Estate Tax – It’s a Killer
One of the reasons often given for eliminating the estate tax is the substantial economic burden it places upon the estate of a deceased business owner and upon the business itself. Specifically, within nine months of the owner’s death, their estate is required to satisfy its federal estate tax liability, which is determined by applying a 40 percent tax rate to the date of death value of the decedent’s assets, including their interest in the business.[i]
Under these circumstances, a decedent’s estate may very well be forced to sell, or to forfeit control of, the business, thereby depriving the decedent’s family of an opportunity to continue the business, and often resulting in the loss of much of the value created by the decedent over a lifetime of hard work and risk-taking.
Truth be told, the decedent’s business usually represents the most valuable – and also the most illiquid – asset in the decedent’s estate. It is also the vehicle through which one or more members of the decedent’s family have been, and hope to continue, earning their living.
How, then, is the deceased owner’s estate going to raise the funds needed to pay the estate tax in a mere nine months, while at the same time trying to adjust to the loss of the individual who was probably both the driving and cohesive force in the business, while also trying to operate and preserve the business?
Plan Ahead
Thankfully, many business owners will consider this estate tax issue, together with other issues that will likely arise following their passing,[ii] while they are still alive, and they will formulate plans to address them.[iii]
If they are well-advised, they will revisit each of these issues periodically, at which time they will reassess their plans and, if necessary, adjust or even replace them.
Reduce the Gross Estate
Because the first step in calculating their future estate tax liability is determining the value of their gross estate, a business owner who is able[iv] and willing to do so, can make gifts and/or sales of interests in the business to family members or to trusts for their benefit,[v] thereby removing those interests as well as the appreciation in their value from the owner’s gross estate.[vi]
Although the reduction of one’s gross estate goes a long way in managing the estate tax burden, it has its limits; for one thing, the owner has to be comfortable with relinquishing the economic benefits associated with the ownership interest to be transferred.
Reduce the Taxable Estate
In some cases, the ability to defer imposition of the estate tax through testamentary transfers may be meaningful. This approach usually requires planning for deductions, especially with respect to transfers for the benefit of a spouse who may or may not be involved in the business, but who may require the revenue from the business. However, this approach will only defer payment of the tax.
Installment Payments
Long ago, Congress recognized the business owner’s quandary – or that of their estate – and in response added a provision to the Code[vii] for the express purpose of helping to preserve a deceased owner’s closely held business. Under this provision, the estate of a deceased owner may elect to pay the estate tax attributable to the value of the decedent’s interest in the closely held business over a period of up to ten years.
Furthermore, these tax payments do not begin until the fifth year after the estate tax return is filed; until then, only interest is payable on the deferred tax liability attributable to the business.
Requirements
In order to qualify for this benefit, the value of the decedent’s interest in the closely held business must exceed 35 percent of the decedent’s adjusted gross estate – which may dissuade some owners from even considering a lifetime gifting program lest they inadvertently drop below this threshold – and the decedent must have owned at least a 20 percent interest in the business.[viii]
In addition, the business in question must constitute an active trade or business, as opposed to a passive or investment-type activity. Even if the active trade or business requirement is satisfied, the decedent’s interest will not qualify for tax deferral to the extent its value is attributable to non-business assets.
Acceleration
Assuming the deceased owner’s estate qualifies for installment payments, it must be vigilant to maintain this benefit. For example, if any of the decedent’s interest in the closely held business is sold, or if money attributable to such interest is withdrawn from the business,[ix] and the aggregate value of such transactions equals or exceeds 50 percent of the value of such interest, then the extension of time for payment of the estate tax ceases to apply, and the IRS may demand payment of the unpaid portion of the estate tax.[x]
The logic behind this acceleration rule is fairly obvious. If the interest is sold, and the estate thereby becomes liquid, then the justification for installment payments – to preserve the interest in the closely-held business – no longer exists.[xi]
“Graegin Loans”[xii]
In other circumstances – for example, where the estate does not qualify for installment reporting, or where it prefers to pay the tax upfront – the estate may be able to borrow the necessary funds from the decedent’s business, which may itself have to borrow the funds from an institutional lender.
