Company-Owned Life Insurance Proceeds are Taxable
Brothers Michael and Thomas Connelly were the sole shareholders of a corporation. The corporation obtained life insurance on each brother so that if one died, the corporation would have ready cash to redeem his shares without impairing the company operations. A buy-sell agreement was in place, giving each brother the right to buy the other’s shares at death, and the corporation would redeem the shares if the survivor declined to purchase. Although the agreement included a mechanism for valuing the shares, it was never used.
Michael died first, and the company received $3.5 million of life insurance proceeds. The corporation redeemed the shares for $3 million in an amicable agreement, and Michael’s interest in the business was valued at the same $3 million on the federal estate tax return. A $300,000 estate tax was timely paid, likely out of the remaining $500,000 of proceeds.
Upon audit, the IRS disagreed with the valuation of the company. The $3.5 million must be added to the value of the company, as it was a company asset. That brought the total value of the company to $6.86 million. Michael had owned 77.18% of the company, so the estate tax value of his interest came to about $5.3 million. That meant another $1 million in estate taxes were due. Where that money was to come from was not a concern of the IRS.
In Court, the estate argued that the value of the company was controlled by the shareholder’s agreement, and although the insurance proceeds were a corporate asset they were offset by the obligation on the company to proceed with the redemption. The arguments were unavailing, first in the District Court, then in the Eighth Circuit Court of Appeals, and now, finally, in the U.S. Supreme Court. The Court held unanimously that life insurance proceeds must be included in valuing the company for estate tax purposes, and that a redemption agreement in this case did not reduce the value of the company, even though it drained the company of available cash.
Owners of small businesses need to schedule an early conference with their estate planning advisors to assess the impact of this decision on their planning. Cross purchase agreements, in which each shareholder owns life insurance on the other shareholders, should not be adversely affected, but that arrangement has its own drawbacks. Owners of very small businesses that are below the federal estate tax threshold have less to be concerned about, but even in that situation using life insurance to fund a redemption will raise issues regarding the value of the company and the basis of inherited interests.
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