Thomas Connelly v. United States

United States Court of Appeals
For the Eighth Circuit
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No. 21-3683
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Thomas A. Connelly, in his Capacity as Executor of the Estate of Michael P.
Connelly, Sr.
Plaintiff - Appellant
v.
United States of America, Department of Treasury, Internal Revenue Service
Defendant - Appellee
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Appeal from United States District Court
for the Eastern District of Missouri - St. Louis
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Submitted: December 14, 2022
Filed: June 2, 2023
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Before SMITH, Chief Judge, GRUENDER and STRAS, Circuit Judges.
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GRUENDER, Circuit Judge.
Brothers Michael and Thomas Connelly were the sole shareholders of a
corporation. The corporation obtained life insurance on each brother so that if one
died, the corporation could use the proceeds to redeem his shares. When Michael
died, the Internal Revenue Service assessed taxes on his estate, which included his
stock interest in the corporation. According to the IRS, the corporation’s fair market
value includes the life insurance proceeds intended for the stock redemption.
Michael’s estate argues otherwise and sued for a tax refund. The district court 1
agreed with the IRS, and so do we.
I.
Before Michael died, he and Thomas owned Crown C Corporation, a
building-materials company in St. Louis. Michael owned 77.18 percent of the 500
shares outstanding (385.9 shares); Thomas owned 22.82 percent (114.1 shares). To
provide for a smooth transition of ownership upon either’s death, the brothers and
Crown together entered into a stock-purchase agreement. If one brother died, the
surviving brother had the right to buy his shares. If the surviving brother declined,
Crown itself had to redeem the shares. In this way, control of the company would
stay within the family. The brothers always intended that Crown, not the surviving
brother, would redeem the other’s shares.
The stock-purchase agreement provided two mechanisms for determining the
price at which Crown would redeem the shares. The principal mechanism required
the brothers to execute a new Certificate of Agreed Value at the end of every tax
year, which 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. At any rate, to fund the redemption,
Crown purchased $3.5 million of life insurance on each brother.
After Michael died in 2013, Crown received the life insurance proceeds and
redeemed his shares for $3 million. The actual redemption transaction was part of a
larger, post-death agreement between Thomas and Michael’s son, Michael Connelly,
Jr., resolving several estate-administration matters. No appraisals were obtained
1
The Honorable Stephen R. Clark, Chief Judge, United States District Court
for the Eastern District of Missouri.
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pursuant to the stock-purchase agreement. Instead, the Connellys declared that they
had “resolved the issue of the sale price of [Michael’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. That figure effectively valued Crown, based on Michael’s
77.18 percent share, at $3.89 million. The rest of the proceeds, about $500,000, went
to fund company operations.
Thomas is the executor for Michael’s estate. In 2014, the estate filed a tax
return reporting that Michael’s shares were worth $3 million. To value the shares,
Thomas 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 Michael’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 Michael’s shares by simply relying on the $3 million redemption
payment instead of determining the fair market value of Crown, which should
include the value of the life insurance proceeds. Taking the proceeds into account,
Crown was worth $3 million more than the estate had determined—about $6.86
million. 2 So according to the IRS, just before redemption, Michael’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. See 26
U.S.C. § 7422; 28 U.S.C. § 1346(a)(1).
2
This figure comes from the IRS’s own valuation of Michael’s interest in
Crown plus the $3 million in proceeds used for redemption. The IRS independently
determined that Michael’s shares were worth $2,982,000 exclusive of the proceeds.
At Michael’s 77.18 percent share, that represents a company value of $3.86
million—slightly less than the $3.89 million figure arrived at by deeming Michael’s
shares to be worth $3 million as the redemption transaction effectively did. Because
the estate does not challenge this sans-proceeds value on appeal, we accept it for our
purposes. In any event, it does not affect the issue of how to treat the life insurance
proceeds used for stock redemption.
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The estate claims that the redemption transaction, made in furtherance of the
stock-purchase agreement, determined the value of Crown for estate-tax purposes,
so there is no need to conduct a fair-market-value analysis. Alternatively, the estate
argues that Crown’s fair market value should not include the life insurance proceeds
used to redeem Michael’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 Crown’s value. By contrast, the IRS argues that the
stock-purchase agreement should be disregarded and that any calculation of Crown’s
fair market value must account for the proceeds used for redemption.
