Life Insurance and Business Valuation After the Connelly Decision

Explore how the Supreme Court’s approach departs from valuation principles and what it means for estate planning.

Succession planning for closely held business owners is challenging in many ways. One of those is how to provide liquidity to the estate of a deceased owner. Companies or other owners may have the excess capital to address small minority ownership interests, but what about large blocks of stock?

Funding redemptions with life insurance has long been a succession planning strategy among closely held businesses. For decades, owners and their advisors have relied on life insurance to provide liquidity when a shareholder dies. By insuring business owners with policies that are sufficient to cover the value of their shares and by designating the corporation as the beneficiary of the policy, companies can avoid the liquidity crunch of an unexpected redemption. These life insurance policies are often coupled with the terms of a buy-sell agreement that mandates corporate redemption and keeps control within the intended hands. And until recently, the estate tax consequences of this arrangement were broadly understood and not highly controversial.

But the Supreme Court’s 2024 decision in Connelly v. United States has upended that understanding. The ruling held that life insurance proceeds received by a corporation to fund a redemption must be included in the company’s fair market value for estate tax purposes, without an offsetting redemption liability. In other words, the proceeds used to buy the shares must now be treated as part of the value of the company that owns them, effectively double-counting the company’s value.

This ruling has significant implications for closely held businesses. This ruling puts practical planning tools at odds with the way that the estate value is measured, forcing a disconnect between how redemptions are structured and how they are taxed. The Supreme Court’s decision in Connelly diverges from the Eleventh Circuit’s earlier decision in Estate of Blount v. Commissioner, which excluded such life insurance proceeds because they were offset by a binding redemption obligation and conferred no lasting economic benefit to the company.

Understanding the Supreme Court’s reasoning in Connelly starts with the facts of the case.

Crown C Supply (“CCS”) was a Missouri-based building supply business, closely held by brothers Michael and Thomas Connelly who owned 77.18% and 22.18% of the company, respectively. In 2001, they entered into a buy-sell agreement designed to maintain the business’s ownership between the brothers. Under the agreement, the surviving brother would have the first right to purchase the shares of the brother who died. If the surviving brother declined to purchase, then the corporation would be required to redeem those shares.

To finance this arrangement, CCS purchased $3.5 million worth of life insurance on each brother. When Michael passed away in 2013, Thomas elected not to exercise his option to buy Michael’s shares, which amounted to over 77% of the company. This triggered the corporate redemption obligation, and CCS used $3.0 million of the life insurance proceeds to redeem Michael’s shares from the estate.

The purchase price was determined informally and agreed upon by Thomas Connelly and the estate without reference to a fixed formula or valuation method in the buy-sell agreement. The price was based primarily on the available life insurance proceeds (after restoring a $500,000 shortfall in working capital) rather than on a formal valuation. It is important to note that the best practice would be to get a qualified appraisal and attach to the estate tax return to meet “adequate disclosure” and significantly reduce audit risk.

The estate reported the fair market value of Michael’s shares at $3.0 million, the price paid by the company. The IRS disagreed, asserting that the full amount of the life insurance should be included in the company’s valuation, despite its purpose to redeem the shared. The IRS valued Michael’s 77.18% interest at $5.3 million, which included the taxpayer’s value ($3.0 million) plus the pro rata percentage of the life insurance proceeds $3.0 million × 77.18% = $2.3 million) used in the redemption. This triggered approximately $890,000 in additional estate tax.

The estate elected to pay the additional tax and then sue the IRS to recover it. The estate argued that the life insurance proceeds had no accretive value to the company and was fully offset by the required redemption. The IRS argued that the corporation received the life insurance proceeds and therefore the corporation was more valuable at the moment of Michael’s death. The District Court sided with the estate. Then, the Eighth Circuit reversed the District Court’s decision, siding with the IRS’s position. Later, the Supreme Court affirmed the Eighth Circuit’s decision.

Justice Thomas framed the issue narrowly in a unanimous opinion. He focused on whether a corporate redemption obligation reduces the value of a decedent’s shares for estate tax purposes under Internal Revenue Code §2031 and concluded that it did not.

The opinion emphasized that a corporation’s obligation to redeem shares is not a liability, because the obligation is to shareholders, not to external creditors, and because it does not diminish the claims of third parties. Therefore, the Supreme Court agreed that the life insurance increased the corporation’s value, regardless of what happened to the funds afterward.

However, this framework ignores the substance of the transaction. A rational buyer would never pay $5.3 million for a block of stock, considering that the company had a built-in obligation to pay out $3.0 million immediately. The valuation assumes a willing buyer with no regard for economic reality.

This strategy has been widely used and has long been considered a settled issue from a valuation perspective for the past 20 years.

