A latest case demonstrates the affect {that a} stock-purchase settlement and life insurance coverage can have (or not have) on the valuation of a carefully held firm for property tax functions.

Earlier than diving into the case, some context is useful. It isn’t unusual for carefully held companies to have buy-sell agreements. In lots of cases, the opposite house owners are the principle market to promote your shares while you exit, and that exit could embrace demise. Thus, these agreements can present for a “cross-purchase” choice, which signifies that the opposite house owners buy the exiting proprietor’s curiosity. An alternative choice is a redemption, which signifies that that the enterprise purchases (redeems) the exiting proprietor’s curiosity.

As a part of these agreements, there may be usually a value setting mechanism (to find out the buyout value). For property tax functions, if the decedent owned an curiosity within the enterprise, that worth is included within the gross property. A essential difficulty then arises of whether or not the value set by the buyout settlement is binding for property tax functions. That difficulty is resolved by § 2703 and is mentioned extra beneath. Virtually, the house owners additionally need a liquidity supply to assist pay for the buyout; which may be achieved by life insurance coverage.

Particularly, this case explores when a court docket will respect an settlement beneath § 2703, and the way the presence of life insurance coverage proceeds have an effect on the valuation of the corporate for property tax functions.

With that context, let’s get to the case.

Within the case, two brothers had been the only real shareholders of an organization; one brother owned about 77% of the corporate and the opposite brother owned the remaining. The brothers had a stock-purchase settlement. Beneath the settlement, upon the demise of a brother, the surviving brother might buy the shares. If the surviving brother opted to not, the corporate needed to redeem the shares. As properly, the company bought life insurance coverage on the brothers in order that the coverage proceeds might be used to fund such a redemption. The aim of this planning, after all, was to make sure that management would keep inside the household. Furthermore, in keeping with the court docket, the brothers supposed the corporate to effectuate the redemption, somewhat than a surviving brother effectuating the cross-purchase choice.

Beneath the stock-purchase settlement, there have been two methods to find out the redemption value. The primary technique was that, on the finish of every tax yr, the brothers would agree to cost per share in a “Certificates of Agreed Worth.” And, if such annual settlement didn’t happen, the settlement required two or extra value determinations. Nevertheless, the brothers didn’t do both of those choices. Regardless of that, the corporate bought $3.5 million of life insurance coverage on every brother.

The bulk-owner brother died in 2013. After his demise, the corporate obtained the life insurance coverage proceeds and redeemed his shares for $3.0 million, the value of which was resolved by the household with none appraisal. The remaining life insurance coverage proceeds ($500,000) was used for company operations.

On the brother’s property tax return, the shares within the firm had been valued at $3 million—the value of the redemption cost. Upon an audit, the Service concluded that the property undervalued the corporate by counting on the redemption cost as an alternative of valuing the corporate and together with the worth of the life insurance coverage proceeds as a company asset. The IRS decided that the corporate was price about $6.86 million. Particularly, the IRS valued the deceased brother’s shares at $2,982,000, unique of the life insurance coverage. Given his 77.18% possession, this represents an organization worth of $3.86 million. It then added the $3 million in proceeds for the redemption. Importantly, the court docket famous that the property didn’t problem the “sans-proceeds” valuation on attraction, and thus accepted it for functions of the attraction.

Primarily based on the IRS’s valuation, then, the deceased brother had a 77.18% curiosity in a $6.86 million firm, which means the curiosity was price about $5.3 million. The IRS despatched a discover of deficiency for the extra tax. After paying the deficiency, the property sued for a refund. The district court docket granted abstract judgment for the federal government, which the property appealed to the Eighth Circuit.

The property superior two arguments. The primary was that the redemption transaction, beneath the stock-purchase settlement, set the value for estate-tax functions, and subsequently no valuation was wanted. The second argument was that the valuation mustn’t embrace the life insurance coverage proceeds as a result of though the proceeds could have represented an asset, they had been offset by the redemption obligation, which was a legal responsibility. For its half, the federal government countered that the stock-purchase settlement must be disregarded. It additionally argued that any calculation of honest market worth should account for the insurance coverage proceeds.

Undoubtedly, the brother’s gross property included his company shares (see § 2033). Thus, the true difficulty within the case is the correct valuation of these shares. And, extra acutely, the problem is concerning the inclusion of the life insurance coverage proceeds as a part of that valuation.

