By Mark Fischer and Ron Lefebvre
Our firm represents many closely-held businesses. Such entities often use life insurance to fund the buyout of an owner’s interests upon death. A recent decision of the United States Supreme Court should cause these small companies to review their current use of life insurance to fund such repurchases.
In Connelly vs. United States, the Court examined such an arrangement. Here, two brothers (Michael and Thomas) were the sole shareholders of a company. To ensure that the company would stay in the family if either brother died, they entered an agreement whereby each brother had the right to purchase the deceased brother’s shares; and if the surviving brother declined, the company would redeem such shares. To fund the company redemption, the company obtained a $3.5 million life insurance policy on each brother.
When Michael died, Thomas declined the purchase option. The company received the $3.5 million life insurance proceeds, and Thomas and Michael’s estate agreed that the shares were worth $3 million. Such amount was paid by the company to Michael’s estate, using the life insurance proceeds, and reported on the estate’s inheritance tax return.
The IRS, however, audited the return. In connection with this audit, the company hired an analyst who determined that the company was worth $3.86 million at the time of Michael’s death, which determination supported Thomas’s and the company’s agreement that Michael’s 77.18% interest in the company was worth approximately $3 million. In making this determination, the analyst excluded the $3 million paid to Michael’s estate from the estate’s assets.
The IRS disagreed with the analyst, arguing that the company’s redemption obligation did not offset the life insurance proceeds. Instead, it contended that the $3 million must be included in the company’s valuation, which would make the company worth $6.86 million (and Michael’s interest approximately $5.3 million). As a result, the IRS found that the estate owed an additional $889,914 in taxes.
The Supreme Court agreed with the IRS in a unanimous decision, holding that “[a]n 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.”
To illustrate its point, the Court provided this example:
A simple example proves the point. Consider a corporation with one asset—$10 million in cash—and two shareholders, A and B, who own 80 and 20 shares respectively. Each individual share is worth $100,000 ($10 million ÷ 100 shares). So, A’s shares are worth $8 million (80 shares x $100,000)and B’s shares are worth $2 million (20 shares x $100,000). To redeem B’s shares at fair market value, the corporation would thus have to pay B $2 million. After the redemption, A would be the sole shareholder in a corporation worth $8 million and with 80 outstanding shares. A’s shares would still be worth $100,000 each ($8 million ÷ 80 shares). Economically, the redemption would have no impact on either shareholder. The value of the shareholders’ interests after the redemption—A’s 80 shares and B’s $2 million in cash—would be equal to the value of their respective interests in the corporation before the redemption. Thus, a corporation’s contractual obligation to redeem shares at fair market value does not reduce the value of those shares in and of itself.
The result of this decision is to make it more difficult for small businesses to use life insurance for fair market value redemptions, given the significant tax consequences described above. In light of Connelly, businesses should review their buy-sell and other repurchase arrangements, particularly with respect to the use of life insurance and the tax consequences of such arrangements.
As the Connelly Court suggested, it is possible that a cross-purchase agreement could be used, where the owners agree to repurchase each other’s shares in the event of death and where they each hold life insurance policies on each other to fund the purchase. In this way, the insurance proceeds never become assets of the company. The owners, however, would need to address the funding of these policies and ensure that one owner does not default on the obligation to maintain the policies.
Please contact our firm if you would like assistance in reviewing these issues.
YMFZ is a closely-held Pittsburgh law firm which for more than 30 years has been offering good counsel, personal attention, and cost-effective representation to its clients for all manner of business legal needs, including commercial litigation, business set-up and finance, commercial and technology contracting (including bank representation), employment law, real estate (including oil and gas), and intellectual property. YMFZ clients include both large national and multi-national corporations and regional and local businesses. For more information on our firm, please visit www.ymfzlaw.com.