Seeing Through the Sleight of Hand: Estate Tax Consequences of Redeeming Stock With Life Insurance Proceeds

Abstract

The Supreme Court granted certiorari in Connelly v. United States to resolve a circuit court split concerning the federal estate tax valuation of shares in a closely held corporation when that corporation uses life insurance proceeds to satisfy its obligation to redeem the decedent-shareholder’s shares.

We argue that treating the insurance proceeds as suddenly appearing and then quickly disappearing is akin to the magician’s “now you see it, now you don’t” sleight of hand. Seeing through this sleight of hand, we advance the literature by explaining that the secret to dispelling this illusion is to properly consider the mortality gain, when it occurs, in the insurance policy. To accomplish this, we argue that life insurance used for liquidity purposes in the buy-sell context operates no differently than any sinking fund funded with corporate cash. Consequently, using that sinking fund analogy, the valuation of the corporate shares for estate tax purposes should include the corporation’s mortality gain, when it occurs. We also show that treating the redemption obligation as a liability does not change the value of the corporation because that liability arises from a transformation of the redeeming shareholder’s residual equity claim into a liability claim on corporate assets.

Keywords: Connelly, corporation, redemption, life insurance, sinking fund, estate tax, estate tax valuation, valuation

JEL Classification: K00, K2, K34