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 Crown must include the life insurance
proceeds used for redemption because they were a significant asset of the company.
In doing so, the district court declined to follow Estate of Blount v. Commissioner,
428 F.3d 1338 (11th Cir. 2005), relying instead on the tax code, Treasury
regulations, and customary valuation principles. The estate appeals.
II.
A federal tax applies to the transfer of a decedent’s estate, which comprises
the gross estate minus applicable deductions. 26 U.S.C. §§ 2001, 2051; Comm’r v.
Est. of Hubert, 520 U.S. 93, 99-100 (1997). A decedent’s gross estate includes “the
value at the time of his death of all property, real or personal, tangible or intangible,
wherever situated” in which he had an interest. §§ 2031(a), 2033. Property includes
stocks. See 26 C.F.R. §§ 20.2031-1, 20.2031-2. For Michael’s gross estate, the only
issue on appeal is the value of his Crown shares.
The parties dispute whether Crown’s value, and hence the value of Michael’s
shares, should include the life insurance proceeds used for redemption. If not, then
the estate is entitled to a refund. If the proceeds should be included, as the district
court determined, then the IRS is correct and summary judgment was proper. With
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this in mind, we review the district court’s grant of summary judgment de novo.
Westerman v. United States, 718 F.3d 743, 746 (8th Cir. 2013). In refund actions,
“[t]he [IRS’s] determination of a tax deficiency is presumptively correct, and the
taxpayer bears the burden of proving that the determination is arbitrary or
erroneous.” Day v. Comm’r, 975 F.2d 534, 537 (8th Cir. 1992).
We first consider whether the stock-purchase agreement controls how the
company should be valued. Finding that it does not, we then consider whether a
fair-market-value analysis of Crown must include the life insurance proceeds used
for redemption. It must.
A.
Generally, the value of any property for tax purposes is determined “without
regard to any option, agreement, or other right to acquire . . . the property at a price
less than the fair market value” or to “any other restriction on the right to sell or use
such property.” 26 U.S.C. § 2703(a). These sorts of agreements are commonly used
by closely held corporations to keep control among a small group of people. See 3
James D. Cox & Thomas Lee Hazen, Treatise on the Law of Corporations § 18:13
(3d ed. Dec. 2022 update). Section 2703(a) tells us to ignore these agreements unless
they meet the criteria in subsection (b). Under § 2703(b), to affect valuation, 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. Here, the estate argues that we should look
to the stock-purchase agreement to value Michael’s shares because it satisfies these
criteria.
But the estate glosses over an important component missing from the stock-
purchase agreement: some fixed or determinable price to which we can look when
valuing Michael’s shares. After all, if § 2703 tells us when we may “regard”
agreements to acquire stock “at a price less than the fair market value,” we naturally
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would expect those agreements to say something about value in a definite or
calculable way. See Est. of Lauder v. Comm’r, 64 T.C.M. (CCH) 1643, 1656 (1992)
(“It is axiomatic that the offering price must be fixed and determinable under the
agreement.”); see also Est. of Amlie v. Comm’r, 91 T.C.M. (CCH) 1017, 1027 (2006)
(reviewing the comparability of price terms to determine whether the agreement
satisfied § 2703(b)(3)). Otherwise, why look to the agreement to value the shares?
Further, the Treasury regulation that clarifies how to value stock subject to a
buy-sell agreement refers to the price in such agreements and “[t]he effect, if any,
that is given to the . . . price in determining the value of the securities for estate tax
purposes.” 26 C.F.R. § 20.2031-2(h). The regulation also states that “[l]ittle weight
will be accorded a price” in an agreement where the decedent was “free to dispose
of” the securities at any price during his lifetime. Id. Courts thus recognize that an
agreement must contain a fixed or determinable price if it is to be considered for
valuation purposes. Est. of Blount v. Comm’r, 428 F.3d 1338, 1342 (11th Cir. 2005);
Est. of True v. Comm’r, 390 F.3d 1210, 1218 (10th Cir. 2004); Est. of Gloeckner v.
