Circuit Court Decides Results in Business Valuation Quandary

Eighth Circuit Decision Creates Uncertainty as To the Effect on Company Value of Company-Owned Life Insurance Acquired to Fund a Share Redemption Obligation

Introduction:

Business owners often enter into agreements amongst themselves giving options, or imposing obligations, to purchase one another’s company equity interests (whether shares of stock of a corporation, or units of businesses organized as limited liability companies) upon the occurrence of certain triggering events (such as death of an equity owner, retirement, termination of employment, disability, etc.).  Typically such agreements provide a mechanism for determining the price at which the equity interests will transfer.  If the agreement provides for a company redemption of shares upon a triggering event and one such triggering event is the death of an equity owner, the business which will have the redemption obligation upon death often acquires life insurance on equity owners to provide a source of funds to pay for the shares to be redeemed.  

Such an arrangement was entered into by brothers Michael and Thomas Connolly and their company, Crown C Supply, Inc.  Issues related to the implementation of this arrangement and whether life insurance owned by company was to be included in the company value determination with no offset attributable to the obligations for which the insurance was acquired were contested by the IRS upon Michael’s death, and the District Court to which the matter was submitted agreed with the IRS position – resulting in a split amongst the courts of two circuits.  Given the additional uncertainty resulting from this decision and the split in circuit court treatment – now is a good time to consider the effect of such an arrangement on company business valuations.

Facts:

Brothers Michael and Thomas Connolly were the sole shareholders of Crown C Supply, Inc. (the “Company”), a building materials supplier.  Michael owned 385.9 shares of the total outstanding 500 shares (so, Michael’s interest constituted 77.18% of the outstanding shares), and Thomas owned the remaining 114.1 shares (22.82%).

Michael and Thomas and the Company entered into a Stock Purchase Agreement (which may be referred to below as the “SPA”) in 2000 in order to maintain family ownership of the Company and to satisfy their estate planning objectives.  The terms of the SPA provided that upon the death of a shareholder, the surviving shareholder was granted the option to purchase the decedent’s shares at a price determined in accordance with the agreement. If the surviving shareholder elected not to exercise that option, the Company was required to redeem the shares at that same price. For purposes of determining the value of a share pursuant to the agreement, the shareholders were to annually execute a Certificate of Value stipulating the per share value.  In the event they failed to annually stipulate a value, the value of the Company (and its shares) was to be determined by appraisal.  The Company owned insurance on the life of each shareholder to fund any share redemption obligation which might arise as the result of a shareholder’s death. The Company, therefore, owned life insurance insuring Michael with a death benefit of $3.5 million dollars.  Michael died in October, 2013, survived by Thomas, who elected not to exercise the purchase option granted to him under the SPA relating to Michael’s Company shares.  The Company was therefore required to redeem Michael’s shares at a price which was to be directed by the SPA using the proceeds from the life insurance to fund the redemption obligation.

A fair market value of $3 million was used for the redemption price. Certificates of Value had never been executed by the shareholders as contemplated by the SPA, and the redemption price was not determined by appraisal but was instead estimated by Company executives, principally Thomas (who had also been named as the representative of Michael’s estate).  For purposes of determining the $3 million stock value, the life insurance owned by the company on Michael’s life was not included given the redemption obligation which would require use of those funds, consistent with the treatment of corporate owned insurance proceeds in the 11^th Circuit Court of Appeals decision in the Blount case (Estate of Blount v. Commissioner, 428 F.3d 1338 (11^th Cir. 2005)).

An estate tax return was filed for Michael’s estate reporting $3 million as the value of Michael’s stock.  The IRS then audited Michael’s estate tax return submission and, as a result, disputed and challenged the reported valuation of Michael’s stock on the basis that (1) the stock purchase agreement and the valuation provisions contained therein should be ignored, and (2) the death benefit of the life insurance owned by the Company on Michael’s life should have been included when valuing the Company and its stock, with no offset to reflect the redemption obligation.

District Court Consideration:

The dispute was initially submitted to the US District Court for the Eastern District of Missouri.  The District Court in that case addressed two principal disputed issues. The first was whether the Company’s stock purchase agreement governed the value of shares owned by a decedent shareholder upon that shareholder’s death. The second issue was whether life insurance owned by the Company which was purchased to fund the redemption of a deceased shareholder’s shares as required by the SPA was includable in the value of the Company when determining the per share value for estate tax purposes.

For purposes of determining whether the SPA governed the calculation of a per share value, the court undertook an analysis applying Internal Revenue Code Sections 2703 and 2031 (and the related Treasury Regulations) to the presented facts and circumstances.  Section 2703(a) provides that, generally, the value of any property for tax purposes is determined “without regard to any option, agreement, or other right to acquire … the property at a price less than the fair market value” or without regard to “any other restriction on the right to sell or use such property”. Section 2703(a) requires that such agreements be disregarded unless they meet the 3 prong exemption criteria of Section 2703(b).  

