U.S. Supreme Court,
Family
Sep. 25, 2024
Recent U.S. Supreme Court ruling influences business valuations in family law cases
The Court concluded that the cash value of a life insurance policy increases a business's fair market value, regardless of its use for redeeming interests.
Stanley Mosk Courthouse
Dean Hansell
Judge, Los Angeles Court Superior Court
Northwestern University Pritzker School of Law, 1977
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.
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