Certiorari Granted In Connelly

• Published date: 22 January 2024
• Subject Matter: Corporate/Commercial Law, Government, Public Sector, Litigation, Mediation & Arbitration, Tax, Corporate and Company Law, Constitutional & Administrative Law, Trials & Appeals & Compensation, Income Tax, Tax Authorities, Shareholders
• Law Firm: Carter Ledyard & Milburn
• Author: Richard B. Covey and Jerome Caulfield

A. Introduction

The certiorari application in Connelly v. Internal Revenue Service, 70 F.4^th 412 (8^th Cir. 2023), was granted by the Supreme Court on December 13, 2023. It commences as follows:

QUESTION PRESENTED

Closely held corporations often enter into agreements requiring the redemption of a shareholder's stock after the shareholder's death in order to preserve the closely held nature of the business. Corporations that enter such agreements often purchase life insurance on the shareholder in order to fund the transaction. The question presented is:

Whether the proceeds of a life-insurance policy taken out by a closely held corporation on a shareholder in order to facilitate the redemption of the shareholder's stock should be considered a corporate asset when calculating the value of the shareholder's shares for purposes of the federal estate tax.

The Eighth Circuit answered this question in the affirmative despite the fact that in earlier cases two other circuit courts had ruled to the contrary. Estate of Cartwright v. Comm'r, 183 F.3d 1034 (9th Cir. 1999); Estate of Blount v. Comm'r, 428 F.3d 1338 (11th Cir. 2005).

B. Treasury Regulation

Treas. Reg. '20.2031-2(f), dealing with valuation, states:

Where selling prices or bid and asked prices are unavailable. If the provisions of paragraphs (b), (c), and (d) of this section are inapplicable because actual sale prices and bona fide bid and asked prices are lacking, then the fair market value is to be determined by taking the following factors into consideration:

(1) In the case of corporate or other bonds, the soundness of the security, the interest yield, the date of maturity, and other relevant factors; and

(2) In the case of shares of stock, the company's net worth, prospective earning power and dividend-paying capacity, and other relevant factors.

Some of the "other relevant factors" referred to in subparagraphs (1) and (2) of this paragraph are: The good will of the business; the economic outlook in the particular industry; the company's position in the industry and its management; the degree of control of the business represented by the block of stock to be valued; and the values of securities of corporations engaged in the same or similar lines of business which are listed on a stock exchange. However, the weight to be accorded such comparisons or any other evidentiary factors considered in the determination of a value depends upon the facts of each case. In addition to the relevant factors described above, consideration shall also be given to nonoperating assets, including proceeds of life insurance policies payable to or for the benefit of the company, to the extent such nonoperating assets have not been taken into account in the determination of net worth, prospective earning power and dividend-earning capacity. Complete financial and other data upon which the valuation is based should be submitted with the return, including copies of reports of any examinations of the company made by accountants, engineers, or any technical experts as of or near the applicable valuation date.

The Eighth Circuit concluded that "an obligation to redeem shares is not a liability in the ordinary business sense." The language from the Treasury regulation does not specifically answer the question regarding inclusion.

C. Facts

Thomas and Michael Connelly were the owners of a closely-held building-materials company [Crown]. With the company, they entered into an agreement providing that the company would redeem the shares of whichever brother died first. Crown purchased $3.5 million in life insurance on each brother. After Michael died, his son and Thomas negotiated an agreed upon redemption price of $3 million for Michael's stock.

The parties in the case entered into stipulations during the District Court proceedings. First, they stipulated that under the agreement the brothers intended for Crown (rather than the surviving brother) to purchase the deceased brother's shares. They also stipulated that if the life insurance proceeds were not added to the total value of Crown, the fair market value of the estate's shares would be $3.1 million.

D. Reasoning of Connelly

The Blount decision cited above and relied on by the Eighth Circuit in Connelly said:

To establish the fair market value of BCC, the Tax Court blended the analyses of the experts to arrive at a value of $6.75 million. The IRS and the Taxpayer, albeit alternatively, agree that this is the base value for the assets and liabilities of BCC as of the date of Blount's death. We accept the accuracy of this value as not clearly erroneous. The Tax Court then added the insurance proceeds that BCC would receive on Blount's death to the value of the company, concluding that the value of BCC would have been $9.85 million. In doing so, the Tax Court erred.