Provided this borrowing represents a bona fide indebtedness between the business and the estate, provided the business did not have substantial liquid assets at the time of the loan, and provided the interest to be paid by the estate in respect of the loan can be ascertained with reasonable certainty – for example, the loan may not be prepaid as to principal or interest – the estate may be able to deduct the total amount of interest payable under the loan for purposes of determining its estate tax liability.
The deduction of interest may be described as an administration expense incurred to prevent the financial loss that may otherwise occur as a result of a forced sale of the business in order to pay the estate tax.[xiii]
Life Insurance
In addition to the foregoing options, many business owners will often acquire insurance on their lives,[xiv] hopefully in an irrevocable life insurance trust that will prevent the insurance proceeds from being included in the decedent’s gross estate for purposes of the estate tax.
After the insurance proceeds are paid following the death of the owner, they may be used to purchase the decedent’s business interest.
Where the insurance policy is owned by and is paid to a trust, the trust may then purchase the business interest from the estate, and the terms of the trust will provide for the disposition of the interest.
In other situations, the business itself,[xv] or the decedent’s fellow partners or shareholders, may acquire life insurance on the decedent; pursuant to the terms of a shareholders’, partnership, or other buyout agreement, the owner/beneficiary of the policy would use the insurance proceeds to acquire the decedent’s business interest from the estate.[xvi]
Regardless of the buyout structure, there are two important tax considerations when the transaction is funded through life insurance: make certain the insurance proceeds (i) are not subject to income tax and (ii) are not included in the insured’s gross estate.
The second of these considerations was at issue in a decision rendered earlier this month by the Eight Circuit Court of Appeals.[xvii] Specifically, the Court addressed whether the insurance proceeds paid to the business upon the death of a shareholder should have been included in the value of the business for purposes of the estate tax notwithstanding the business’s obligation to use the proceeds to buy the decedent’s shares in the business from their estate.
Redemption Agreement
Before Bro-1 died, he owned 77.18 percent of the outstanding shares of Corp’s stock, while Bro-2 owned 22.82 percent. To provide for a smooth transition of ownership upon either’s death, the brothers and Corp together entered into a stock-purchase agreement. If one brother died, the surviving brother had the right to purchase the decedent’s shares. If the surviving brother declined to do so, Corp itself was required to redeem the shares. In this way, control of the business would stay within the family. According to the opinion, the brothers always intended that Corp, not the surviving brother, would redeem the other’s shares.
Valuation
The stock-purchase agreement provided two mechanisms for determining the price at which Corp would redeem the shares. The brothers were required to execute a new “Certificate of Agreed Value” at the end of every tax year, which would set the price per share by “mutual agreement.” If they failed to do so, the brothers were supposed to obtain two or more appraisals of fair market value.
The brothers never executed a Certificate of Agreed Value or obtained appraisals as required by the stock-purchase agreement.[xviii] At any rate, to fund its redemption obligation, Corp purchased $3.5 million of life insurance on each brother.[xix]
After Bro-1 died, Corp received the life insurance proceeds and redeemed his shares for $3 million.[xx] The actual redemption transaction was part of a larger, post-death agreement between Bro-2 and the decedent’s son, Junior, that resolved what were described as several “estate administration” matters. Contrary to the terms of the stock purchase agreement, no appraisals were obtained. Instead, Bro-2 and Junior simply declared that they had “resolved the issue of the sale price of [Bro-1’s] stock in as amicable and expeditious [a] manner as is possible” and that they “have agreed that the value of the stock” was $3 million. The Court observed that this figure effectively valued Corp, based on Bro-1’s 77.18 percent share, at $3.89 million. The rest of the proceeds, about $500,000, went to fund Corp’s business operations.
Tax Return, Exam, & Refund Claim
Bro-2 was the executor for Bro-1’s estate. The estate filed an estate tax return reporting that Bro-1’s shares were worth $3 million. To value the shares, Bro-2 relied solely on the redemption payment, rather than treating the life insurance proceeds as an asset that increased the corporation’s value and hence the value of Bro-1’s shares. All told, this resulted in an estate tax of about $300,000, which was paid.
The IRS audited the estate’s return. It concluded that the estate had undervalued Bro-1’s shares by simply relying on the $3 million redemption payment instead of determining the fair market value of Corp, which should have included the value of the life insurance proceeds.
