Taxes punish success. They are a consequence of hard work or, in some cases, ingenuity. Even seemingly common business transactions can trigger this type of punishment, and the consequences can be sizeable.
This is especially true when it comes to the Federal estate tax. The tax itself can amount to 40% of the value of the estate assets. If a business transaction inadvertently doubles how the assets are counted for tax purposes, the tax can approach 80%.
The recent case of Connelley v. United States, No. 21-3683 (8th Cir. 2023), illustrates how this can happen. It involves two brothers who intended to transfer their corporation to the surviving brother upon the death of one of them. While they achieved their goal, they also triggered more tax than they had hoped for.
Facts & Procedural History
This case involves two brothers who owned a C corporation. The corporation executed a buy-sell agreement. The buy-sell agreement stated that when one brother died, the surviving brother had the right to buy the shares of the corporation. If the survivor failed to do so, the corporation had to redeem the shares.
The terms of the buy-sell agreement also said that the purchase price was to be determined each year by mutual agreement or by an annual appraisal. The brothers never obtained an appraisal.
The brothers decided to fund the buy-sell agreement with a $3.5 million dollar life insurance policy. The policy was owned by the corporation.
One of the brothers died in 2013 and the corporation received the $3.5 million dollar proceeds. The brother’s estate was settled, and an agreement was reached whereby $3 million was determined to be the value of the shares owned by the brother who died. Thus, $3 million dollars was paid from the corporation to the estate.
The estate filed an estate tax return reporting the corporate stock with a $3 million dollar valuation. The IRS audited the estate tax return and determined that the business was worth $3 million dollars more as it owned the life insurance policy. This resulted in an increase in the estate tax liablity. This court case was an appeal of the district court, which upheld the IRS’s determination.
About Buy-Sell Agreements
A buy-sell agreement is a legal contract, commonly used by owners of closely held businesses to transfer their ownership interest to their successors. It is an agreement a business owner can enter into now that provides for the future sale of their business interest.
Under the terms of a buy-sell agreement, the buyer is legally obligated to buy the interest in the business from the owner’s estate, and the owner’s estate is legally obligated to sell the business interest at their death. The buyer can be a business partner, the business itself, or another party.
Why is a Buy-Sell Agreement Essential?
A buy-sell agreement provides for the orderly transfer of your business when a business owner dies. The absence of a buy-sell agreement can lead to significant complications for an estate and put the business in jeopardy.
When an owner of a business passes away and there is no buy-sell agreement or other governing agreement, the impact on the business depends on the legal form of the business entity.
Here’s an explanation of what typically happens in different business forms:
- Sole Proprietorship: In the case of a sole proprietorship, the business is directly tied to the owner. Upon the owner’s death, the business is legally terminated by operation of law. Employees do not have the authority to continue the operations. However, the executor of the owner’s estate can continue the business and may be personally liable to the beneficiaries of the estate for any losses incurred during the continuation of the business.
- Partnership: In a partnership, the death of a partner usually leads to the dissolution of the partnership. The surviving partner(s) become responsible for winding up the business and liquidating its assets. This can lead to disputes between the remaining partners and the executor, particularly if the business is one of the largest assets in the estate.
- Professional Entity: Ownership of a professional entity is typically restricted to members of the same profession. As a result, heirs or the personal representative of the deceased owner’s estate may not be able to assume ownership of the stock in the professional entity, which can mean that the business operations immediately terminate leaving the executor in the position of trying to abruptly close the business and issuing client refunds.
- Corporation, LLC: A corporation or LLC, as a separate legal entity, does not terminate upon the death of an owner. However, the loss of an owner can disrupt the operations of the corporation or LLC and leave no one with authority to manage the business, which often results in the business closing or being sold for nominal value.
This is why a buy-sell agreement is often needed.
Benefits of a Buy-Sell Agreement
A well-drafted buy-sell agreement acts as a comprehensive plan that addresses vital aspects of the transfer, including:
- Ownership Succession: Clearly outlines how the business ownership will be transferred and who can acquire the deceased owner’s share.
- Valuation: Establishes a fair and objective method for determining the value of the business interest, minimizing potential disputes among surviving owners, beneficiaries, and the estate.
- Funding Mechanisms: Identifies the financial resources available to fund the purchase of the deceased owner’s interest, ensuring a smooth transition without placing an undue financial burden on the business or surviving owners.
- Estate Liquidity: Provides the necessary liquidity to the estate, enabling the fair distribution of assets and payment of estate taxes without the need to sell the business or other valuable assets.
- Family & Business Harmony: Helps prevent conflicts among family members, co-owners, or beneficiaries by establishing a clear plan that respects everyone’s interests and intentions.
As explained below, these goals may not always be realized–particuarly when estate taxes are at play.
About the Estate Tax
The Federal estate tax can kill small businesses. It is a tax imposed on the transfer of property from a deceased person to their beneficiaries. It is a tax levied on the value of the decedent’s estate at the time of their death. This differs from the income tax, for example, which is a tax on the receipt of income.
