Recent U.S. Supreme Court ruling influences business valuations in family law cases

Lost in the shuffle of so many high-profile U.S. Supreme Court decisions is a recent decision that affects how family law bench officers value closely held businesses.

Briefly, the U.S. Supreme Court concluded that business valuations include the cash value of corporate owned life insurance (COLI). In Connelly v. United States (No. 23-146, decided June 6, 2024), the Supreme Court unanimously affirmed an Eighth Circuit decision that COLI must be added to the value of a business for tax valuation purposes. The Court rejected the taxpayer's executor's argument that, since COLI exists to buy out the interests of a retiring or deceased partner, its value should not be included in assessing the interests of the taxpayer in the fair rental value of the business.

Successful closely held corporations owned by more than one person (or that have more than one partner) often purchase life insurance to facilitate the purchase of the interests of one of the co-owners or partners should that person want to sell or dies. As the high court explains, the structure of closely held businesses often requires the retiring partner or estate to first offer their interests in the business to the corporation or to its remaining partners. Many closely held businesses are family businesses and their owners want to keep them in family hands. The cash value of a COLI provides the necessary funds to buy out the interests of the retiring or deceased partner. Often, the interest must be first offered to the surviving partners, and if they decline, it is the corporation which owns the insurance that has the ability to redeem the interests. The business acquiring that person's interests in the business decreases the number of shares outstanding of the business, and pro tanto increases the value of the remaining partners' shares of the company.

Although the controversy arose in the context of a tax dispute between the estate of a shareholder and the IRS, the Supreme Court's logic applies to family law proceedings involving the valuation of a closely held corporation or partnership. The proper time to assess the value of a partner's interest in the business is before the life insurance is used to redeem the interest of the retiring or deceased partner. The existence of a life insurance policy as an asset of the business with cash value increases the fair market value of the business. The fact that the life insurance must be used to redeem a retiring or deceased partner's interests, the Court concluded, does not mean the cash value of the policy does not count.

"An obligation to redeem shares at fair market value does not offset the value of life insurance proceeds set aside for the redemption because a share redemption at fair market value does not affect any shareholder's economic interest." Stated another way, since a fair market value redemption has no impact on any shareholder's economic interests in the business, no willing buyer purchasing the shares of the retiring or deceased partner's interest would treat the obligation of the business to redeem those shares at fair market value to be relevant to the value of those shares.

In family law proceedings in assessing the value of a closely held business, the cash value of any corporate owned life insurance increases the value of the business and therefore is to be treated as an asset of the corporation. The fact that the corporation will be required to use the cash value of the life insurance to purchase the interests of one of the partners who wishes to retire or who dies is of no consequence.