement, but there can be significant implications to how that’s accomplished.
While the Supreme Court opinion has significant impacts on how closely held businesses are valued and reported for estate tax purposes, one option discussed in the Connelly opinion is the use of cross-purchase agreements (where one party agrees to purchase the shares from the other) and each shareholder purchases life insurance on the other to fund the agreement. However, this too has its drawbacks, as each party would have to pay the premium for the insurance policy. With the Connelly decision, owners of privately held businesses should dust off their redemption (or buy-sell) agreements, understand the implications and funding mechanisms involved, and discuss it all with their team of trusted advisors.
If you have any questions about your redemption or buy-sell agreement or are interested in learning about how the value of your business may be impacted by the Connelly decision, please reach out to your BMSS professional for more information. You can reach us by calling (888) CPA-BMSS or visit our website for contact information.
[1] Shares, stock, or stockholders are being used as generic terms to represent ownership interest in privately held businesses. This can be in the form of shares of stock, an ownership interest in a partnership or limited liability company, partnership interest, LLC membership units or interest, etc.