In 2005, the Eleventh Circuit Court in Blount, provided a more nuanced analysis and provided a long-accepted precedent. William Blount owned 83% of Blount Construction Company. The company held life insurance on Blount’s life and a stock-purchase agreement that obligated the company to redeem his shares upon his death. The agreed redemption price was $4.0 million.

When Blount died, the estate reported his shares at $4.0 million, the amount paid under the buy-sell agreement. The IRS challenged this amount and valued the company at $7.9 million by including the life insurance proceeds. Sound familiar? The Tax Court agreed with the IRS. However, the Eleventh Circuit reversed this decision and sided with the estate.

In Blount, the Eleventh Circuit Court addressed two critical issues:

The Eleventh Circuit Court argued that the buy-sell agreement price did not establish fair market value because the agreement lacked key features of an arm’s-length transaction. There was no fixed pricing formula, no independent negotiation, and no evidence that the price reflected what a willing buyer would actually pay. The price was determined by the insiders themselves and without regard to market inputs.

The Eleventh Circuit Court also said that the life insurance proceeds should not be included in the valuation of the company. The Eleventh Circuit Court emphasized that the proceeds were not available for general use. It said the proceeds were required to be used to redeem the shares and would exit the company at the same time as their entry. The Eleventh Circuit Court concluded that the company experienced no increase in enterprise value as a result of the life insurance proceeds.

In Blount, the Court focused on economic substance. If the company received money for the purpose of immediately paying it out, it said the company’s value would not be meaningfully enhanced. Including such proceeds in the valuation inflated the estate’s taxable value on the basis of fleeting assets.

In Connelly, the Supreme Court treated the life insurance proceeds as an unencumbered asset of the corporation at the time of majority owner Michael Connelly’s death, regardless of whether the funds were committed to redeeming the decedent’s shares. That treatment does not reflect the economic reality faced by a hypothetical willing buyer.

The Supreme Court did not recognize the redemption as a liability and therefore did not offset the insurance proceeds. However, under ASC 480-10-25-4, the redemption would be recorded as a liability (reclassed from equity). This is because there is a mandatory redemption, the triggering event (Michael’s death) has occurred, and the redemption amount was measurable. Additionally, the redemption would likely have preference over other equity holders in a liquidation scenario.

When a company receives life insurance proceeds solely to fund a redemption, those proceeds do not enhance the long-term value of the business. They enter and exit the balance sheet in short order by returning that cash to the estate in exchange for the subject shares. There is no net economic benefit to the corporation, no increase in its ability to generate income, and no surplus capital that can be used for distribution. What exists is a transitory moment of increased cash immediately followed by a mandatory outflow. Valuing the company as if those proceeds are retained misstates what an actual buyer would acquire and be willing to pay for.

The result is a form of double counting. The estate receives a payment funded by the insurance proceeds. At the same time, the IRS treats those proceeds as having increased the value of the decedent’s estate. That means the estate is taxed not only on the proceeds it receives, but also on the misinterpreted increase in stock value caused by those very same proceeds. This is not merely a technical discrepancy. For taxable estates, it can result in nearly all of the redemption proceeds going directly to the estate tax bill and functionally taxing at nearly 100 percent.

From a valuation perspective, the approach above fails to account for the realities of the marketplace. A rational, well-informed buyer would know that the company is obligated to use the insurance proceeds in order to redeem the shares and thus the buyer would factor the expected life insurance proceeds into their valuation of the company. Fair market value is defined by what a willing buyer would pay and by what a willing seller would accept, both having reasonable knowledge of the facts. It is not defined by accounting line items isolated from context.

In Blount, the Eleventh Circuit Court properly acknowledged that substance must govern over form when determining value. Estate tax valuation should reflect what the business is actually worth to a buyer after the transaction has been completed. When life insurance is used solely to redeem shares, the proceeds do not enhance the enterprise value. They simply facilitate the exit of one owner. To include those proceeds in the value of the business is to mistake transient movement of money for the creation of value.

The Connelly decision isn’t gospel and doesn’t eliminate the need for thoughtful, grounded valuation analysis. It is more important than ever for estate planners and valuation professionals to understand how to value companies with life insurance proceeds and redemption obligations, and how to distinguish between temporary funding mechanisms and true accretions of value. The first defense against an estate tax audit is a qualified appraisal. This appraisal will make a strong base of support and reduce risk of additional taxes and penalties.

At Withum, we help clients and advisors navigate this complex landscape with clarity. Whether you are planning a shareholder exit, in need of an estate valuation, or assessing the design of a buy-sell agreement, our team can help you understand the implications of Connelly and build a valuation approach that reflects true economic value.

Author: Anthony Venette, CPA, ABV | [email protected]