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The U.S. Supreme Court affirmed a decision on Thursday denying a tax refund to the estate of a building materials company owner, who used a $3.5 million life insurance payout to purchase his shares in the business.

Taxing on Estate Insurance Payout :Court Decision and Impact

In a unanimous opinion, the court upheld the Eighth Circuit's ruling from last year. The court found that the life insurance proceeds used for stock redemption by Crown C Supply, following the death of co-owner Michael Connelly, were an asset that increased Crown's value. This, in turn, inflated the value of Connelly's stock and increased the estate's tax liability.

The court rejected the estate's argument that the proceeds should be considered a liability for Crown C Supply, which would reduce its value for calculating estate tax, similar to any debt.

Taxing on Estate Insurance Payout : Key Arguments and Rulings

Thomas Connelly, the executor of the estate and Michael Connelly’s brother, argued that the proceeds were a stock redemption. Justice Clarence Thomas stated that this view “cannot be reconciled with an elementary understanding of stock redemption.”

The conflict began when Michael Connelly died in 2013, and Thomas used $3.5 million in life insurance proceeds to fund a $3 million redemption of his brother's 77% share in Crown, based in St. Louis. The IRS rejected the $3 million valuation on the estate's tax return, asserting that the redemption obligation did not offset the insurance proceeds. The IRS valued Crown at nearly $6.9 million and claimed an additional $890,000 in taxes.

Affirmation by Lower Courts

After the estate paid the tax and challenged the IRS valuation, a Missouri federal court upheld the IRS's position. The court stated that the payout increased the company's fair market value and the family's equity.

In June 2023, the Eighth Circuit affirmed this decision, ruling that Crown was not owed a tax refund. The circuit court reasoned that a hypothetical buyer could cancel the redemption obligation and benefit from the additional value.

Supreme Court’s Reasoning

The justices agreed with the government's argument that the insurance payout used to redeem Michael Connelly's shares increased the company's value under the willing-buyer and willing-seller legal test. They emphasized that in a fair-market-value assessment, Crown’s value would include the life insurance proceeds.

The court cited Internal Revenue Code Section 2033, defining a gross estate as including all property value at the time of death, and U.S. Treasury Regulation Section 20.2031-1(b), which states that such property’s value is its fair market value at the time of death.

Implications for Future Cases

The estate argued that the Eighth Circuit’s ruling conflicted with decisions from the Ninth and Eleventh circuits, potentially depriving closely held corporations of a critical tool for continuity after an owner's death.

However, the justices noted, "A corporation that pays out $3 million to redeem shares should be worth less than before the redemption."

Taxing on Estate Insurance Payout: Conclusion

Kannon K. Shanmugam of Paul Weiss, representing the estate, declined to comment. The U.S. Department of Justice did not immediately respond to a request for comment.

The estate was represented by Kannon K. Shanmugam, William T. Marks, and Yishai Schwartz of Paul Weiss Rifkind Wharton & Garrison LLP, and Robert L. Devereux and Mary C. Devereux of Aegis Law. The government was represented by Solicitor General Elizabeth B. Prelogar and several other attorneys from the U.S. Department of Justice.