8th Circuit Affirms Connelly

In my talk at the Notre Dame Estate Planning Institute last fall, I predicted that Connelly would be upheld. The Eighth Circuit issued its affirmation on June 2, 2023 here. As a reminder of the crux of the original summary judgment for the government, it held that the valuation of a decedent's interest in a business entity had to include the life insurance proceeds due to the entity upon the death of the owner/insured as a factor in the valuation of the deceased's interest.

The danger in the opinion to business owners and their advisors is not so much that the case was upheld. If it were only strictly limited to its facts (namely, that the parties completely ignored the terms of the buy-sell agreement after death and negotiated their own value rather than using independent appraisers), it may not concern those who practice in business succession planning for closely held businesses much. However, the case goes a bit further in its conclusions - namely, the complete rejection of the 11th Circuit's Blount v. Comm. case (which held that the value of life insurance tied to a requirement in a buy-sell agreement to purchase a decedent/insured's interest of the business was not to be considered in its valuation). This is a Circuit-level decision, which is binding in the 8th Circuit and citable and may be persuasive in any Circuit other than perhaps the 11th Circuit, where the Blount case was decided.

Thus, we are left with a great deal of uncertainty in when and how an entity is to be valued whenever there is life insurance owned by the entity tied to a buy-sell agreement. What if the parties mostly follow the agreement, but for efficacy or expediency cut a few corners to save cost, or miss a deadline, or agree to a minor modification after death? What if the Connelly family had obtained only one independent appraisal rather than two as the agreement had required? That may sound reasonable, but would have likely led to the same result under the court’s reasoning.?What if they merely modified the payment schedule? Where is the line??? Who can now say if their entity buy-sell will fix the fair market value of the shares for estate tax purposes when there is insurance owned by the entity tied to the buy-sell? Under the 8th Circuit's reasoning, it seems likely that even following the agreement to the letter would have led to the same result.

This is an important case and it may factor into many business owners and their advisors deciding to avoid the risk altogether by moving to a cross-purchase buy-sell agreement or even using a separate LLC to hold such insurance. See the article in Leimberg Information Services: Steven Seel & Ed Morrow: Revisiting Life Insurance LLCs for Entity Buy-Sell Agreements After Connelly, LISI?Business Entities Newsletter #260 (November 9, 2022).

Remember that including the value of life insurance proceeds in the estate does not just have the potential to cause more estate tax, but it may completely distort the value of what the widow or other family of a decedent ultimately receives and may cause litigation outside of the tax context.

The decedent's family may have their inheritance decimated if there is no provision to use values as finally determined for estate tax purposes, receiving $X but having to pay 40% (or more in some states) estate tax on $2X (which is essentially what happened in Connelly).

Alternatively, the buy-sell agreement might revalue the business based on amounts as finally determined for estate tax purposes, and now the business doesn't have the wherewithal to purchase the decedent's interest, since the valuation is so dramatically increased by the insurance proceeds. How much incentive does the decedent's family have to fight the IRS as to estate tax valuation if they would receive more from the business entity through such a clause? This case has the potential to ultimately cause more litigation between the parties, not just with the IRS.

Imagine you represent the surviving spouse (or a trustee or other family) that has contractual rights under an entity buy-sell funded with life insurance to be bought out for the fair market value of the interest.?An appraisal not counting the life insurance would be $5 million, but an appraisal counting the life insurance proceeds would be $7.5 million.?Which value does the surviving family want the appraiser to use?? Do you now have an obligation to insist on the appraiser counting the proceeds, with some authority now pursuant to Connelly??Even in the rare case that there is a taxable estate, a family would rather get $2.5 million more minus 40% estate tax than no more at all.?And where does this put appraisers, who don’t know how far to take the 8th Circuit’s repudiation of Blount? They’re valuation experts, not legal experts.?Traditionally they would not have counted the proceeds in the valuation if they were tied to a buy-sell obligation, but now they have competing interests pulling them each way.?

Imagine the buy-sell agreement fixes the right under state law at $5 million pursuant to an appraisal (or prior agreed certificate of value) that the widow cannot further appeal, and there is no proviso to gross up the amount for amounts as finally determined for estate tax purposes.??What does the widow inevitably want to argue that the fair market value of her interest really was to the IRS, which provides the basis of her interest in calculating the gain or loss on the receipt of the $5 million from the sale??$7.5 million, of course, and pursuant to our friendly 8th Circuit analysis and rejection of the Blount case in Connelly, she now has a colorable argument to use the higher basis. The IRS may have forgotten that higher fair market values for estate inclusion eventually actually cost the government more in the 99.9% of estates that do not pay estate tax, due to increased depreciation and/or reduced capital gains or increased capital losses.