High Court’s Estate Tax Refund Denial Shuts Down Avoidance Method

In Connelly v. United States, the US Supreme Court resolved a circuit split on how to value a decedent’s interest in a closely held corporation in cases where a redemption obligation is disregarded under Section 2703 of the tax code.

The court held that taxpayers who failed to satisfy Section 2703’s requirements couldn’t offset non-operating assets with such obligations, thus reducing the corporation’s value and, derivatively, the value of the decedent’s shares. The decision prevents shareholders from artificially reducing the value of a decedent’s shares by simply agreeing that shares will be redeemed upon death.

The Supreme Court affirmed the earlier decision of the US Court of Appeals for the Eighth Circuit, which ruled in 2023 that redemption obligations don’t offset corporate assets when valuing a corporation for estate tax purposes and therefore don’t affect the value of a decedent’s shares.

The court determined that redemption obligations differ from other kinds of corporate liabilities and that allowing redemption obligations to offset corporate assets would lead to illogical results—e.g., that 23% of the corporation would be worth than 77% of the corporation, and the corporation wouldn’t shrink as a result of the redemption.

It further noted that offsetting corporate assets with a redemption obligation valued the post-redemption company—not a company in which the decedent’s shares were outstanding.

In its opinion, the court focused on the nature of redemption obligations and the logical consequences of either reducing corporation value on account of redemption obligations or not doing so. As often happens in tax cases, the decision was more of a policy discussion focused on tax logic than statutory analysis or an investigation into the meaning of—or appropriate weight to give—administrative guidance.

Many Supreme Court decisions focus on the plain meaning of the constitutional or statutory text, the original understanding of specific terms, or alleged historical practices. While this does happen in tax cases, as often as not, the court focuses on the tax code’s underlying theory and logic. This approach is particularly prevalent in situations where taxpayers seek to evade or reduce taxes in ways at odds with the tax system’s goals, like in Connelly.

The court also side-stepped the petitioner’s argument that life insurance proceeds obtained to fund a redemption were somehow different from other kinds of corporate assets because they allegedly only pass through the corporation.

Such a rule would have created an unprincipled and unwarranted tax advantage for insurance-funded redemptions. Instead, the court made clear that life insurance policies are no different from other corporate assets. That they may have been obtained to redeem shares and even contractually obligated for that purpose simply isn’t relevant to the analysis.

The court further dispatched the petitioner’s argument that its valuation should be upheld because the shareholders could have achieved the same post-redemption results and avoided the tax liability by structuring the transaction differently.

As the court noted, structuring the transaction differently would have imposed different legal rights and risks, warranting different treatment, implicitly following the long-standing rule that taxpayers are normally bound by the form of the transaction they chose.

Despite the clear government victory that appears to close the door on any future litigation, the court included a curious footnote toward the end of its decision, noting that a redemption obligation could affect corporate value if a redemption caused the corporation to liquidate operating assets. If the redemption were large enough, liquidating such assets could affect the corporation’s earning capacity, which in turn could affect its value going forward.

This wouldn’t occur if the corporation obtained life insurance to fund the redemption, as was the case in Connelly and the Eleventh Circuit decision in Estate of Blount that redemption obligations reduce corporate value and the value of a decedent’s shares. The court in effect suggests a possible tax benefit for redemptions not funded with life insurance or other non-operating assets, the obverse of petitioner’s proposal.

The court offers no opinion as to how it might rule in such a case. However, liquidating operating assets would affect the value of the remaining shareholder’s interests post-redemption—not the interest of the deceased shareholder in the pre-redemption company.

Although not at issue in Connelly, allowing a redemption obligation to reduce the value of the deceased shareholder’s interest in such cases would further facilitate the kind of tax evasion Section 2703 was designed to prevent. But as the court noted, that is a question for another day.

The case is Connelly v. United States, U.S., No. 23-146, Opinion 6/6/24.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Adam Chodorow is professor of law at Arizona State University’s Sandra Day O’Connor College of Law.

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