In the Supreme Court case Connelly vs. United States, Justice Thomas delivered the opinion of the unanimous court in favor of the United States, while stating the unfavorable result to the taxpayer was a consequence of how the parties chose to structure their stock purchase agreement. Below are the key points of this landmark decision:
Case Overview:
- Parties Involved: Brothers Michael and Thomas Connelly were sole shareholders in Crown C Supply, a supplier of exterior remodeling products located in St. Louis, MO.
- Stock Purchase Agreement: In the event of the death of one of the brothers, the surviving brother would have the option to purchase the deceased brother’s shares. If declined, the Company would be required to redeem the shares. Upon Michael’s death, Thomas elected not to purchase the shares. Michael’s son (representing the Estate) and Thomas (representing the Company) agreed to a purchase price of $3.0 million for Michael’s shares. The $3.0 million value was reported on the tax return for the Estate.
- Life Insurance Proceeds: The stock purchase agreement stipulated that life insurance proceeds were to be used to fund the redemption of Michael’s shares upon his death.
- Business Valuation: A third-party business valuation was performed determining the value of Michael’s shares at approximately $3.0 million dollars. However, the valuation excluded the life insurance proceeds on the premise that the amount would be offset by the Company’s obligation to redeem the shares.
- IRS Position: The IRS argued the life insurance proceeds should be included in the value of the Company, but the off-setting redemption obligation should be excluded. This higher valuation resulted in an $889,914 estate tax deficiency.
- Supreme Court Ruling: The Supreme Court ruled in favor of the United States stating, “a corporation’s contractual obligation to redeem shares is not necessarily a liability that reduces a corporation’s value for purposes of the federal estate tax.”
This case offers crucial lessons for business owners, underscoring the necessity of precise and unambiguous language in buy-sell agreements and the importance of share redemption’s alignment with fair market values to ensure compliance with tax regulations. Business owners should proactively engage legal, insurance, and valuation experts to draft, review, and regularly update buy-sell agreements, ensuring they accurately reflect current market conditions and legal standards. By doing so, they can protect their business interests, ensure legal compliance, and avoid costly consequences. If you are interested in business valuation services, Seidel Schroeder can help.
Contact Amber Widener, CPA/ABV, ASA I partner
979.251.6721
awidener@ssccpa.com