The estate tax applies to a relatively small number of estates each year, as it only affects estates that exceed a certain threshold, known as the estate tax exemption. This exemption amount is subject to change and has fluctuated quite a bit over the years. Any estate value above the exemption threshold is subject to taxation at a specific rate, which also varies depending on the total value of the estate.
To calculate the taxable value of an estate, a few deductions and exclusions are allowed. These deductions are few and far between. For example, there are deductions for funeral expenses, debts, and charitable contributions made by the decedent.
There are even a few exclusion rules. For example, some assets, such as those passing to a surviving spouse or qualified charitable organizations, may be excluded from the taxable estate.
This is why estate taxes are all about valuation. The higher the value of the assets, the higher the estate tax due. If the increased tax results in a tax balance, the IRS even has special collection tools for estate taxes.
Corporate-Owned Life Insurance & Estate Taxes
For estate tax purposes, Section 2042 says that the gross estate includes life insurance proceeds received by the estate and other beneficiaries under policies, but only if the decedent had ownership rights at the time of death.
Treasury regulation § 20.2042-1(c)(6) says that a decedent’s possession of incidents of ownership described in Section 2042 does not arise simply due to their status as a controlling shareholder in a corporation that owns and benefits from the policy.
Therefore, life insurance policies and their proceeds owned by a corporation, as in this case, would not be included in the estate of the shareholder when they die.
This leads to the question of whether the owner of the life insurance policy increases the value of the corporation shares, as there is no doubt that the corporation shares are included in the estate. This is what the district and appeals courts address in this case.
Corporate Life Insurance & Value of the Corporation
The appeals court starts the analysis of a similar case from another appeals court:
We must therefore consider the value of the life insurance proceeds intended for redemption insofar as they have not already been taken into account in Crown’s valuation and in light of the willing buyer/seller test. In this sense, the parties agree that this case presents the same fair-market-value issue as Estate of Blount v. Commissioner, 428 F.3d at 1345-46, from the Eleventh Circuit. But they disagree on whether Blount was correctly decided. Like here, Blount involved a stock-purchase agreement for a closely held corporation. Although the court referenced the requirement in 26 C.F.R. § 20.2031-2(f)(2) that proceeds be “taken into account,” it concluded that the life insurance proceeds had been accounted for by the redemption obligation, which a willing buyer would consider. 428 F.3d at 1345. In balance-sheet terms, the court viewed the life insurance proceeds as an “asset” directly offset by the “liability” to redeem shares, yielding zero effect on the company’s value. The court summarized its conclusion with an appeal to the willing buyer/seller concept: “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.” Id. at 1346
The appeals court in this case goes on to explain why it beleives the the Blount case was incorrect.
Blount‘s flaw lies in its premise. An obligation to redeem shares is not a liability in the ordinary business sense. See 6A Fletcher Cyclopedia of the Law of Corporations § 2859 (Sept. 2022 update) (“The redemption of stock is a reduction of surplus, not the satisfaction of a liability.”). Treating it so “distorts the nature of the ownership interest represented by those shares.” See Est. of Blount v. Comm’r, 87 T.C.M. (CCH) 1303, 1319 (2004), aff’d in part and rev’d in part, 428 F.3d at 1338. Consider the willing buyer at the time of Michael’s death. To own Crown outright, the buyer must obtain all its shares. At that point, he could then extinguish the stock-purchase agreement or redeem the shares from himself. This is just like moving money from one pocket to another. There is no liability to be considered—the buyer controls the life insurance proceeds. A buyer of Crown would therefore pay up to $6.86 million, having “taken into account” the life insurance proceeds, and extinguish or redeem as desired. See 26 C.F.R. § 20.2031-2(f)(2). On the flip side, a hypothetical willing seller of Crown holding all 500 shares would not accept only $3.86 million knowing that the company was about to receive $3 million in life insurance proceeds, even if those proceeds were intended to redeem a portion of the seller’s own shares. To accept $3.86 million would be to ignore, instead of “take into account,” the anticipated life insurance proceeds. See id.
The appeals court reasoning is based on there being a single owner, so the original buy-sell agreement had two owners and one dies, leaving the surviving owner able to void the requirement to redeem the interest. The court’s reasoning would also not apply if the obligation was irrevocable, even by one party. This could be accomplished by the language in the buy-sell agreement. There a myriad of other ways to plan for this too–such as incorporating an irrevocable trust. These are issues that can even be implemented after death while administering the probate estate.
Regardless, there is now a split in the circuits on this issue. Those incorporating buy-sell agreements into their estate plans should factor this decision into their planning.
This case highlights the importance of incorporating a well-drafted buy-sell agreement into estate planning for closely held businesses. A buy-sell agreement provides for the orderly transfer of business ownership and helps prevent complications upon the death of an owner. It can establish a fair method for determining the value of the business interest and ensure adequate funding for the purchase of the deceased owner’s share. However, absent careful planning, it may inadvertently increase the estate taxes that are due to the IRS as it did in this case.