IRC Section 2703(b) specifies a 3 part test which must be met for an agreement to qualify as an exemption to the general rule of 2703(a).  Each of the 3 parts of 2703(b) must be met in order to qualify as an exemption.  The three parts to the 2703(b) test require that an Agreement (1) must be a bona fide business arrangement; (2) must not be a device to transfer interests to family members for less than full consideration; and (3) must be comparable to similar arrangements entered into by persons in an arm’s length transaction.  The District Court determined that the Connolly arrangement failed prongs 2 and 3 of the 2703(b) test and focused on prong (2), concluding that the agreement was essentially testamentary in nature in that a bargain price was used for the redemption creating a windfall for the surviving owner and that the pricing mechanisms provided for by the Agreement were never followed (no Certifications of Value were ever prepared and no appraisal was ever undertaken).  As a result of its 2703(b) analysis, the District Court determined that the Agreement was to be disregarded under 2703(a).

The Court supplemented its IRC §2703 analysis by considering whether the SPA pricing terms would pass muster under IRC §2031.  IRC §2031 requires that for an agreement such as the Connolly SPA to be determinative with respect to pricing, (1) the price must be fixed and determinable; (2) the Agreement must be legally binding both during life and at death; and (3) the Agreement must be bona fide and not entered into as a testamentary substitute.  The District Court held that the Connolly SPA, as implemented, failed all 3 requirements; most importantly the price was determined to not be fixed and determinable because the 2 pricing mechanisms had not been followed, and the 3^rd test failed based on the §2703 analysis.

Following the District Court’s determination that the SPA was to be disregarded, the Estate then argued that even if the mechanisms provided for in the Agreement for determining value were not followed, the amount reported was nevertheless the fair market value of Michael’s interest.  The District Court disagreed and determined that the Estate’s fair market value calculation was inaccurate because the life insurance death benefit to be received was not included, even though once received the death benefit was to be used to fund the redemption obligation.  In reaching this conclusion, the District Court considered but disregarded the 11^th Circuit Blount Case, which held that the life insurance death benefit to be received by a business for purposes of funding a redemption obligation was not includable, because the proceeds received were offset by the obligation.  The District Court held that the Blount Case, which was not binding on the Connolly ruling given that Blount was an 11^th Circuit case and the Connolly District Court was in the 8^th Circuit, was “demonstrably erroneous” on this issue.  To provide a basis for its determination on this issue, the Connolly District Court made a pointed distinction between a company liability and an agreement to redeem shares.

Ruling and Appeal:

As a result of the analysis summarized above, the Connolly District Court ruled in favor of the IRS on both issues: (1) the SPA did not govern the pricing of shares of a deceased Company shareholder, and (2) life insurance owned by the Company which was acquired to fund a redemption obligation under the SPA was includable for purposes of determining the value of the Company and its shares, with no offset to reflect the redemption obligation.  The District Court therefore granted summary judgement in favor of the IRS.  The matter was then appealed by the Estate to the Eighth Circuit Court of Appeals, which upon review recently confirmed the District Court’s ruling (Connolly v. IRS, No. 21-3683 (8^th Cir. 2023)).  The result is a split in the Courts of Appeal between the 8^th and 11^th Circuits as to whether company owned life insurance acquired to fund a redemption obligation is includable when determining company value with no offset for the redemption obligation itself.

Takeaways:

• Many commentators have concluded that this is, to an extent, a “bad facts” case.  However, the district court’s ruling (upheld on appeal) should not be simply disregarded.  Note the IRS position on these matters and the increased risk and uncertainty resulting from the split amongst district court circuits;
• The Connolly SPA specifically provided that the price was to be determined without regard to valuation discounts.  The Appeals Court noted that notwithstanding the provisions of the SPA (if that had been determinative), a control premium should have been applied when determining the fair market value of Michael’s controlling interest.  The implication from this court direction is that notwithstanding the provisions of an agreement, proper business valuation standards, methodologies, and considerations need to be applied.  The 8^th and 11^th Circuit Courts of Appeal disagreed as to the inclusion of corporate owned life insurance in the valuation of company shares.  However, the Circuit Courts of Appeal were not in conflict with respect to application of a control premium when determining fair market value for purposes of “full and adequate consideration”.
• Given the split amongst circuit courts, business valuation treatment of life insurance acquired by a company for redemption purposes may depend, in part, on what circuit the business (or the taxpayer) is located in;
• Preferably have a value determination by appraisal rather than stipulation or use of a formula – use of an independent third party to professionally determine an updated value is more likely to reflect reality at that time, rather than applying pricing parameters determined at a random prior date (such as when an agreement was put into effect);
• If a formula is to be used and applied for valuation on an ongoing basis, consider having the business professionally appraised initially and have the appraiser define an appropriate formula to utilize thereafter, with that formula subsequently reviewed periodically to confirm continued applicability.

Effective Date: June 30, 2023. This post was derived from sources which we believe to be accurate as of the Effective Date. Notwithstanding that, we do not guarantee the accuracy of the information provided. Further, circumstances after the Effective Date may change and such changed circumstances are obviously not considered in this posting. No action should be taken based on the information provided in this post without first discussing this topic with your appropriate advisors.