Comm’r, 152 F.3d 208, 213 (2d Cir. 1998); see also St. Louis Cnty. Bank v. United
States, 674 F.2d 1207, 1210 (8th Cir. 1982) (describing when restrictive buy-sell
agreements “may fix the value of property for estate-tax purposes” (emphasis
added)). Congress enacted § 2703 against the backdrop of 26 C.F.R. § 20.2031-
2(h), which has remained substantially unchanged, and courts have since interpreted
the two in tandem. See Amlie, 91 T.C.M. (CCH) at 1024 (“[R]egardless of whether
section 2703 applies to a restrictive agreement, the agreement must satisfy the
requirements of pre-section-2703 law to control value for Federal estate tax
purposes.”); Blount, 428 F.3d at 1343 n.4 (“[C]ourts generally agree that the
limitation in . . . § 2703 should be read in conjunction with the court-created rule.”);
True, 390 F.3d at 1231 (describing § 2703 as “essentially codif[ying] the rules laid
out in § 20.2031-2(h)” that had existed before § 2703 was added in 1990).
We need not resolve the precise contours of what counts as a fixed or
determinable price because, wherever that line may be, the stock-purchase
agreement here falls short given that the brothers and Crown ignored the agreement’s
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pricing mechanisms. It suffices for our purposes to think of a determinable price as
one arrived at by “formula,” see Gloeckner, 152 F.3d at 213, as by a “fair, objective
measure,” see Lauder, 64 T.C.M. (CCH) at 1659, or “calculation,” see True, 390
F.3d at 1213.
Here, 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. One was the Certificate of Agreed Value, which appears to be
nothing more than price by “mutual agreement”—essentially, an agreement to agree.
The other was an appraisal process for determining the fair market value of Crown.
Although this second mechanism seems to carry more objectivity, there is nothing
in the stock-purchase agreement, aside from minor limitations on valuation factors,
that fixes or prescribes a formula or measure for determining the price that the
appraisers will reach. Instead, the agreement required only that the appointed
appraisers “independently determine and submit” their “appraisal[s] of the fair
market value of the Company.” The brothers were then supposed to average the
results or consult a third appraiser as a tiebreaker. None of this was ever done. See
St. Louis Cnty. Bank, 674 F.2d at 1211 (noting that upon death, the provisions of the
stock-purchase agreement were not invoked and that post-death conduct may be
relevant to understanding the nature of the agreement). Thus, “under the
circumstances of th[is] particular case,” neither price mechanism constituted a fixed
or determinable price for valuation purposes. See 26 C.F.R. § 20.2031-2(h). If
anything, the appraisal mechanism calls for a rather ordinary fair-market-value
analysis, which § 2031 and § 2073(a) essentially require anyway. Nothing therefore
can be gleaned from the stock-purchase agreement.3
3
The estate does not argue that the stock-purchase agreement otherwise
controls the fair market value of Crown by virtue of its restriction on the transfer of
shares (i.e., through non-price-related means). Compare § 2703(a)(2), with
§ 2703(a)(1). And even if we understood the estate to make this argument, we find
it indistinguishable from the estate’s fair-market-value argument that we address in
Part II.B below.
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Thomas tries to get around this problem by directing us to the price fixed by
the redemption transaction—the $3 million that Crown actually paid for Michael’s
shares. In his view, this is an appropriate valuation because the redemption
transaction links back to the stock-purchase agreement and was done pursuant to it.
We are not convinced. For one, the $3 million price was chosen after Michael’s
death. See 26 U.S.C. § 2031(a) (requiring that value be determined “at the time of
[the decedent’s] death”); True, 390 F.3d at 1218 (noting that “the terms of the
agreement [must be] binding throughout life and death”). And second, the $3
million price came not from the mechanisms in the stock-purchase agreement but
rather from Thomas and Michael Connelly, Jr.’s “amicable agreement” resolving
outstanding estate-administration matters. Thus, Crown’s value must be determined
“without regard” to the stock-purchase agreement. See § 2703(a).
B.
We now consider the fair market value of Michael’s shares. The key question
is whether the life insurance proceeds received by Crown and intended for
redemption should be taken into account when determining the corporation’s value
at the time of Michael’s death.4 Two principles guide the analysis. The first deals
with valuing property in general, and the second addresses companies whose stock
prices cannot be readily determined from an exchange, as is the case with closely
held corporations.
4
We focus on this moment in time—after Michael’s death but before his
shares are redeemed. See Bright’s Est. v. United States, 658 F.2d 999, 1006 (5th Cir.
