Supreme Court takes on life insurance as a corporate asset

Should the proceeds of a life insurance policy taken out by a corporation on a shareholder be considered a corporate asset that raises the value of the company for calculating estate taxes? Or are they simply a pre-existing liability the company has to meet to purchase the shares from the estate of a deceased shareholder?

That was the question facing the U.S. Supreme Court this week in the case of Connolly vs. U.S.

When Michael Connolly died in 2013, his brother and business partner, Thomas, invoked a life insurance policy the company had on Michael to allow Thomas to purchase his brother’s shares in the firm, Crown C. Corp., of St. Louis, from his estate.

It was a fairly simple stock-purchase agreement and a somewhat standard one as Crown, a building materials company, had obtained a life insurance policy on each brother as protection for exactly the circumstance with which it was tragically confronted.

The purchase price for each share was determined by mutual agreement between Thomas and Michael’s heir, his son Michael Connolly Jr., in “an amicable and expeditious manner as is possible” and they agreed the value of the stock was $3 million. That put the value of the entire company, based on Michael’s 77% share, at $3.89 million.

In 2014, the estate filed a tax return reporting that Michael’s shares were worth $3 million, relying on the redemption payment. This resulted in an estate tax of about $300,000, which was paid.

Not so fast, according to the Internal Revenue Service, which concluded the $3 million in stock raised the company’s value to nearly $7 million and another $1 million was owed in estate taxes.

Connolly paid the amount but filed for a refund and then sued when the IRS refused. The lower courts sided with the tax collector and the case went all the way to the U.S. Supreme Court, which heard arguments on Wednesday.

Lower court decisions called 'erroneous'

Connolly’s attorney, Kannon K. Shanmugam, told the justices that the lower court decisions were “erroneous.”

“Because the proceeds from a life insurance policy to fulfill a contractual redemption obligation do not increase the corporation's net worth, they do not increase the estate tax owed on the decedent's stock,” he said. “The legal framework governing this case is relatively straightforward.”

The attorney said the IRS methods fail to distinguish between a contractual obligation to redeem stock on the one hand and a voluntary stock redemption on the other.

“The government's approach would lead to a grossly inflated valuation of the decedent's shares, and it would effectively lead to double taxation,” he said. “It would defy common sense to take one side of the transaction into account but to ignore the other for purposes of the estate tax. And it would destroy a valuable succession planning tool that the nation's small businesses have openly used for decades.”

Justice Clarence Thomas, however, said the value of the shares must be accounted for someplace.

“Does it go into the value of the remaining stocks?” he asked. “And if it is there, why isn't the appropriate valuation $6.86 million?”

A case of double-counting?

Shanmugam responded that the government was trying to account for the insurance proceeds twice: once when calculating the estate tax – because the IRS wants to tax at the higher amount – and again when subjecting Thomas Connolly to capital gains taxes.

“In our view, this is the fundamental problem with the government's approach, and that is why this is effectively double taxation,” he said.

Justice Elena Kagan, however, said the problem with Connolly’s approach is that his asset, his share of the company’s ownership, quadrupled in value without him putting a single cent more into the company.

“It's a tell that your way of calculating the thing is wrong that somebody can come away with four times the value without putting a single cent into the company,” she said.

Shanmugam strongly disagreed.

Proceeds 'extinguish' liability

“It is true that Thomas is in a very real sense is the beneficiary of the life insurance proceeds,” he said. “But those proceeds extinguish the offsetting liability on the books. Now the government complains…the capital gains tax only operates upon realization, so there is a stepped-up basis when someone dies and passes the stock along. But those are all features of the capital gains tax system. That is not a bug with our position. Our position is the rational one precisely because the tax system captures that increase.”

The government, not surprisingly, said the estate's evaluation of Michael Connelly's shares “contradicts basic math and valuation principle.” According to the estate, “before we can value Michael's shares in Crown, we must first subtract the price that Crown paid for Michael's shares,” said the government’s attorney Yaira Dubin.

“The estate's theory is that before you can value something, you must first subtract the price paid for the very thing you are trying to value,” she said. “That makes no sense. Using the item, you're trying to value as a line item in its own valuation will never give you the correct answer, and it doesn't give the estate the right answer here either. The estate's contrary view rests on a fundamental misunderstanding of the nature of a redemption obligation.”

Dubin said a redemption obligation is not a corporate debt that reduces a corporation's net worth or the value of the shares to be redeemed.

“A debt owed to creditors reduces corporate and shareholder value,” she said. “A redemption obligation divides the corporate pie among existing shareholders without changing the value of their interests. And here the corporate pie was worth $6.86 million, not $3.86 million.”

But Justice Williams pointed out that the company received insurance proceeds of $3.5 million and paid it out to receive the shares.

“So, it’s a wash,” he said.

Is redemption obligation debt or liability?

But the government contends that argument would depend on the notion that the redemption obligation is a debt or liability.

“And that's just not correct,” Dubin said. It’s “a promise to cash out one of the existing shareholder's shares. It is not the same thing as the corporation owing a mortgage or some other debt, which would reduce the value of the company and the value for its shareholders. That is simply not true of a redemption obligation.”

Dubin also pooh-poohed the notion that the government was “double dipping.”

“Had these shares been redeemed for fair market value, which is $5.3 million, there would be no risk of double taxation,” she said. “In a transaction that was done at fair market value you would have had $5.3 million go to Michael's estate, be subject to the estate tax, and never be subject to any possibility of future taxation through capital gains on Thomas.”

Justice Brett Kavanaugh seemed be skeptical of the government’s position, saying the whole purpose of buying the life insurance was to guarantee continuity and not devalue the company’s net worth.

“Maybe you say they just messed up, but the whole purpose of the life insurance policy was to make sure that didn't happen,” he said. “It's weird to walk away the day after his death with a company that's suddenly worth 50 percent of what it had been worth the day before his death, even though you bought a life insurance policy to cover the redemption.”

It’s not known when the court will decide the issue.

Doug Bailey is a journalist and freelance writer who lives outside of Boston. He can be reached at [email protected].

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Doug Bailey is a journalist and freelance writer who lives outside of Boston. He can be reached at [email protected].