Our founder, Chris Mercer, recently wrote a case review regarding the Supreme Court’s decision in the matter of Connelly v. United States. This case involved two brothers, Michael and Thomas Connelly, who were the sole shareholders of a small building supply corporation. They entered into an agreement to ensure that the company would stay in the family if either passed away. Under that agreement, the corporation would be required to redeem (i.e., purchase) the deceased brother’s shares. To fund the possible share redemption, the corporation obtained life insurance on each brother. After Michael died, a dispute arose over how to value his shares for calculating his estate tax. The central question is whether the corporation’s obligation to redeem Michael’s shares was a liability that decreased the value of those shares.
The primary takeaway from that decision is that life insurance received at the death of a shareholder is a corporate asset that adds to the value of the company for federal gift and estate tax purposes.
While the case itself directly addressed tax law, with regard to deferred compensation and taxation of assets, its implications extend beyond tax law alone. This ruling also has relevance in the realm of divorce valuations, where the accurate assessment of assets is crucial. In this article we highlight some specific areas where the Connelly case has relevance for business owner clients going through a divorce.
In the context of Connelly v. United States, when calculating the federal estate tax, the value of a decedent’s shares in a closely held corporation must reflect the corporation’s fair market value. Life-insurance proceeds payable to a corporation are an asset that increase fair market value. The question in this case is whether the contractual obligation to redeem the decedent’s shares at fair market value offsets the value of life-insurance proceeds committed to funding that redemption.
The Supreme Court concluded no. Because the Court determined a fair-market-value redemption has no effect on any shareholder’s economic interest, and no hypothetical buyer purchasing the decedent’s shares would have treated the life-insurance obligation as a factor that reduced the value of those shares.
However, the decision is a reminder also for family law valuations to consider future tax liabilities when dividing marital assets pursuant to a divorce. The eventual tax obligations should be accounted for in the present value of the settlement. Otherwise, one spouse could potentially receive an asset that appears more valuable but carries a significant tax burden when eventually realized.
The Connelly decision underscores the idea that risk should be considered in asset valuation. In divorce cases, this suggests family law matter should account for potential fluctuations in the value of deferred corporate assets, ensuring that both parties share equally in any future financial risks or rewards. Another element is timing.
Should stock options granted during the marriage but vesting after divorce be valued at the date of divorce assuming the full stock options or considering a coverture fraction on the stock options?
Designed to both reward performance and retain employees, these benefits can be difficult to value, particularly at a random moment for the purpose of marital dissolution. The Connelly decision provides a useful analogy by emphasizing that the timing of valuation has material consequences and can affect how equitable the division appears in hindsight.
Most family law cases that require the use of a financial expert share some combination of the following: a high-dollar marital estate, complex financial issues, business valuation(s) performed, and/or the need for forensic services. In the Connelly case, there were intricate financial issues regarding the life insurance corporate asset as well as the potential corporate liability to repurchase shares upon the death of a shareholder.
Determining the present value for deferred compensation assets like pensions or life-insurance plans can be legally and financially complex. When these types of situations occur in the context of a divorce, an experienced financial expert that can communicate their opinions and conclusions on these issues is a priceless asset for your team.
