It is a well-known best practice for business owners to clearly state in the company’s governing documents the valuation methodology for determining the purchase price of a deceased owner’s equity. In Connelly v. IRS, No. 21-3686 (8th Cir. 2023), this best practice was missed, cautioning all closely held business owners to review their governing documents.
In Connelly, the two shareholders executed an agreement outlining the mechanics for the buyout of a deceased shareholder’s interest. Per the agreement, the shareholders could agree to a purchase price and execute a Certificate of Agreed Value on an annual basis, or, in the absence of such an agreement and accompanying certificate, hire two independent appraisers to value the business.
Upon the death of one of the shareholders, the surviving shareholder ran afoul of the agreement and arbitrarily set a value for the Company’s redemption of the stock. The redemption was funded using the proceeds of a life insurance policy on the deceased shareholder’s life.
Upon the audit of the deceased shareholder’s Federal estate tax return, the IRS assessed additional Federal estate tax in excess of $1,000,000 stating that the deceased owner’s stock was undervalued.
On appeal, the Court affirmed the IRS assessment and held that the proceeds of a life insurance policy used to finance a redemption is an asset of the company to be considered when valuing a deceased owner’s interest for Federal estate tax purposes.
Had the shareholders followed the company’s agreement and obtained a professional valuation, the IRS assessment may have been more favorable.
The Court’s decision in Connelly is a cautionary reminder for closely held business owners to regularly review their governing documents so that best practices are employed, and estate tax consequences are minimized. It is vital for business owners to include their attorney, CPA and financial advisor in discussions regarding the structure of a company’s governing documents.
If you have any questions or request more information on how to properly structure your company’s governing documents to minimize estate tax consequences, please contact Stefanie L. Pate.
Stefanie Pate is a Partner in the firm’s Estates & Trusts Practice Group, as well as the Nonprofits & Tax-Exempt Organizations Group. Stefanie is based in the firm’s Pittsburgh office, and is licensed to practice in Pennsylvania, Florida, and New York. She can be reached at 412.261.1600 or spate@leechtishman.com.
Farah Bayonova, JD Candidate 2024, Western New England University School of Law, contributed to the research and drafting of this article.