In one of the most significant estate tax opinions issued this year (Connelly v. U.S., 70 F.4th 412 (8th Cir. 2023)), the Eighth Circuit Court of Appeals affirmed a district court’s grant of summary judgment in favor of the IRS with respect to the effects of a buy-sell agreement upon the estate tax value of the decedent’s stock in a closely held corporation. On August 15, the executor requested relief from the U.S. Supreme Court, and on October 30, the IRS submitted a brief requesting that the Court deny that appeal. If the Court grants that appeal, the decision could have a profound effect on the valuation of companies when life insurance is used to fund a buy-sell obligation.
Understanding Buy-Sell Provisions
Buy-sell provisions may be represented within a dedicated stand-alone agreement between owners of a company, but more often than not, are incorporated into the company’s governing documents. By definition, buy-sell provisions set forth the circumstances under which
- the company (via a redemption), certain owners of the company (via a cross-purchase), or both are required (or are granted an option) to buy an equity interest from another owner or
- an owner is required (or is granted an option) to sell an equity interest to the company, the other owners, or both.
The most common circumstances that trigger buy-sell provisions are the death of an owner; a divorce, bankruptcy, or other litigation involving an owner; or the receipt of a bona fide offer to purchase the equity interest (usually, but not necessarily, from an outside party). The buy-sell provisions should also describe the process for determining the buy-out price of the equity interest. In any case, the primary purpose of buy-sell provisions is to keep the company’s ownership—and thus, control of management and business operations— “in the family” (colloquially speaking). That said, members of families (in the literal sense) have also used buy-sell provisions to depress the value of equity interests that pass to their beneficiaries for estate and gift tax purposes.
Valuation Principles for Estate and Gift Tax
As a general principle, the estate and gift tax value of any property is “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of the relevant facts.” In the context of an interest in a closely held company, the Treasury regulations apply this general principle by requiring an assessment of the company’s net worth, prospective earning power, and dividend-paying capacity; the goodwill of the business; the economic outlook of the particular industry; the position of the company in the industry and its management; the degree of control of the business represented by the interest transferred; the values of publicly-traded securities of other companies engaged in similar lines of business; and the nonoperating assets of the company (including life insurance). For a number of reasons, any estate or gift tax assessment of an equity interest with a significant value should be made by a qualified appraiser. Indeed, outside the context of a right of first refusal to an offer received from an outside party, buy-sell provisions often mandate that a buy-out price be determined by one or more qualified appraisals.
Special Rules for Family-Owned Companies
All of that said, the Internal Revenue Code, regulations, and case law currently provide that when 50% or more of the value of the company is owned by certain members of a donor’s or decedent’s family, the rights and restrictions reflected in the buy-sell provision will not affect the valuation of the subject business interest—and any pricing mechanism that deviates from the general valuation principle above will not control the valuation of the subject interest for estate and gift tax purposes—unless such provisions:
- Constitute a bona fide business arrangement,
- Are not merely a device to transfer such property to members of one’s family or natural objects of one’s bounty for less than full and adequate consideration, and
- In the case of provisions adopted or substantially modified after October 8, 1990, are comparable to similar arrangements entered into by persons in arms-length transactions.
Connelly Case: Pricing Mechanism Challenges
As this special set of rules is applied by the courts, any pricing mechanism provided for in the buy-sell agreement should be “fixed and determinable.” In the Connelly case, two siblings who were the sole shareholders were required to execute a “Certificate of Agreed Value” by mutual agreement each year, but the court determined that an “agreement to agree” is not sufficient to establish a value of the deceased shareholder’s stock for estate tax purposes (even if the siblings had followed the procedures, which they did not). Moreover, to avoid running afoul of requirement (2) above, the buy-sell provisions—including any pricing mechanism—should not only apply at death but should also apply during the life of the decedent.
Impact of Connelly on Life Insurance in Buy-Sell Agreements
What is most concerning about the Connelly holding, however, is how the courts applied the general “fair market value” principles in the context of a company that purchases life insurance to meet its obligation to redeem the deceased shareholder’s stock at death. In rejecting prior rulings from the Ninth and Eleventh Circuit Courts of Appeals, the Eighth Circuit held that the proceeds from the life insurance are included in the value of the company for purposes of determining the estate tax value of the deceased shareholder’s stock with no offsetting reduction for the amount that the company has to pay to redeem the stock.
Recommendations for Closely-Held Business Owners
Unless and until the U.S. Supreme Court reverses the Connelly decision, owners of closely-held companies within the jurisdiction of the Eighth Circuit (North Dakota, South Dakota, Nebraska, Minnesota, Iowa, Missouri, and Arkansas) should consider substituting a company redemption obligation with a cross-purchase arrangement between the owners if life insurance is necessary to finance any buy-sell provisions effective upon the death of an owner. As an alternative to life insurance, the buy-sell provisions could also allow for the deferral of any redemption payments over a fixed period of time with adequate interest and security. That said, even closely held business owners outside of the Eighth Circuit should consider revisiting any buy-sell provisions that deviate from an appraisal process in setting a buy-out price and ensuring that any procedures mandated by such buy-sell provisions are actually being carried out.