In June, the Eighth Circuit Court of Appeals issued its opinion in Connelly v. United States (1) creating a split with the Eleventh Circuit on whether life insurance proceeds should be included in a fair market value determination of closely held stock owned by a decedent. In each case, the shares were subject to a stock redemption agreement funded by insurance on the life of the decedent, payable to the company. Although the agreements included mechanisms fixing the value of the stock, both courts disregarded them and instead attempted to determine the stock’s fair market value. In doing so, the courts diverged on whether an obligation to redeem stock is a legitimate liability that offsets the dollar value of the insurance proceeds.
Before addressing the cases, it is worth reviewing the rules. For a buy-sell agreement to control the Federal Estate Tax value of closely held stock, the agreement must meet several requirements under section 2703 of the Internal Revenue Code of 1986, as amended (the “IRC”). Under IRC §2703(a), the value of property for Federal Estate Tax purposes will 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 (without regard to such option, agreement, or right), or (2) any restriction on the right to sell or use such property. However, IRC §2703(a) will not apply to any option, agreement, right, or restriction that meets each of the following requirements under IRC §2703(b): (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; and (3) its terms are comparable to similar arrangements entered into at arm’s length.
Treasury Regulation (“Treas. Reg.”) §20.2031-2 governs the valuation of stocks and bonds for Federal Estate Tax purposes. Under Treas. Reg. §20.2031-2(f)(2), the value of a closely held company may include life insurance proceeds payable to or for the benefit of the company “to the extent such nonoperating assets have not been taken into account in the determination of net worth, prospective earning power and dividend-earning capacity.” As discussed later, reasonable minds will disagree on the meaning of this language.
Treas. Reg. §20.2031-2(h) addresses the valuation of securities subject to an option or contract to purchase (such as a buy-sell agreement) and should be interpreted “in tandem” with IRC §2703.2 The stated price in a buy-sell will control for Federal Estate Tax purposes where (1) the price is determinable from the agreement, (2) the terms of the agreement are binding in life and death, (3) the agreement is legally binding and enforceable, and (3) the agreement was entered into for bona fide business reasons and is not a testamentary substitute intended to pass on the decedent’s interests for less than full and adequate consideration.(3)
In 2005, the Eleventh Circuit decided Blount v. C.I.R. (4) In that matter, Jennings and Blount, the two shareholders of Blount Construction Company (“BCC”), entered into a stock-purchase agreement with BCC that obligated the company to purchase the stock of a shareholder on that shareholder’s death at a price agreed upon by the parties or, in the event there was no agreement, for a purchase price based on the book value of the company. BCC purchased $3 million insurance policies on the lives of the shareholders to finance the buyback. When Jennings died, BCC purchased his shares from his estate based on the company’s book value in the previous year. Blount was then in complete control of the company.
Thereafter, Blount and BCC executed an amendment to the stock-purchase agreement that required BCC to purchase Blount’s shares from his estate for $4 million after his death. The amended agreement did not provide for any future adjustments to this price. After Blount died, BCC paid his estate $4 million for his shares, and Blount’s Federal Estate Tax Return reported the value of the shares at $4 million. Since Blount was able to unilaterally modify the agreement, the IRS and the Tax Court found it was not binding on him or his estate and should therefore be set aside.5 In determining the fair market value of his estate’s shares, the Tax Court added the insurance proceeds to BCC’s other assets.
The Eleventh Circuit affirmed the Tax Court’s decision to disregard the stock-purchase agreement, but reversed the decision to include the life insurance proceeds in the business valuation. The value of the insurance proceeds was, in the Court’s opinion, offset by the obligation to pay Blount’s estate in the stock buyback. Citing Treas. Reg. §20.2031-2(f)(2), the panel found the phrase “to the extent that such nonoperating assets have not been taken into account” precluded the inclusion of the insurance proceeds in valuation of the company. The life insurance payout was “taken into account” by the company’s obligation to purchase Blount’s stock and was therefore “offset dollar-for-dollar.” Even though the buy-sell agreement was disregarded for valuation purposes, it was still an enforceable liability against the company and could therefore offset the insurance proceeds on the company balance sheet.
Connelly presented a similar fact pattern. Brothers Michael and Thomas Connelly were the sole shareholders of Crown C Corporation (“Crown”), with Michael owning a 77.18% majority stake. Under a stock-purchase agreement, if one brother died, the surviving brother had a right of first refusal to purchase the decedent’s shares. If the surviving brother declined, Crown was obligated to redeem the shares. Crown purchased $3.5 million life insurance policies on both Michael and Thomas.
The Crown stock-purchase agreement provided two mechanisms for valuing the shares. First, the brothers were to execute a “Certificate of Agreed Value” at the end of every tax year, setting the price per share by “mutual agreement.” In the absence of mutual agreement, the brothers were directed to obtain two or more appraisals of fair market value. The brothers failed to actually perform either valuation method.