1981) (en banc) (“[T]he estate tax is an excise tax on the transfer of property at death
and accordingly . . . the valuation is to be made as of the moment of death and is to
be measured by the interest that passes, as contrasted with the interest held by the
decedent before death or the interest held by the legatee after death.”). Regardless
of the timing, no one argues that the proceeds were ever in doubt. Crown expected
to receive $3.5 million from the policy, most of which would be used to buy
Michael’s shares.
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Generally, the value of property in the 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.” 26 C.F.R. § 20.2031-1(b); see also United States v. Cartwright,
411 U.S. 546, 551 (1973) (“The willing buyer-willing seller test of fair market value
is nearly as old as the federal income, estate, and gifts taxes themselves . . . .”).
To this end, for closely held corporations, the share value “shall be determined
by taking into consideration, in addition to all other factors, the value of stock or
securities of corporations engaged in the same or a similar line of business which are
listed on an exchange.” 26 U.S.C. § 2031(b). Treasury regulations have interpreted
this as a “fair market value” analysis. 26 C.F.R. § 20.2031-2(a). The fair market
value 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.” 26 C.F.R. § 20.2031-2(f)(2); see also Est. of Huntsman
v. Comm’r, 66 T.C. 861, 876 (1976) (“[W]e . . . determine the fair market value of
the decedent’s stock . . . by applying the customary principles of valuation . . . .”).
Setting aside for the moment the life insurance proceeds used to redeem Michael’s
shares, so far as Crown’s operations, revenue streams, and capital are concerned, we
know its value—about $3.86 million. See supra n.2.
But in valuing a closely held corporation, “consideration shall also be given
to 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.” 26 C.F.R. § 20.2031-2(f)(2). This need to “take[] into
account” life insurance proceeds appears again in a nearby regulation, 26 C.F.R.
§ 20.2042-1(c)(6). That regulation clarifies 26 U.S.C. § 2042, which has to do with
life insurance proceeds that go to beneficiaries other than the decedent’s estate.
Understanding the relationship between § 2031 (defining the gross estate) and
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§ 2042, along with their corresponding regulations, helps further illuminate what it
means to “take[] into account” life insurance proceeds.
Section 2042 says that the value of a decedent’s gross estate includes life
insurance proceeds received directly by the estate 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.” For example, if Michael obtained a life
insurance policy for the benefit of Crown, the value of that policy’s proceeds would
be included in Michael’s gross estate. See § 2042(2). Yet here, Crown obtained the
policy for its own benefit.
Now, there might be a plausible argument that under § 2042 Michael
possessed “incidents of ownership” in the life insurance policy through his
controlling-shareholder status. If that were the case, then § 2042 would require that
Michael’s gross estate include the proceeds used for his stock redemption. But that
is not the case. Treasury regulation § 20.2042-1(c)(6) clarifies that a decedent does
not possess the “incidents of ownership” described in § 2042 merely by virtue of
being a controlling shareholder in a corporation that owns and benefits from the
policy.
Still, although § 2042 does not require that the proceeds be included here, it
does not exclude them either. We are cautioned to “[s]ee § 20.2031-2(f) for a rule
providing that the proceeds of certain life insurance policies shall be considered in
determining the value of the decedent’s stock.” 26 C.F.R. § 20.2042-1(c)(6). Thus,
although the life insurance proceeds intended for redemption do not directly
augment Michael’s gross estate by way of § 2042, they may well do so indirectly
through a proper valuation of Crown. Indeed, the $500,000 of proceeds not used to
redeem shares and which simply went into Crown’s coffers undisputedly increased
Crown’s value according to the principles in § 2031 and 26 C.F.R. § 20.2031-2(f)(2).
We must therefore consider the value of the life insurance proceeds intended
for redemption insofar as they have not already been taken into account in Crown’s
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valuation and in light of the willing buyer/seller test. In this sense, the parties agree
that this case presents the same fair-market-value issue as Estate of Blount v.
Commissioner, 428 F.3d at 1345-46, from the Eleventh Circuit. But they disagree
on whether Blount was correctly decided. Like here, Blount involved a stock-
purchase agreement for a closely held corporation. Although the court referenced
the requirement in 26 C.F.R. § 20.2031-2(f)(2) that proceeds be “taken into
account,” it concluded that the life insurance proceeds had been accounted for by
the redemption obligation, which a willing buyer would consider. 428 F.3d at 1345.