According to the IRS, taking the insurance proceeds into account, Corp was worth $3 million more than the estate had determined – about $6.86 million.[xxi] So according to the IRS, just before redemption, Bro-1’s estate actually had a 77.18 percent stake in a $6.86 million company, worth about $5.3 million.
As a result, the IRS sent a notice of deficiency to the estate for $1 million in additional tax liability. The estate paid the deficiency and sued for a refund.[xxii]
Estate’s Position
The estate claimed that the redemption transaction, made in furtherance of the stock-purchase agreement, determined the value of Corp for estate-tax purposes, so there was no need for an appraisal.
Alternatively, the estate argued that Corp’s fair market value should not include the life insurance proceeds used to redeem Bro-1’s shares because, although the proceeds were an asset, they were immediately offset by a liability – the redemption obligation. In other words, the proceeds added nothing to Corp’s value.
By contrast, the IRS argued that the stock-purchase agreement should be disregarded, and that any calculation of Corp’s fair market value had to account for the proceeds used for the redemption.
District Court
The district court granted summary judgment to the IRS. The court first concluded that the stock-purchase agreement did not affect the valuation.
The court then determined that a proper valuation of Corp had to include the life insurance proceeds used for redemption because they were a significant asset of the company.
The estate appealed to the Eighth Circuit.
Court of Appeals
The only issue on appeal was the value of Bro-1’s shares of Corp stock; specifically, whether the value of Corp, and thus the value of Bro-1’s shares, should have included the life insurance proceeds that were paid to Corp on Bro-1’s death, and used by Corp for the redemption of those shares. If not, then the estate would have been entitled to a refund. If the proceeds should have been included, as the district court had determined, then the IRS was correct and summary judgment was proper.
The Court first considered whether the redemption agreement controlled how Corp should be valued. Suffice it to say that the Court had good reasons for finding that it did not.[xxiii]
The Court next considered whether a fair-market-value analysis of Corp had to account for the life insurance proceeds.
Fair Market Value
The Court explained that the fair market value of property in a decedent’s gross estate is “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.”[xxiv]
To this end, the Court continued, the share value for closely held corporations depends on the company’s net worth, prospective earning power and dividend-paying capacity, and other relevant factors like: “the good will of the business; the economic outlook in the particular industry; the company’s position in the industry and its management; [and] the degree of control of the business represented by the block of stock to be valued.”[xxv]
The Court noted that, without regard to the life insurance proceeds used to redeem Bro-1’s shares, and looking only to Corp’s operations, revenue streams, and capital, its value was approximately $3.86 million as of Bro-1’s date of death.
Nonoperating Assets
However, the Court observed that, according to IRS regulations, the valuation of a closely held corporation must also consider its “nonoperating assets, including proceeds of life insurance policies payable to or for the benefit of the company, to the extent such nonoperating assets have not been taken into account in the determination of net worth, prospective earning power and dividend-earning capacity.”[xxvi]
The Court then turned to another provision of the Code and the regulations promulgated thereunder.
According to the Code, the Court stated, the value of a decedent’s gross estate includes life insurance proceeds received directly by the estate under policies on the life of the decedent, as well as proceeds received by other beneficiaries under insurance policies in which the decedent “possessed at his death any of the incidents of ownership.”[xxvii]
The Court added that the regulations issued under this provision reinforce the need to “take into account” life insurance proceeds paid to a corporation in which the decedent was a shareholder.[xxviii]
Now, Just a Minute
At that point, the Court launched into the reasoning behind its decision to include the insurance proceeds in the value of Corp but it did so without spending much time reviewing the balance of the above-referenced regulation. Therefore, before considering the Court’s conclusion, let’s take a moment to examine the “omitted” portion of the regulation.
According to the regulation, when the insurance policy is on the life of the sole or controlling[xxix] shareholder of a corporation, the corporation’s incidents of ownership will not be attributed to the decedent through his stock ownership to the extent the proceeds of the policy are payable to the corporation.
Any proceeds that are payable to a third party for a valid business purpose, such as in satisfaction of a business debt of the corporation, so that the net worth of the corporation is increased by the amount of such proceeds, is deemed to be payable to the corporation; thus, the corporation’s incidents of ownership in the policy will not be attributed to the deceased controlling shareholder.
