A Planning Oversight Costs a Family Business $1 Million

A recent appeals-court case highlights the importance of not just good planning but also proper execution.

By Steve Parrish
Steve Parrish
Steve Parrish

In June, the advisory community was shocked by a business-owner tax case handed down by the 8th Circuit Court of Appeals in St. Louis (Connelly v. United States). The case involved life insurance owned by a business that was included in the business owner’s estate.

At its core, these are the facts:

A family business, Crown C Supply (“Crown”), owned life insurance on its majority shareholder, Michael Connelly Sr. Michael owned 77.18% of the company stock. The insurance policy was earmarked to fund a redemption agreement in the event of Michael’s death. The idea was that Crown, co-owned by Michael and his brother, Thomas, would use the insurance proceeds to redeem Michael’s stock upon his death in order to keep the business in the family.

Upon Michael’s death, Crown collected the policy’s $3.5 million death benefit and used the proceeds to buy his stock for $3 million.

To the family’s surprise, the IRS was able to successfully include in Michael’s gross estate both his stake in the business and the proceeds of his life insurance policy that were used to fund the redemption agreement. At a 40% estate tax rate, the family ended up having to pay an additional $1 million in federal estate tax, plus attorney’s fees.

This case is a cautionary tale for both business owners and their advisors. The lesson learned is that if you want to keep your successful business in your family, get good advice – and follow that advice.

The advice

One way or another — whether at death or at retirement — business owners will eventually exit their business. Particularly with family businesses, it is essential to arrange for an efficient exit, in terms of both funding and taxes.

To their credit, the Connelly brothers started their planning. They implemented a stock purchase plan so that if either of the brothers were to exit the business, their company would purchase his interest to keep ownership in the family. Crown owned life insurance on both brothers to fund this agreement. The insurance policy addressed the funding part of their succession plan.

Now to the tax piece, which is where the brothers were less prepared.

The IRS has a number of statutory tools to make sure that relatives who buy and sell stock in family-owned businesses do this as a bona fide business arrangement instead of transferring business ownership on the cheap.

Many of these tools relate to the valuation the family places on the business and its stock. The rules are complex, and business attorneys must thread the needle carefully to come up with a valuation the IRS won’t attack.

In the Connelly example, the stock purchase agreement had clear terms. Two mechanisms were put in place to determine the price at which Crown would redeem the shares if either brother left the business. The first required the brothers to execute a new Certificate of Agreed Value at the end of every tax year. This set the price per share by “mutual agreement.”

If they failed to agree on this annual valuation, as a stop gap the brothers were to obtain two or more appraisals of fair market value. The assumption was that this valuation would be the price used for valuing the brothers’ stock interests in their estates.

What happened?

As often happens with business tax issues that end up in litigation, bad facts make for bad law. In other words, because of the particulars of how a transaction occurs, courts often get cornered into making bad decisions that carry over as precedent to other cases.

With the Connelly brothers, things started off poorly from the outset. They never executed a Certificate of Agreed Value or obtained appraisals as required by the stock-purchase agreement. Further, when Michael died, other facts further sullied the legitimacy of the agreement.

First, Thomas was the executor of his brother’s estate – arguably a conflict between being a fiduciary to the estate and representing the interests of the company to which he would be sole owner. Second, even upon Michael’s death, neither the estate nor Thomas Connelly obtained an appraisal. Instead, the estate and Crown agreed that the value of the stock was $3 million. Crown collected the $3.5 million death benefit and used it to redeem Michael’s shares.

The IRS ignored the $3 million valuation used by the estate. Instead, it asserted the real value of Crown, taking the life insurance proceeds into account, was $6.86 million. Since Michael’s estate had a 77.18% stake in Crown, the IRS valued Michael’s interest at about $5.3 million and declared his estate owned an additional $1 million in estate taxes. Both the district court and 8th Circuit Court agreed with the IRS.

Takeaways

Although this case involves many legal arguments, the bottom line is that it is a defeat not only for the Connelly brothers’ family business but for family businesses in general.

A similar case in the 11th Circuit Court, Blount v. Commissioner, had better facts and a better outcome for the plaintiff. The IRS lost that case and the value of the company’s life insurance proceeds was not included in the deceased shareholder’s estate.

Now, family-owned companies based in the 13 states represented by the 8th Circuit Court of Appeals need to review — and possibly rewrite — their stock purchase and life insurance plans. Even family businesses throughout the country should be nervous. This disagreement between appellate courts may well end up being reviewed by the U.S. Supreme Court.

While we let the lawyers and courts duke out this mess, what messages can we take from this unfortunate case?

Clearly, one moral of the story is that business owners need to act on the advice given by their professional advisors. The Connelly brothers were wise enough to set up a succession plan, but they failed to follow through on the details. The fact that from day one the brothers never executed a Certificate of Agreed Value was a red flag to the IRS.

Another lesson is that business owners should share their plans with their team of advisors. Perhaps the Connellys’ attorney created the stock purchase agreement as a one-time transaction and had no further interaction with Crown or the brothers. In contrast, it’s possible that the advisor who provided the life insurance funding worked with the family business on an ongoing basis. Ideally, some advisor would have given the brothers a heads-up to certify the company value.

How advisors can help

The more that business owners can do to make sure their advisors stay informed and coordinate actions, the less chance that an unfortunate administrative mistake leads to $1 million in extra taxes. Advisors must also stay alert and be proactive.

Additional Reading: Don’t Lose Clients When They Retire

Whether or not your clients own a business, there are steps you can take to help them avoid incurring additional taxes. For starters, make sure that they file their tax returns on time, start taking their required minimum distributions at age 73, and review the timing of their income recognition to save Medicare premiums. The list goes on.

Family business owners must also attend to corporate formalities. When the business is the owner’s largest asset, attention to detail is especially critical. Not only is it important for owners to have a business succession plan; it’s even more important to execute on that plan.

Steve Parrish, JD, RICP, CLU, ChFC, AEP, is the co-director of the Center for Retirement Income at The American College of Financial Services, where he also serves as an adjunct professor of advanced planning. With over 45 years’ experience as an attorney and financial planner, Parrish frequently addresses the financial challenges of individuals, business owners, and executives nationwide. 

 

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