Supreme Court finds life insurance proceeds increase estate value

In a unanimous decision, the Supreme Court ruled for the IRS and against a taxpayer arguing that life insurance proceeds reduced the value of a family business for estate tax purposes.

The June 6 outcome in Connelly v. Internal Revenue Service came in as expected, after justices displayed skepticism in the March arguments that a late brother's estate paid $889,914 in erroneous extra taxes based on the proceeds of a life insurance policy requiring a small building supply corporation to purchase the deceased shareholder's stake in the firm. Financial advisors, tax professionals and their clients are also waiting on a ruling in another case involving personal finance, Moore v. U.S., that experts say appears likely to result in a decision upholding the status quo rather than upending current policy.

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In the life insurance and estate planning case, the court concluded that "the corporation's obligation to redeem [the late brother's] shares" was not "a liability that decreased the value of those shares," Justice Clarence Thomas wrote in the opinion for the court. The decision affirmed a lower court ruling that conflicted with a previous case cited by the taxpayer as their precedent for valuing the company at a lower amount due to the life insurance policy.

"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," Thomas wrote. "A corporation's contractual obligation to redeem shares at fair market value does not reduce the value of those shares in and of itself."

Noting that the plaintiff "asserts that affirming the decision below will make succession planning more difficult for closely held corporations," Thomas sounded like an advisor or tax professional explaining that the extra taxes were "simply a consequence of how the Connelly brothers chose to structure their agreement." The family had other potential methods, he pointed out.

"The brothers could have used a cross-purchase agreement — an arrangement in which shareholders agree to purchase each other's shares at death and purchase life-insurance policies on each other to fund the agreement," Thomas wrote.

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"A cross-purchase agreement would have allowed [the surviving brother] to purchase [the late brother's] shares and keep [the business] in the family, while avoiding the risk that the insurance proceeds would increase the value of [the late brother's] shares," he continued. "The proceeds would have gone directly to [the surviving brother] — not to [the business]. But, every arrangement has its own drawbacks. A cross-purchase agreement would have required each brother to pay the premiums for the insurance policy on the other brother, creating a risk that one of them would be unable to do so. And, it would have had its own tax consequences."

While the case drew industry notice based on its potential impact to estate planning if the court had ruled for the plaintiffs, the decision to back the IRS position won't carry the same level of reverberation, according to SCOTUSBlog writer Ronald Mann.

"I doubt this decision will have a major impact on the estate tax burden on the owners of closely held corporations," he wrote. "Even the court — certainly not the last word on creative tax planning — suggests a variety of mitigating strategies, and I have every reason to think that the highly skilled tax planners of our economy will find a way to solve this problem, either by transactional design or by an appropriate amendment of the tax code."