However, if any part of the proceeds of the policy are not payable to or for the benefit of the corporation and, thus, are not taken into account in valuing the decedent’s stock holdings in the corporation for purposes of the estate tax, then any incidents of ownership held by the corporation as to that part of the proceeds will be attributed to the decedent through his stock ownership where the decedent is the sole or controlling shareholder. Thus, for example, if the decedent is the controlling shareholder in a corporation, and the corporation owns a life insurance policy on the shareholder’s life, the proceeds of which are payable to the decedent’s spouse, the incidents of ownership held by the corporation will be attributed to the decedent through his stock ownership and the proceeds will be included in the shareholder’s gross estate[xxx] – they are not accounted for as an asset of the corporation.
Back to the Court’s Opinion
In the present case, Corp obtained the policy for its own benefit – specifically, to provide it with the liquidity it would need to redeem the Bro-1’s shares following his death.[xxxi]
The Court then conceded, based on the regulatory provisions described above, that Bro-1did not possess Corp’s “incidents of ownership” in the policy on his life merely by virtue of being the controlling shareholder.
However, the Court quickly added that, just because the Code did not require that the proceeds be included in Bro-1’s gross estate, did not also mean that they be “excluded”; more specifically, that they not be considered in determining the value of the decedent’s stock. Although the life insurance proceeds intended for the redemption did not “directly augment” Bro-1’s gross estate, the Court stated they may well have done so “indirectly through a proper valuation” of Corp.[xxxii]
Therefore, the Court considered the value of the life insurance proceeds intended for redemption insofar as they had not already been taken into account in Corp’s valuation and “in light of the willing buyer/seller test.”
Eleventh Circuit’s Decision
As a preliminary matter, the Court reviewed an opinion of the Eleventh Circuit[xxxiii] that presented the same fair-market-value issue. That case involved a stock purchase agreement for the redemption of a decedent’s shares in a closely held corporation.
The estate in that case argued that life insurance proceeds did “not augment a company’s value where they are offset by a redemption liability”; the money just passed through the corporation, and a willing buyer and seller would not account for it.
The IRS countered that “this assumption defies common sense and customary valuation principles.”
That court accepted the estate’s position and concluded that the life insurance proceeds had been accounted for by the redemption obligation.
As the Eighth Circuit described it in the present case:
“In balance-sheet terms, the [Eleventh Circuit] viewed the life insurance proceeds as an ‘asset’ directly offset by the ‘liability’ to redeem shares, yielding zero effect on the company’s value. The court summarized its conclusion with an appeal to the willing buyer/seller concept: ‘To suggest that a reasonably competent businessperson, interested in acquiring a company, would ignore a [buyout] liability strains credulity and defies any sensible construct of fair market value.’”
The Eighth Circuit
The Court commented that the Eleventh Circuit’s opinion was flawed because, the Court stated, “an obligation to redeem shares is not a liability in the ordinary business sense.” Treating it so, the Court continued, “distorts the nature of the ownership interest represented by those shares.”
The Court posited that if a willing buyer had acquired all of Corp’s issued and outstanding shares of stock following Bro-1’s demise, it would have paid up to $6.86 million (the $3.86 million derived from the IRS’s appraisal plus the $3 million insurance proceeds).
On the flip side, the Court continued, a hypothetical willing seller of Corp holding all of its outstanding shares would not have accepted only $3.86 million knowing that the company was about to receive $3 million in life insurance proceeds. To accept $3.86 million, the Court stated, would have ignored the anticipated life insurance proceeds.
“To further see the illogic of the estate’s position,” the Court added, “consider the resulting windfall to” Bro-2. If the insurance proceeds intended for the redemption were ignored, then upon Bro-1’s death, each share was worth $7,720 before the redemption.[xxxiv] After the redemption, however, Bro-2 owns all of Corp’s remaining shares of stock, each of which is worth $33,800.[xxxv] How could this be if Bro-1’s shares were purchased by Corp for an amount equal to their fair market value? Shouldn’t the value of Bro-2’s shares remain the same as they were before the redemption? According to the Court, if the proceeds were applied toward a true “liability.” then the value of Bro-2’s shares would not have changed.[xxxvi]
With that, the Court concluded that Bro-1’s estate had failed to account for the fact that the insurance proceeds were simply an asset that increased the shareholders’ equity.
