Supreme Court Connelly Ruling Shows Flaws of Taxpayer’s Argument

“This was an easy case after all.” That is the takeaway from the US Supreme Court’s unanimous decision in Connelly v. United States addressing the estate tax treatment of life insurance owned by a closely held corporation on its shareholders.

The case concerned a closely held business owned by two brothers, Michael Connelly (owning 77% interest) and Thomas Connelly (owning 23% interest). Following Michael’s death, the corporation used $3 million of proceeds it carried on Michael’s life to redeem his equity interest.

The question before the court concerned the value of the corporation to be used in determining the estate tax value of Michael’s shares—specifically whether the value of the corporation should include the $3 million insurance proceeds or whether those proceeds should be offset by a liability in the same amount on account of the redemption obligation.

The opinion wasn’t long on traditional legal analysis. The court summarized relevant statutes and regulations principally by way of background, and focused instead on critical determinations that could be described as factual or logical.

The court started by pointing out the obvious: “[A] share redemption at fair market value does not affect any shareholder’s economic interest.” Hence, the contractual redemption obligation didn’t amount to a traditional liability that reduced the corporation’s net worth for purposes of valuing Michael’s interest.

The opinion further made a critical framing determination: The estate-tax value of Michael’s shares was properly determined by reference to the corporation at the moment of his death—that is, as the corporation existed prior to the redemption of Michael’s shares.

The court highlighted the logical flaw in the taxpayer’s position that Michael’s percentage interest in the corporation should be valued by reference to the entity post-redemption, noting that the taxpayer’s argument couldn’t be squared with “an elementary understanding” of a stock redemption.

The short, straightforward, and crisp opinion of the Supreme Court in Connelly belies the considerable degree of consternation conveyed by the justices at oral argument regarding proper resolution of the case.

That consternation likely resulted from the superficial appeal of the taxpayer’s argument. The insurance proceeds didn’t come into existence until the fact of Michael’s death, and those proceeds were earmarked to redeem his interest when received. Given the transitory nature of the insurance proceeds in the corporate coffers, perhaps they should be disregarded for purposes of valuing Michael’s shares.

Yet, as the court recognized, the taxpayer’s argument yielded anomalous results—one being that the net worth of the corporation remained the same both before and after the redemption of its majority shareholder. Once one sees the logical flaws in the taxpayer’s position, they can’t be unseen.

What does the Connelly decision mean in terms of planning? Probably not much.

Prior to the decision of the federal district court and the US Court of Appeals for the Eighth Circuit in Connelly, taxpayers could point to the contrary resolution of the issue in Estate of Blount v. Commissioner and Estate of Cartwright v. Commissioner to argue that corporate-owned insurance proceeds weren’t taken into account when valuing a deceased shareholder’s stock holdings. (That position effectively permits the transfer of the insurance proceeds to other shareholders free of estate taxation.) However, whether parties were relying on these decisions by intentionally combining corporate-owned insurance with mandatory redemption obligations is another matter.

In any case, the Supreme Court closed the door on this planning opportunity through its decision in Connelly. By doing so, the court ensured that shareholders of closely held companies that carry life insurance on its owners will be treated the same for estate tax valuation purposes—regardless of whether the entity redeems their shares, their estates sell their shares to other owners, or they simply pass their shares directly on to other family members.

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

Brant J. Hellwig is professor of tax law and faculty director of the graduate tax program at New York University School of Law.

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