Connelly Decision: Supreme Court Rules Company-Owned Life Insurance Must Be Included in Estate Valuation

A recent Supreme Court decision means that owners of closely held companies with company-owned life insurance policies should take extra precautions to avoid an unexpectedly large estate tax bill from the IRS.

On June 6, 2024, the Supreme Court of the United States decided in Connelly v. United States that the value of a company-owned life insurance policy death benefit must be included in the valuation of a closely held corporation for federal estate tax purposes regardless of any contractual redemption obligation imposed on the death benefit proceeds.[1]

Federal estate tax is imposed on “all property, real or personal, tangible or intangible” owned by a decedent at the time of their death.[2] Therefore, if a person owns shares in a closely held corporation at the time of their death, the fair market value of those shares must be included in the valuation of the decedent’s taxable estate.

In the past, questions have arisen surrounding the valuation of a decedent’s shares in a closely held corporation when the corporation receives a death benefit from a company-owned life insurance policy on the deceased employee; if death benefit proceeds are “offset” by a redemption obligation which pays those proceeds to the estate of the decedent-shareholder, should the value of the life insurance proceeds still be included in the corporation’s valuation?

The Supreme Court says YES. In Connelly, a UNANIMOUS Supreme Court held that the value of any death benefit from a company-owned life insurance policy must be included in the valuation of a closely held corporation regardless of any stock redemption obligation being fulfilled by the insurance proceeds. The Court 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.

The Connelly decision means that closely held corporations should take extra precautions when taking out company-owned life insurance policies and drafting stock redemption obligations that draw from those policies. If corporations are not prudent, the Court’s decision can ultimately lead to higher company valuations, which in turn means inflated estate tax liability for decedent-shareholders.

However, business owners should take care before rushing to restructure the ownership of their corporation’s company-owned life insurance policies. Subject to some exceptions, the “transfer-for-value” rule stipulates that if a life insurance policy is transferred from one owner to another for something of value (cash or otherwise), a significant portion of the policy’s death benefit will be subject to taxation as ordinary income.[3]

We recommend consulting with a Dinsmore advisor to structure a plan that works best for each individual tax situation going forward.

Read more about Lee Stautberg's practice here: https://www.dinsmore.com/lee-m-stautberg/

*Emmy Cairns is a summer associate and not yet licensed to practice law.