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By Eaton Vance on Washington

Without much ado, the U.S. Supreme Court ruled in favor of the Internal Revenue Service (IRS), agreeing that a corporation's obligation to redeem a deceased shareholder's position under a stock redemption does not offset any includable corporate-owned life insurance proceeds when calculating the value of the corporation for estate tax purposes.

The unanimous decision in Connelly v. United States centered on a closely held business, Crown C Supply, a building supply corporation, solely owned by two brothers, Michael Connelly (77% stake) and Thomas Connelly (23% stake). After Michael died, the corporation used $3 million of proceeds it carried on his life to redeem his equity interest.

"The dispute in this case is narrow. All agree that, when calculating the federal estate tax, the value of a decedent's shares in a closely held corporation must reflect the corporation's fair market value. And, all agree that life insurance proceeds payable to a corporation are an asset that increases the corporation's fair market value. The only question is whether Crown's contractual obligation to redeem Michael's shares at fair market value offsets the value of life-insurance proceeds committed to funding that redemption," the high court wrote in a June 6 decision.

The brothers used a buy-sell agreement to ensure the business stayed in the family, allowing the surviving brother to buy the deceased brother's shares. Thomas declined to buy Michael's shares, forcing Crown to redeem them using the $3 million life insurance proceeds. While the estate reported the shares' value at $3 million, the IRS valued them at $5.3 million, including the value of the company. Including life insurance proceeds in the corporation's valuation created an additional estate tax liability of $889,914.

The decision sheds light on the need for other small business owners to scrutinize the nuance of buy-sell agreements and consider the estate tax liabilities, as well as life insurance policies. Closely held corporations, especially those with only two owners, may consider alternatives, such as a cross-purchase buy-sell agreement, in which each co-owner buys a life insurance policy on the life of the other co-owner, pays the annual premium, and is the beneficiary of the policy.

Bottom line: Owners of closely held family businesses must carefully consider estate planning, insurance products, and the potential tax implications of all corporate agreements. It is always essential to speak with your financial and tax planning advisers to ensure you have the best succession plan in place.