The court docket first thought-about whether or not the stock-purchase settlement managed the valuation of the corporate for estate-tax functions. Beneath § 2703(a), the worth of property is set with out regard to “any choice, settlement, or different proper to amass or use the property at a value lower than the honest market worth of the property (with out regard to such choice, settlement, or proper)” and “any restriction on the fitting to promote or use such property.” In different phrases, § 2703(a) primarily says to disregard the stock-purchase settlement, except sure standards are met, that are set forth in subsection (b). Beneath subsection (b), the settlement should meet three necessities. First, it have to be a “bona fide enterprise association.” Second, it should not be a “gadget to switch such property to members of the decedent’s household for lower than full and ample consideration in cash or cash’s price.” And third, “[i]ts phrases are corresponding to related preparations entered into by individuals in an arms’ size transaction.”

The property argued that its stock-purchase settlement glad these standards. The court docket, nonetheless, disagreed. The court docket famous that the settlement was lacking a essential part, particularly a hard and fast or determinable value to think about for valuing the shares. As defined by the court docket, “if § 2703 tells us after we could ‘regard’ agreements to amass inventory ‘at a value lower than the honest market worth,’ we naturally would anticipate these agreements to say one thing about worth in a particular or calculable method.”

Right here, the court docket emphasised that the stock-purchase settlement set forth no mounted value and even prescribed a method for figuring out a value. Slightly, the settlement set forth two methods by which the brothers could have agreed to a value. And, the court docket, rejected the property’s entreaty to repair the value by the redemption transaction as a result of it linked again to the stock-purchase settlement. On this vein, the court docket famous that the value was chosen after the demise, and, furthermore, that value got here not from the acquisition settlement, however somewhat the household’s settlement to resolve estate-administration issues.

In sum, for the primary difficulty, the court docket decided that the company’s worth have to be decided with out regard to the stock-purchase settlement beneath § 2703(a).

The court docket then turned to the second difficulty, which it framed as “whether or not the life insurance coverage proceeds obtained by [the company] and supposed for redemption must be taken into consideration when figuring out the company’s worth on the time of [the brother’s] demise.”

Amongst different issues, the court docket famous that, in valuing a carefully held company, the Treasury Laws present that “consideration shall even be given to nonoperating belongings, together with proceeds of life insurance coverage insurance policies payable to or for the good thing about the corporate, to the extent such nonoperating belongings haven’t been taken into consideration within the willpower of web price, potential incomes energy and dividend-earning capability.” 26 C.F.R. § 20.2031-2(f)(2)

As talked about earlier, the property argued that the life insurance coverage proceeds didn’t increase the corporate’s worth as a result of the proceeds had been offset by the redemption legal responsibility. The court docket, nonetheless, defined that “[a]n obligation to redeem shares isn’t a legal responsibility within the extraordinary enterprise sense.” To take action, it continued, would distort the character of the possession curiosity. In an instance, the court docket famous that, on the brother’s demise, a keen purchaser might get hold of all of the shares after which simply extinguish the settlement or redeem the shares from himself. The court docket mentioned this “is rather like shifting cash from one pocket to a different.” In different phrases, the court docket defined “[t]right here is not any legal responsibility to be thought-about—the client controls the life insurance coverage proceeds.” As utilized right here, the court docket defined {that a} purchaser would pay $6.86 million, which takes into consideration the life insurance coverage proceeds, after which might extinguish or redeem. The court docket moreover famous that “a hypothetical keen vendor of [the company] holding all 500 shares wouldn’t settle for solely $3.86 million understanding that the corporate was about to obtain $3 million in life insurance coverage proceeds, even when these proceeds had been supposed to redeem a portion of the vendor’s personal shares.” Solely accepting $3.86 million, the court docket continued, can be to disregard the anticipated life insurance coverage proceeds.

Lastly, the court docket thought-about one other thought experiment. To worth the corporate with out the life insurance coverage proceeds, every share can be price $7,720 earlier than the redemption. However, after the redemption and the redeemed curiosity is extinguished, the shares can be about $33,800 every, representing full management of the corporate. Thus, “[o]vernight and with none materials change to the corporate, [the surviving brother’s] shares would have quadrupled in worth.”

In sum, the court docket decided that “[t]he proceeds had been merely an asset that elevated shareholders’ fairness. A good market worth of [the deceased brother’s] shares should account for that actuality.”

In reaching this resolution, the court docket disagreed with the Eleventh Circuit’s resolution in Property of Blount v. Comm’r, 428 F.3d 1338 (eleventh Cir. 2005), which held that company insurance coverage proceeds to fund an compulsory buy obligation had been offset by that legal responsibility and subsequently needn’t be included within the firm’s worth.

The case is Connelly v. United States, No. 21-3683 (eighth Cir. June 2, 2023). You possibly can learn the case right here.

That is solely a abstract of the case and a few parts—together with information, points, or evaluation—could have been omitted or edited; should you want recommendation on this space, please evaluate the case in its entirety and seek the advice of an legal professional.