The U.S. Supreme Court issued a plethora of impactful decisions in its last term. One that might have flown under the radar had to do with estate taxes. Though topic of taxes does not normally make for engaging content, this just might be an exception. If you are a business owner (or are related to one), you might be impacted, so please read on.
Now that the hook is out there, let’s turn to the topic: estate taxes and succession planning. Before jumping into the specific case, a breakdown of some of the applicable concepts might be helpful.
Privately-held companies commonly have Buy-Sell Agreements, which set the rules for what happens to a shareholder’s shares in certain situations, such as the death of the shareholder. It is common for these Buy-Sell Agreements to require the company to “redeem” (read “buy back”) the shareholders shares. To pay the redemption price on a shareholder’s shares, companies will oftentimes take out “Key Person Insurance,” which is a life insurance policy on the life of each of its shareholders (or at least its major shareholders). It sounds gruesome, but redemptions can be expensive, and companies often decide it is more affordable to pay premiums on life insurance policies than leave enough of a financial cushion to redeem a shareholder on short notice.
Finally, when a shareholder dies, the value of their shares are reported on the tax return for their estate. That value is supposed to be based on a fair-market valuation of the company. The first $13.61 million of an estate can be transferred without federal estate taxes (yes, you are reading that correctly), and any assets of the estate above that amount are transferred subject to estate tax.
With that quick concept crash course, we can turn our focus to the case: Connelly v. United States. The case involves Michael Connelly, who was a majority shareholder of Crown C Supply, a building supply company Mr. Connelly owned with his brother. When Mr. Connelly died in 2013, his shares in Crown C became subject to redemption under the company’s Buy-Sell Agreement, and the company funded the redemption through a Key Person policy the company took out on Mr. Connelly’s life. The company and Mr. Connelly’s estate agreed on a company valuation that excluded the life insurance money, and the estate reported the value of the shares at $3 million according to that valuation.
The IRS audited the estate, and it determined that the proper valuation should have included the money from the life insurance, which raised the valuation to about $6 million. This increased valuation caused the total value Mr. Connelly’s estate to rise high enough that his estate owed estate taxes (the threshold was $5.25 million in 2013). The Supreme Court’s opinion agreed with the IRS. In its opinion, the Court essentially explained that the insurance money was part of the valuation of the company, despite the Buy-Sell Agreement creating an obligation for the company to pay that money out to the estate.
So now we have the context of the concepts and the case, but what does this mean for the business owners? Tune in next week to read more. Until next week, thanks for reading!