A common use of life insurance is to fund buy-sell agreements. A case recently decided by the United States District Court for the Eastern District of Missouri, Thomas A. Connelly, Executor v. United States, illustrates the need to obtain expert advice when using this technique.
A buy-sell agreement is a tool used to maintain common ownership of a closely-held corporation. A closely-held business is one that has a small number of owners. Its stock is not publicly-traded but privately-held. Often, the owners are members of the same family. A buy-sell agreement provides that, when an owner desires to dispose of his or her shares, either the other shareholders will buy the shares or the corporation will redeem them. This frequently occurs upon the death of a shareholder.
A buy-sell agreement ensures that control of the corporation will remain with the existing shareholders or within the same family. Typically, a buy-sell agreement includes a methodology for determining the purchase price of the shares. Life insurance is the most common source of funding the transaction.
In the Connelly case, brothers, Thomas Connelly and Michael Connelly, were the sole shareholders of a corporation called Crown C Supply, Inc. Michael was the President and CEO, as well as the majority shareholder. Thomas and Michael entered into a Stock Purchase Agreement, which provided that, upon the death of one brother, the surviving brother would purchase the shares of the deceased brother. This is what we are calling a “buy-sell agreement”. The purpose of the agreement was twofold. First, it would ensure that control of the corporation remained with the surviving brother. Second, it would provide liquidity to the deceased brother’s family.
The agreement also provided that the corporation would redeem the shares if the surviving brother chose to not purchase them. This simply means that the corporation would purchase the shares of the deceased brother. Once the corporation acquired the shares of the deceased brother, those shares would no longer be outstanding. As a result, the surviving brother would become the owner of all issued and outstanding shares of the corporation; the same result as if the surviving brother had purchased the shares. The corporation bought life insurance on both brothers to fund its obligation to redeem the shares of the deceased brother.
Michael was the first of the brothers to die, and Thomas was appointed Executor of his estate. Upon Michael’s death, the corporation received life insurance proceeds of more than three million dollars. Thomas chose to not purchase Michael’s shares, so the corporation redeemed them. The corporation valued Michael’s shares at approximately three million dollars. There was some dispute whether the corporation used the methodology contained in the buy-sell agreement to reach that valuation. The corporation used the life insurance proceeds to redeem Michael’s shares.
Thomas, as Executor of Michael’s estate, filed a tax return and paid estate tax on the proceeds of the redemption. The IRS audited the Estate and determined that the Estate had undervalued Michael’s shares in the corporation, because it did not include the life insurance proceeds in its valuation. As a result, it assessed a deficiency against the Estate. The Estate paid the deficiency and brought this action for a refund.
The parties stipulated that the value of Michael’s shares, without regard to the life insurance proceeds, was the amount shown on the Estate’s tax return. So, if not for the life insurance proceeds, there would have been no deficiency in the tax paid by the Estate. But that is where the parties differed.
The Estate claimed that the insurance proceeds did not increase the value of Michael’s shares, because they were offset by a pre-existing obligation of the corporation. The IRS, on the other hand, claimed that, on the date of Michael’s death, the insurance proceeds became an asset of the corporation. As a result, the corporation had an extra $3m in cash that had to be reflected in the valuation of Michael’s shares.
The rules for valuing property for estate tax purposes are set forth in section 2703 of the Internal Revenue Code, which provides, in part, that:
(a) For purposes of this subtitle, the value of any property shall be determined without regard to –
(1) any option, agreement, or other right to acquire or use the property at a price less than the fair market value of the property . . . or
(2) any restriction on the right to sell or use such property.
This would seem to mean that the value of Michael’s shares must include the life insurance proceeds without regard to the corporation’s corresponding obligation to redeem the shares.
However, section 2703(b) provides that:
(b) Subsection (a) shall not apply to any option, agreement, right, or restriction which meets each of the following requirements:
(1) It is a bona fide business arrangement.
(2) It is not a device to transfer such property to members of the decedent’s family for less than full and adequate consideration in money or money’s worth.
(3) Its term are comparable to similar arrangements entered into by persons in an arms’ length transaction.
The treasury regulations added a couple of other requirements;
(1) The agreement must establish a fixed and determinable offering price.
(2) The agreement must be legally binding on the parties both during the life and after the death of the parties.
The issue for the court was whether the existence of the buy-sell agreement, which obligated the corporation to redeem Michael’s shares, should impact the valuation of the shares for estate tax purposes. Or, whether the value of Michael’s shares should include the insurance proceeds without regard to the corporation’s obligation to use the insurance proceeds to redeem the shares. In other words, did the buy-sell agreement satisfy the requirements of section 2703(b), so that the provisions of section 2073(a) could be ignored?
The first issue addressed by the court was whether the buy-sell agreement was a bona fide business arrangement. The answer to this question would depend, in part, upon whether there was a legitimate business purpose for the agreement. The court said that it is well-accepted that preserving family control over a business is a legitimate purpose for a buy-sell agreement. As a result, the court found that this factor would likely support the Estate’s position.
