Earlier this year, we wrote about the Connelly case heading to the Supreme Court for final adjudication.  The Court handed down its ruling in June, siding with the IRS in a unanimous decision.

Readers may recall that the essence of the case was whether the contractual obligation of a family business (Crown Corporation) to redeem the shares of a deceased shareholder was a corporate liability that effectively offset the incremental value represented by the life insurance proceeds earmarked to fund the redemption.

• The taxpayer argued that the obligation reduced the fair market value of the deceased shareholder’s subject interest.
• The IRS argued that the redemption obligation properly had no effect on the fair market value of the shares.

In its brief opinion, the Supreme Court ruled in favor of the IRS, stating that “a share redemption at fair market value does not affect any shareholder’s economic interest.”  The Court’s opinion provides a simple example to illustrate the underlying economic rationale for their conclusion.

For multi-generational family businesses with dozens of individual owners, using company-owned life insurance as a funding vehicle for shareholder redemptions at death is rarely practicable.  However, the Court’s opinion does provide an opportunity to reflect on how family businesses can incorporate looming redemption obligations in their long-term capital planning.

While the Supreme Court’s economic reasoning in its Connelly decision is impeccable, the need to redeem shares to fund eventual estate tax obligations of significant shareholders can disrupt, or at least complicate, the best-laid plans of growing family businesses.  The opinion acknowledged that reality in a footnote to its decision:

“We do not hold that a redemption obligation can never decrease a corporation’s value.  A redemption obligation could, for instance, require a corporation to liquidate operating assets to pay for the shares, thereby decreasing its future earning capacity.” (emphasis in original)

In this footnote, the Court acknowledges that while redeeming shares at fair market value is an economically neutral event, if available capital is scarce, such obligations can “crowd out” investments that would otherwise support — and stimulate growth in — the earning capacity of the family business.

The desire to keep the family business in the family constitutes a (self-imposed) constraint on capital availability.  If raising new equity capital from non-family investors is off the table, how can directors and shareholders responsibly balance the capital needs of the family business and family shareholders?

Whose Responsibility?

It is important to be clear that the estate tax is an obligation of the shareholder’s estate, not the family business.  Sometimes, we see discussions on this topic get off track when the parties assume that the family business is responsible for paying estate taxes, which puts the onus for planning solely on the company.  Of course, if the family business is the primary source of a family’s wealth, it will also be the primary source of liquidity to pay the estate tax, but it is important to acknowledge the joint responsibility of the family business and shareholders to plan responsibly.

Steps for Family Shareholders

Family shareholders can do their part in three primary ways:

1. Take steps to minimize the eventual estate tax liability through proactive tax planning. There are a host of strategies available to shareholders to reduce their eventual estate tax obligation.  Since 2017, shareholders have enjoyed historically high exemption levels, but time may be running out on that opportunity.  Given all the tools at their disposal, significant family shareholders are irresponsible not to engage with competent tax counsel to take steps to minimize their estate tax obligation.
2. Be a responsible steward of liquidity provided by the family business. This will look different for every family business, but when family shareholders do receive dividends, they should responsibly balance consumption with investment in other assets to diversify their own household portfolio.  When invested prudently over decades, accumulated distributions from the family business can provide a significant liquidity pool to fund estate tax obligations when they come due.
3. Evaluate other personal strategies. While the Connelly case highlights some of the limitations of company-owned life insurance, for individual shareholders life insurance (or similar financial products) may be an efficient way to prepare for future estate tax obligations.  Further, for qualifying estates, the Section 6166 deferral option can help ease the liquidity crunch of the estate tax.

Steps for Family Businesses

Family businesses also have three primary ways to do their part:

1. Maintain a good relationship with lenders. The best time to (arrange to) borrow money is when you don’t need it.  Many family businesses are debt-averse, and that’s okay.  But even family businesses that eschew debt should cultivate relationships with quality lenders and have credit facilities in place well ahead of an actual need.  Investing in transparency and educating lenders on what’s going on in the family business will pay dividends when capital is needed.
2. Don’t hoard capital. In some families, there can be a reluctance to pay dividends or fund periodic voluntary redemption programs.  There can be a perception of safety in retaining capital in the family business even when the company has no attractive investment opportunities.  However, that “excess” capital has a tendency to become lazy with negative consequences for both the family and the business.
3. Invest in shareholder communication. Finally, family businesses need to prioritize communicating with their family shareholders.  Public companies invest significant resources to ensure that current and potential investors are well-informed about the historical results and strategies for the future.  Family businesses that do the same are richly rewarded with a more engaged family shareholder base.  In our experience, engaged shareholders are more motivated to be good owners and do their part to keep estate taxes from “crowding out” other worthwhile investment opportunities for the family business.

Conclusion

The Supreme Court’s Connelly decision is a timely reminder that family businesses and their shareholders need to work together to prepare for possible redemptions.  An independent opinion regarding the fair market value of your family business is an essential component in advancing that conversation productively.  Give one of our senior valuation professionals a call today to discuss your situation in confidence and see how we can help.