Timing May Be Everything
The value of a decedent’s gross estate for purposes of the federal estate tax is determined at the time of the decedent’s death.
The value of every item of property includible in a decedent’s gross estate for purposes of the tax is its fair market value at the time of the decedent’s death.
The fair market value of an item of property is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell, and both having reasonable knowledge of relevant facts.
Consider the holding of the Eleventh Circuit.
Assume a corporation has a fair market value of $200 and is owned equally by two shareholders. The corporation holds a $100 life insurance policy on each shareholder. One of the shareholders dies and the insurance proceeds are paid to the corporation. The corporation has no control over the proceeds – it is obligated to, and in fact does, distribute them to the decedent’s estate in exchange for the decedent’s shares. The remaining shareholder now owns all of the corporation, which has a fair market value of $200.
If such shareholder were to sell one half of their shares to a hypothetical buyer – necessarily not on the deceased shareholder’s date of death – they would do so for $100, which is also the amount for which the decedent’s shares (a 50 percent interest) were redeemed.
There is something appealing about this reasoning, isn’t there? Yes, but how does it address the remaining shareholder’s newfound wealth of an additional $100?
At the date of death, as the Eighth Circuit reminded us, the corporation had a vested right to receive an additional $100 from the policy, thereby increasing its value to $300. According to the Court, this insurance bump-up was not accounted for by the estate of the deceased shareholder.
The basis for the Court’s conclusion was that Corp’s obligation to redeem Bro-1’s shares was not a business liability; in other words, the receipt of the proceeds was not offset by any liability. Is that correct, though? Many courts have determined that a corporation has a business purpose in facilitating the transfer of its stock. Still, how does one explain the enhanced value of the remaining shareholder’s interest?
Compare this alternative: instead of life insurance, the corporation borrows the money for the redemption from a bank. The corporation has not experienced any accretion in value, and after it distributes the redemption proceeds its value is reduced by half.
Is there anything to be said for the following approach: because the buyout took the form of a redemption, the hypothetical “buyer” should instead have been analyzed as one who contributes capital to the corporation in exchange for a 50 percent interest? Of course, it costs more to acquire the same interest by way of a capital contribution than it does by way of a cross-purchase – double where the corporation has only one shareholder.
Then again, perhaps the best approach is to make certain that the method by which one’s shareholders’ agreement established the purchase price for the corporation’s shares complies with the applicable statutory and regulatory requirements.
The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.
[i] The imposition of a state “death tax,” such as New York’s 16% tax, only exacerbates the problem.
[ii] Especially, who will inherit the business and, perhaps more importantly, who will manage it – not necessarily the same individual.
[iii] Hopefully in consultation with professional advisers and not commissioned salespeople, though the latter have a supporting role to play.
[iv] For example, under the terms of a shareholders’ or operating agreement; don’t forget to check other agreements such as loan agreements and leases.
[v] The enhanced estate and gift tax exemption is scheduled to be reduced by 50% after 2025. Moreover, the IRS has begun to chip away, through regulations, the ability to utilize grantor trusts for such transfers. A Democratic victory in the 2024 federal elections may well spell the end for sales to grantor trusts, the use of zeroed out GRATs, and certain valuation discounts.
[vi] Such gifts may also position the owner’s interest for a more favorable date of death valuation by bringing their voting interest to something less than a majority position.
[vii] IRC Sec. 6166.
[viii] In addition, the business must not have more than 45 owners. Not a problem for most closely held businesses.
[ix] There is an exception for redemptions described in IRC Sec. 303. The Code coordinates these redemptions with the scheduled payments under Sec. 6166.
[x] IRC Sec. 6166(g).
[xi] Indeed, installment reporting is not available for that portion of the tax that is attributable to passive, non-business assets held by the business entity.
[xii] 56 T.C.M. 387 (1988).
[xiii] Sounds good, right?
