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 corporate property that increases the company's value for estate tax calculations? Or is it simply a pre-existing liability that the company has to meet in order to purchase shares from the estate of a deceased shareholder?

That was the question before the US Supreme Court this week in Connolly v. US

When Michael Connolly died in 2013, his brother and business partner, Thomas, used a life insurance policy from the company's company for Michael, so that Thomas could be sold to the St. Louis firm, Crown C. Corp. So that I can get permission to buy my brother's shares. estate.

This was a fairly simple stock-purchase agreement and was somewhat of a standard arrangement because the construction materials company Crown had obtained a life insurance policy for each brother as security for the exact situation he had tragically encountered.

The purchase price for each share was determined “in as amicable and expeditious a manner as possible” by mutual agreement between Thomas and Michael's successor, his son Michael Connolly Jr. and they agreed that the stock was valued at $3 million. This valued the entire company at $3.89 million, based on Michael's 77% stake.

In 2014, the estate filed a tax return stating that Michael's shares were worth $3 million based on the redemption payment. This resulted in property taxes of approximately $300,000, which were paid.

Not so fast, according to the Internal Revenue Service, which concluded that $3 million in stock inflated the company's value by nearly $7 million and that $1 million was owed in property taxes.

Connolly paid the amount but filed for a refund and filed a lawsuit when the IRS refused. Lower courts sided with the tax collector and the case went to the US Supreme Court, where arguments were heard on Wednesday.

Lower court decisions were described as 'wrong'

Connolly's lawyer, Kannan K. Shanmugam told the judges that the lower court's rulings were “wrong”.

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

The lawyer said that IRS statutes fail to distinguish between a contractual obligation to redeem stock on the one hand, and a voluntary stock redemption on the other.

“From the government's point of view the valuation of the deceased's shares would be inflated and would effectively lead to double taxation,” he said. “Taking into account one side of the transaction but ignoring the other for wealth tax purposes would be a disregard for common sense. “And it would destroy a valuable succession planning tool that the nation’s small businesses have freely used for decades.”

However, Justice Clarence Thomas said that the value of the shares must be accounted for somewhere.

“Does it go into the value of the remaining stock?” He asked. “And if it's there, why isn't the fair valuation $6.86 million?”

A case of double counting?

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

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

However, Justice Elena Kagan said the problem with Connolly's approach is that his asset, his stake in the company's ownership, quadrupled in value without investing even a cent more in the company.

“It shows that your way of calculating is wrong that someone can bring in four times the value of the company without investing a single penny,” he said.

Shanmugam completely disagreed with this.

Income 'eliminates liability'

“It is true that Thomas is the beneficiary of the life insurance proceeds in a real sense,” he said. “But those earnings offset the compensation obligation on the books. Now the government complains…capital gains tax only applies to realizations, so when someone dies and passes the stock there is a stepped-up basis. But these are all features of the capital gains tax system. There is nothing wrong with our situation. Our position is absolutely logical because the tax system captures that growth.”

Not surprisingly, the government said the estate's valuation of Michael Connelly's shares “contradicts basic mathematics and valuation theory.” As 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 government lawyer Yaira Dubin.

“The principle of property is that before you can value something, you first have to subtract the price paid for the thing you're trying to value,” she said. “This makes no sense. By using itemized, you are trying to price the property as a line item in your own appraisal, it will never give you the right answer, and it will also make the property the right answer here. does not. The opposite view of property is based on a fundamental misunderstanding of the nature of the redemption obligation.

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

“Debt owed to creditors reduces corporate and shareholder value,” he said. “A redemption obligation divides the corporate share among existing shareholders without changing the value of their interests. “And the value of the corporate pie here was $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 to receive the shares.

“So, it's a wash,” he said.

Is the redemption obligation a loan or a liability?

But the government argues that the logic would depend on the assumption that the redemption obligation is a debt or liability.

“And that's just not right,” Dubin said. It is “a promise to redeem one of the shares of an existing shareholder. This is not the same as having a mortgage or other debt outstanding on the corporation, which would reduce the value of the company and the value to its shareholders. This is not true of the redemption obligation.”

Dubin also refuted the notion that the government is “double dipping”.

“If these shares had been redeemed at the fair market value, which is $5.3 million, there would be no risk of double taxation,” he said. “In a transaction that was done at fair market value, you would have seen $5.3 million go to Michael's estate, subject to estate tax, and not subject to any possibility of future taxation through capital gains on Thomas. Will be.”

Justice Brett Kavanaugh was skeptical of the government's position, saying that the entire purpose of purchasing life insurance was to guarantee continuity and not to devalue the company's net worth.

“You might say they just messed up, but the whole purpose of a life insurance policy was to make sure that didn't happen,” he said. “It's strange to walk away the day after their death with a company whose value is suddenly 50 percent of what it was the day before their death, even if you bought a life insurance policy to cover the redemption.”

It is not known when the court will decide on this issue.

Doug Bailey is a journalist and freelance writer based out of Boston. can be reached (email protected),