When Michael died, Crown purchased Michael’s shares from his estate for $3 million. That amount arose from a separate agreement between the estate and Michael’s son, not from the stock-purchase agreement. No appraisals were obtained to arrive at this figure. On Michael’s Federal Estate Tax Return, his executor relied solely on the redemption payment and valued the Crown shares at $3.0 million.
After an audit, the IRS disregarded the stock-purchase agreement and found the estate had undervalued Michael’s shares by only using the $3.0 million redemption payment and not considering the actual fair market value of the company, which included the life insurance proceeds. The IRS concluded that the company was worth $6.86 million and Michael’s estate’s 77.18% stake was therefore worth about $5.3 million. Michael’s estate paid the deficiency and sued for a refund.
The estate argued the company’s obligation to buy the shares was an enforceable obligation that offset the life insurance proceeds. The District Court disagreed, holding that a stock redemption agreement is “not an ordinary corporate liability.” Therefore, a proper valuation of Crown must treat the insurance proceeds like a company asset with no offsetting liability.
The Eighth Circuit affirmed. First, it found that the stock-purchase agreement had no bearing on the valuation of Michael’s shares because the brothers failed to follow the prescribed methods for determining value (i.e., executing certificates of agreed value by “mutual agreement” or obtaining independent appraisals). The Court disfavored the certificate of value method because it was nothing more than “an agreement to agree.” Interestingly, the Court also suggested that following the agreement and obtaining an independent appraisal would have been insufficient because the agreement failed to “fix[] or prescribe[] a formula or measure for determining the price that the appraisers will reach.” Even if the valuation mechanisms were valid, Michael and Thomas failed to actually perform them, and Michael’s estate reported a stock value based on an unrelated agreement with a beneficiary. Therefore, the Court disregarded the stock-purchase agreement under IRC §2703(a) and undertook to determine fair market value.
Blountly (6) rejecting the Eleventh Circuit, the Eighth Circuit found that Crown’s obligations under the stock-purchase agreement did not offset the life insurance proceeds. The two courts split on their interpretation of Treas. Reg. §20.2031-2(f)(2), which, as stated above, in determining the estate tax value of closely held stock, excludes life insurance proceeds that have already been “taken into account in the determination of net worth.” According to Connelly, the insurance policy was not “taken into account” because the “redemption of stock is a reduction of surplus, not the satisfaction of a liability.” The Eighth Circuit draws a categorical distinction between a corporate liability and an agreement to redeem shares, while the Eleventh Circuit does not.
Connelly offers this illustration: If a willing buyer purchased all the shares of Crown, the buyer could then “extinguish the stock-purchase agreement or redeem the shares from himself. This is just like moving money from one pocket to another. There is no liability to be considered – the buyer controls the life insurance proceeds.” Whether the buyer chooses to extinguish the agreement or actually redeem the shares, the buyer ends up with a company worth $6.86 million. Further, the Court noted that a willing seller would not accept $3.86 million for a company about to receive a $3 million influx of cash. Therefore, the Court determined that the stock-purchase agreement was not a true liability of the company.
A petition for writ of certiorari in Connelly was filed on August 16, 2023. A Supreme Court opinion settling this disagreement would provide clarity to our practice. Whichever way this shakes out, careful consideration of IRC §2703 and the §2031 Treasury Regulations is crucial when drafting a buy-sell agreement of any type.
Key Takeaways:
If the IRS disregards a buy-sell agreement in a Federal Estate Tax audit, it may attempt to appraise the value of closely held stock. Appellate courts have disagreed about whether life insurance proceeds should be included in that valuation. This uncertainty can be avoided by using a properly drafted buy-sell agreement.
A buy-sell agreement should be respected for Federal Estate Tax purposes if (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; and (3) its terms are comparable to similar arrangements entered into at arm’s length. The agreement should have real economic effect other than the minimization of taxes.
The valuation mechanism in the contract should be more than just an “agreement to agree” and should instead be tied to an objective measure (e.g., independent appraisals or periodic adjustments based on a formula).
Ensure that the client and all counterparties are actually following through with the valuation mechanisms stated in the agreement.
Andrew J. Barron is an associate in the Trusts, Estates, & Personal Planning group at Stradley Ronon Stevens & Young, LLP. Andrew represents high-net-worth individuals in all aspects of estate, trust, and tax planning. He also represents fiduciaries in the administration of trusts and estates.
(1) 70 F.4th 412 (2023).
(2) Connelly, 70 F.4th at 417.
(3) Estate of True v. C.I.R., 390 F.3d 1210, 1218 (10th Cir. 2004).
(4) 428 F.3d 1338 (11th Cir. 2005).
(5) See Treas. Reg. § 20.2031-2(h) (“Little weight will be accorded a price contained in an option or contract under which the decedent is free to dispose of the underlying securities at any price he chooses during his lifetime.”)
(6) Sorry.