Cautionary Tale #12: The Supreme Court Decides a Business Valuation

What happens when the IRS tries to get more money from a small business owner and loses in the lower courts? They appeal to the Supreme Court. In the case of Connelly vs. the United States, they won, and won unanimously, leading to an additional tax bill of $889,914. So, how did this happen?

The Facts of the Case

The “Connelly” in the name of the case above referred to Michael and Thomas Connelly, two brothers who owned Crown C Supply Company. They had taken the time to create a buy-sell agreement to make sure that the business stayed in the family when one of them died. In this particular case, upon the death of one brother, the other would have the option to purchase the deceased brother’s shares. If the brother declined, the company (Crown) was required to buy the shares.

The share price would be determined either by a Certificate of Agreed Value executed annually by agreement of the parties or through two or more written appraisals. The agreement also authorized Crown to purchase life insurance on the lives of the shareholders, the proceeds of which could be used to pay for the purchase. Michael Connelly took out $3.5M on his life and assigned the policy to Crown, and Crown took out a policy on Thomas Connelly for the same amount.

This all sounds good and we would have been applauding as business advisors up to this point. The catch? Michael and Thomas did not appraise the business at the time of the execution of this business and they did not execute a Certificate of Agreed Value every year. And as we always say, if you don’t do a key part of the paperwork at the time of an agreement, the chances of you doing it down the line decrease exponentially.

What Happened Next

Michael died in 2013 with a majority interest in Crown. Thomas declined to purchase the shares. Crown then used $3M of the $3.5M in insurance proceeds to purchase the shares from Michael’s estate. Thomas, who was also the executor of Michael’s estate, filed an estate tax return reporting the value of Michael’s stock at $3M, which was an amount agreed to by Michael’s son and Thomas.

The IRS audited the estate tax return and noted that this $3M was not supported by a qualified appraisal. This led to a report submitted to the IRS by Thomas valuing Michael’s shares at $3.86M. This included the $500k of life insurance proceeds that were not used for the redemption of Michael’s shares, but also excluded the $3M that was used to purchase stock from Michael’s estate.

Stay with us here: this procedure was itself advised by a case called Estate of Blount v. Commissioner in which insurance proceeds were properly deducted from the value of a corporation when “offset by an obligation to pay those proceeds to the estate in a stock buyout.”

The IRS concluded that the entire $3.5M of insurance proceeds needed to be added to the value of Crown. That put the value of the business up to $6.86M, of which Michael’s shares were worth $5M, leaving the estate with a fresh additional tax bill of $889,914.

The Court Rules

The Court held that the obligation in this particular buy/sell agreement was not a liability that decreased the net value of Crown by the amount of the life insurance used to purchase the shares. The Court concluded that a corporation’s obligation to redeem shares at fair market value does not reduce the value of the shares, hence any buyer of Michael’s shares would expect to receive the fair market value of those shares, which in this case included an extra $3.5M.

New Rules, New Practices

So, now that we have a new Supreme Court ruling, we need to adjust our planning accordingly:

• Get a valuation of your business sooner rather than later. Do not wait for a health event or death.
• Review any of your existing buy/sell agreements in relation to share price for estate tax purposes.
• Consider other options than the brothers used, for example a “cross-purchase” agreement in which each shareholder owns a policy on the other, with proceeds used to buy a shareholder’s interest, or a special purpose LLC, which could be owned by the shareholders and used to hold the life insurance policies.

Surprised by this Supreme Court ruling and wondering if your buy/sell agreements are up to snuff? Give us a call. We’d love to look them over with you.