In order to give effect to a buy-sell agreement, it must not be a substitute for a testamentary transfer of property. In other words, it cannot be used as a device to avoid paying estate taxes. The fact that there may be a legitimate business purpose for a buy-sell agreement does not mean that it is not also a device to avoid a testamentary transfer of property. If the property is transferred for less than full consideration, that is evidence that the parties were simply seeking to avoid estate taxes.
In the instant case, the court found that the buy-sell agreement was a device to avoid the testamentary transfer of property. The court’s reasoning was a bit of sophistry. First, it stated that, on this issue, it was not required to decide whether the value of the corporation included the life insurance proceeds. Yet, it found that the Estate had understated the value of Michael’s shares by not including the life insurance proceeds. Further, the court found that ignoring the life insurance proceeds in determining the redemption price was evidence that Thomas and the Estate were using the buy-sell agreement as a testamentary device to avoid estate taxes.
The court’s reasoning is suspect. It claimed that excluding the life insurance proceeds from the valuation of the corporation enabled “Thomas to obtain a financial windfall at the expense of Michael’s estate”. However, the court overlooked a number of obvious facts. First, the corporation would never have owned the life insurance policy and received the proceeds if not for the buy-sell agreement. The life insurance was never intended to accrete to the value of the corporation. It was always intended to be paid out immediately upon receipt.
Second, the value of the corporation during the life of both brothers did not include the life insurance proceeds. The corporation could not access the proceeds until one of the brothers had died. An unrelated third-party making an offer for the shares of either or both brothers would not have included the life insurance proceeds in his offer. That would result in an overpayment.
Third, as far we know, Thomas was not Michael’s heir. He would not have been the object of Michael’s testamentary intentions. That would have been his Estate, and, upon Michael’s death, his Estate received a cash payment of $3m and paid taxes on that amount. It did not receive shares in the corporation, which, the court claimed, could have been sold for more than $3m. The result is the court imposed a phantom tax on the Estate. It determined that the estate tax should be paid on assets the Estate did not receive rather than on the asset that the Estate actually did receive.
By “comparable to similar arrangements”, the Code requires that a buy-sell agreement between family members be the same as an “arms’ length” transaction between unrelated parties. The court said that a corporation with unrelated shareholders would have included the life insurance proceeds in the redemption value of the stock.
The major problem with the court’s reasoning is that it provided no support for its position. Life insurance purchased to fund a buy-sell agreement is never considered an asset of the corporation. It is simply the funding mechanism to accomplish the legitimate business purpose of enabling the surviving shareholders to retain control of the corporation. This business purpose is just as legitimate for family members as it is for unrelated shareholders. And life insurance is used as frequently in buy-sell agreements between unrelated shareholders as it is in agreements between family members.
A buy-sell agreement must provide for a fixed and determinable price for the redemption of the shares. While the agreement in this case did provide a formula for determining the price, the problem was that the parties did not apply that formula. As a result, even if the redemption price established by Thomas and the Estate was fair, the court could not give effect to the buy-sell agreement
The court found that the buy-sell agreement was not binding during the life of the parties because it required an annual certification of the value of the shares. However, not once, while both brothers were alive, did they prepare the annual certification of value. Furthermore, the court found that it was not binding after Michael’s death, because the redemption price was not determined in accordance with the methodology contained in the agreement.
For the reasons discussed above, the court found that the value of Michael’s shares for estate tax purposes was not governed by the buy-sell agreement. Instead, the value was the “fair market value” of the shares. And here is where the court really went off the rails.
The court said that it was obligated to apply the “willing buyer” test. That required it to determine what a willing buyer would pay for the shares of the corporation. However, the court did not ask what a willing buyer would pay for the shares. It asked what a willing buyer would expect to get when it purchased the shares. And it found that, on the date of Michael’s death, the willing buyer would expect to own a corporation that had an extra $3m in the bank.
Further, the court said that a willing buyer would not reduce the value of Michael’s shares because of the redemption obligation. A buyer purchasing Michael’s shares would become the majority shareholder of the corporation. And, as majority shareholder, he could either cancel the redemption obligation or he would satisfy the obligation by paying himself.
What is most maddening about the court’s decision is that he ignored precedent established in 2005 by the United States Court of Appeals for the Eleventh Circuit in the case, Estate of Blount. In that case, the Appeals Court overruled the Tax Court and said that life insurance proceeds are never included in the valuation of a corporation when the proceeds are used for a redemption obligation.
The problem is that Missouri is in the Eighth Circuit, and decisions of another Circuit are not binding. So, the court was not obligated to follow the precedent establish by the Eleventh Circuit and was able to render a contrary result.
Life insurance is a valuable planning tool. People buy life insurance to protect their family in the event of an untimely death. It can be used to create a charitable legacy. It can be used to provide cash to pay estate taxes. And, notwithstanding the court’s decision in the Connelly case, it can be used to fund a buy-sell agreement. However, it must be done right, and to ensure that you follow the rules, it is vital to consult with a life insurance expert.