[xiv] A word of unsolicited advice here. There are insurance professionals and there are insurance salespeople. Both make a living selling policies. The former are technicians whose knowledge and experience can be invaluable in structuring a buyout. The latter, however, will often try to sell more coverage than is required or a policy that is inappropriate for the circumstances – don’t tell me you haven’t seen that. Also within this group are those who, having disclaimed any knowledge of the law, proceed to give legal advice and to treat the attorney – the estate “planner” – as their scrivener. Stay away from these folks.
[xv] Where spouses are both owners, a second-to-die policy may be advisable, depending on the circumstances, and less expensive than a single life policy. Ask the broker – they should be all over this.
[xvi] In the case of a cross-purchase, the parties have to be careful of the transfer for value rule, which could cause the insurance proceeds to become taxable. IRC Sec. 101(a)(2).
[xvii] Connelly v. IRS, Eighth Circuit, No. 21-3683 June 2, 2023.
[xviii] No surprise there, right?
[xix] Mind you, one owned 77.18% and the other 22.82%. Go figure.
[xx] The proceeds were never in doubt. Corp expected to receive $3.5 million from the policy, most of which would be used to buy Bro-1’s shares.
[xxi] This figure came from the IRS’s own valuation of Bro-1’s shares of Corp stock plus the $3 million in proceeds used for the redemption. The IRS independently determined that Bro-1’s shares were worth $2.98 million exclusive of the proceeds. At Bro-1’s 77.18% share, that represented a company value of $3.86 million—slightly less than the $3.89 million figure arrived at by deeming Bro-1’s shares to be worth $3 million as the redemption transaction effectively did.
[xxii] IRC Sec. 7422.
[xxiii] The Court explained that IRC Section 2703 tells us to ignore buy-sell agreements unless they meet certain criteria: for valuation purposes the agreement must (1) be a bona fide business arrangement, (2) not be a device to transfer property to members of the decedent’s family for less than full and adequate consideration, and (3) have terms that are comparable to other similar arrangements entered into in arm’s length transactions.
In addition, the agreement must contain a fixed or determinable price if it is to be considered for valuation purposes. Here, the shareholders ignored the agreement’s pricing mechanisms. Moreover, the stock-purchase agreement fixed no price nor prescribed a formula for arriving at one. It merely laid out two mechanisms by which the brothers might agree on a price.
[xxiv] Reg. Sec. 20.2031-1(b); Sec. 20.2031-2(a)
[xxv] Reg. Sec. 20.2031-2(f)(2). The Court also stated that one should consider, “in addition to all other factors, the value of stock… of corporations engaged in the same or a similar line of business which are listed on an exchange.”
[xxvi] Reg. Sec. 20.2031-2(f)(2)
[xxvii] IRC Sec. 2042. In general, the term refers to the right of the insured or his estate to the economic benefits of the policy. Reg. Sec. 20.2042-1(c).
Among other things, an incident of ownership may include a reversionary interest in the policy, the right to borrow against the policy, the right to pledge the policy, the right to assign the policy, the right to change beneficiaries, and the right to surrender the policy.
[xxviii] Reg. Sec. 20.2042-1(c)(6).
[xxix] For purposes of this subparagraph, the decedent will not be deemed to be the controlling stockholder of a corporation unless, at the time of his death, he owned stock possessing more than 50 percent of the total combined voting power of the corporation.
[xxx] Under IRC Sec. 2042.
[xxxi] Contrast the situation in which Bro-1 had obtained and owned a life insurance policy on his life for the benefit of Corp. In that case, the value of the policy’s proceeds would have been included in Bro-1’s gross estate. IRC Sec. 2042.
[xxxii] The Court mentioned the $500,000 of proceeds not used to redeem shares and which simply went into Corp’s coffers, these “undisputedly increased” Corp’s value, the Court stated.
[xxxiii] Estate of Blount v. Commissioner, 428 F.3d 1338 (11th Cir. 2005).
[xxxiv] Appraised value of $3.86 million divided by 500 shares.
[xxxv] $3.86 million divided by 114 shares.
[xxxvi] “When a corporation purchases its own stock, it has depleted its assets by whatever amount of money or property it gave in exchange for the stock. There is, however, an increase in the proportional interest of the non-selling shareholders in the remaining assets of the corporation.”
