US Supreme Court rules estate tax applies to company life insurance policies

The ruling refers to a common estate planning practice in US business-owning families, under which the company maintains a life-insurance policy on the life of an owner. The company pays the premium on the policy and ensures that the policy is sufficient to cover the cost of the redemption. Upon the death of the insured owner, the company uses the proceeds of the life insurance policy to redeem the deceased's interest in the company.

Often, these death benefit proceeds are offset by a redemption obligation that pays those proceeds to the deceased's estate. This has led to confusion as to whether the value of the life insurance proceeds should still be included in the valuation of the corporation's shares.

The Connelly case, concerning two brothers who jointly owned Crown C Supply Corporation, has now resolved this question. The brothers had a stock redemption agreement that would allow the surviving brother to buy out the deceased brother's interest. In the event, the survivor chose not to exercise this option and instead the company bought the deceased brother's interest for USD3 million. A US Internal Revenue Service (IRS) audit of the estate tax return challenged the resulting company valuation. The challenge led to the Supreme Court ruling, which unanimously decided that the proceeds should be included in the company's valuation. It reasoned that an obligation to redeem shares at fair market value does not offset the value of life insurance proceeds set aside for the redemption, because a fair market value share redemption does not affect any shareholder’s economic interest.

Law firm Kohrman Jackson & Krantz commented that the ruling ‘is likely going to result in additional estate tax obligations for family-owned businesses, small business owners, and closely-held business owners and a need to reconsider the appropriate structure for buy-sell arrangements.’

Owners of closely held companies with company-owned life insurance policies should take extra precautions to avoid an unexpectedly large estate tax bill when an employee dies, said law firm Dinsmore & Shohl.

However, the firm also noted that business owners should take care before rushing to restructure the ownership of company-owned life insurance policies, because transfer of a life insurance policy from one owner to another may lead to a significant portion of the policy's death benefit becoming taxable as ordinary income.

Sources

• Dinsmore & Shohl
• Kohrman Jackson & Krantz