In valuing the corporate stock, "consideration shall also be given to nonoperating assets, including proceeds of life insurance policies payable to or for the benefit of the company, to the extent that such nonoperating assets have not been taken into account in the determination of net worth." Treas. Reg. '20.2031-2(f)(2). The limiting phrase, "to the extent that such nonoperating assets have not been taken into account," however, precludes the inclusion of the insurance proceeds in this case. In Cartwright v. Commissioner, the Ninth Circuit approved deducting the insurance proceeds from the value of the organization when they were offset by an obligation to pay those proceeds to the estate in a stock buyout. 183 F.3d 1034, 1038 (9th Cir. 1999)⁵; see also Huntsman v. Comm'r, 66 T.C. 861, 875 (1976)⁶.

The rationale in Cartwright is persuasive and consistent with common business sense. BCC acquired the insurance policy for the sole purpose of funding its obligation to purchase Blount's shares in accordance with the stock-purchase agreement. Even when a stock-purchase agreement is inoperative for purposes of establishing the value of the company for tax purposes, the agreement remains an enforceable liability against the valued company, if state law fixes such an obligation.⁷ Here the law of Georgia required such a purchase. Thus, we conclude that the insurance proceeds are not the kind of ordinary nonoperating asset that should be included in the value of BCC under the treasury regulations. To the extent that the $3.1 million insurance proceeds cover only a portion of the Taxpayer's 83% interest in the $6.75 million company, the insurance proceeds are offset dollar-for-dollar by BCC's obligation to satisfy its contract with the decedent's estate. We conclude that such nonoperating "assets" should not be included in the fair market valuation of a company where, as here, there is an enforceable contractual obligation that offsets such assets. To suggest that a reasonably competent business person, interested in acquiring a company, would ignore a $3 million liability strains credulity and defies any sensible construct of fair market value.

E. Asserted Errors of Eighth Circuit Decision

The brief's analysis of why the decision is incorrect is as follows:

In this case, the court of appeals held that, despite an undisputed contractual obligation for a closely held corporation to use the proceeds of a life-insurance policy on one of its owners for the redemption of the owner's stock, those proceeds should be considered additional assets of the corporation for purposes of determining the fair market value of the stock. That decision was incorrect.

1. As this Court has explained, "a necessary first step in calculating the taxable estate for federal estate tax purposes is to determine the property included in the gross estate, and its value." Commissioner v. Estate of Hubert, 520 U.S 93,99-100 (1997). In order to determine the value of stock held as part of the gross estate, courts must apply the "willing buyer-willing seller test." United States v Cartwright, 411 U.S. 546, 551 (1973). Under that test, a court considers a hypothetical buyer who operates without compulsion and who possesses "reasonable knowledge of relevant facts." Ibid, (citing 26 C.F.R. 20.20314(b)).

In applying that test, a court considers not only a corporation's assets, but also its liabilities. See, e.g., Estate of Jelke v. Commissioner, 507 F.3d 1317,1331-1333 (11^thCir. 2007); Eisenberg v. Commissioner, 155 F.3d 50, 57 (2d Cir. 1998). Accordingly, as the relevant regulations confirm, a company's non-operating assets must be considered only to the extent they are not yet accounted for as part of the company's "net worth." 26 C.F.R. 20.2031-2(f)(2). Indeed, even the court of appeals appeared to accept the premise that nominal assets that are "directly offset" by a corresponding liability should not be considered when establishing the value of a corporation for estate-tax purposes. App., infra, 13a-15a.

If the court of appeals had properly applied those principles, it would have rejected the IRS's attempt to categorize the insurance proceeds as an additional corporate asset relevant to the valuation of Michael Connelly's estate. The court acknowledged that Crown obtained life insurance on Michael for the purpose of ensuring that, when he died, "the corporation could use the proceeds to redeem his shares." App., infra, 1a. The court also acknowledged that the corporation in fact used $3 million in insurance proceeds to purchase the estate's shares. See id. at 3a. And it acknowledged that, excluding consideration of the insurance proceeds, the estate's shares were worth approximately $3 million. See id. at 4a n.2.

In light of those undisputed facts, the court of appeals should have concluded that $3 million of the insurance proceeds was offset by the contractual obligation to use those proceeds to redeem Michael's stock. Put differently, because $3 million of the insurance proceeds were spoken for, the court should have held that those funds constituted a funding vehicle, rather than a genuine asset.

2. Rather than...