In balance-sheet terms, the court viewed the life insurance proceeds as an “asset”
directly offset by the “liability” to redeem shares, yielding zero effect on the
company’s value.5 The court summarized its conclusion with an appeal to the
willing buyer/seller concept: “To suggest that a reasonably competent business
person, interested in acquiring a company, would ignore a $3 million liability strains
credulity and defies any sensible construct of fair market value.” Id. at 1346.
Like the estate in Blount, Thomas argues that life insurance proceeds do not
augment a company’s value where they are offset by a redemption liability. In his
view, the money is just passing through and a willing buyer and seller would not
account for it. The IRS counters that this assumption defies common sense and
customary valuation principles, as reflected in Treasury regulations.
The IRS has the better argument. Blount’s flaw lies in its premise. An
obligation to redeem shares is not a liability in the ordinary business sense. See 6A
Fletcher Cyclopedia of the Law of Corporations § 2859 (Sept. 2022 update) (“The
redemption of stock is a reduction of surplus, not the satisfaction of a liability.”).
5
Blount cited favorably the Ninth Circuit’s decision in Estate of Cartwright v.
Commissioner, 183 F.3d 1034, 1038 (9th Cir. 1999), which employed similar
reasoning. Like the Eleventh Circuit in Blount, the Ninth Circuit’s analysis was
limited—one paragraph citing 26 C.F.R. § 20.2031-2(f)(2) and the tax-court
decision in Estate of Huntsman v. Commissioner, 66 T.C. at 875, which merely
emphasized that life insurance proceeds are to be considered according to § 20.2031-
2(f)(2).
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Treating it so “distorts the nature of the ownership interest represented by those
shares.” See Est. of Blount v. Comm’r, 87 T.C.M. (CCH) 1303, 1319 (2004), aff’d
in part and rev’d in part, 428 F.3d at 1338. Consider the willing buyer at the time
of Michael’s death. To own Crown outright, the buyer must obtain all its shares. At
that point, he could then extinguish the stock-purchase agreement or redeem the
shares from himself. This is just like moving money from one pocket to another.
There is no liability to be considered—the buyer controls the life insurance proceeds.
A buyer of Crown would therefore pay up to $6.86 million, having “taken into
account” the life insurance proceeds, and extinguish or redeem as desired. See 26
C.F.R. § 20.2031-2(f)(2). On the flip side, a hypothetical willing seller of Crown
holding all 500 shares would not accept only $3.86 million knowing that the
company was about to receive $3 million in life insurance proceeds, even if those
proceeds were intended to redeem a portion of the seller’s own shares. To accept
$3.86 million would be to ignore, instead of “take[] into account,” the anticipated
life insurance proceeds. See id.To further see the illogic of the estate’s position, consider the resulting
windfall to Thomas. If we accept the estate’s view and look to Crown’s value
exclusive of the life insurance proceeds intended for redemption, then upon
Michael’s death, each share was worth $7,720 before redemption.6 After
redemption, Michael’s interest is extinguished, but Thomas still has 114.1 shares
giving him full control of Crown’s $3.86 million value. Those shares are now worth
about $33,800 each. 7 Overnight and without any material change to the company,
Thomas’s shares would have quadrupled in value.8 This view of the world
6
$3.86 million divided by 500 shares.
7
$3.86 million divided by 114.1 shares.
8
No one has argued that Michael’s death and Thomas’s subsequent sole
ownership of Crown accounts for such an increase. Cf. Huntsman, 66 T.C. at 879(“The decedent was the dominant force in both businesses, and his untimely death
obviously reduced the value of the stock in the two corporations.”).
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contradicts the estate’s position that the proceeds were offset dollar-by-dollar by a
“liability.” A true offset would leave the value of Thomas’s shares undisturbed. See
Cox & Hazen, supra, § 21:2 (“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
nonselling shareholders in the remaining assets of the corporation.”). In sum, the
brothers’ arrangement had nothing to do with corporate liabilities. The proceeds
were simply an asset that increased shareholders’ equity. A fair market value of
Michael’s shares must account for that reality.
III.
For the foregoing reasons, we affirm the district court’s grant of summary
judgment to the IRS.
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