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Notes -
Supreme Court, Again
I'm back, because the nine are back.
Connelly v. United States
9-0, opinion by Thomas.
This deals with a question about estate planning. Two brothers, Michael and Thomas Connelly, owned a company, Crown C Supply, and agreed that Crown would be contractually obligated to purchase out the shares of either of them upon death (funded by a life insurance policy on each brother, owned by the company). Michael died, the money was paid out, and Crown purchased his stock at a value of 3 million. Then came the IRS, with an audit. An accounting firm that Thomas hired valued the company at 3.86 million, then, with the 77% share held by Michael, the valuation of the shares in the estate were about 3 million. The IRS, on the other hand, argued that the value should be 6.86 million (the 3.86 million valued before+3 million that was about to be paid out), and so there was about $900,000 more owed. The next two courts both ruled in favor of the government, and now, the supreme court rules unanimously for the government.
Now, why?
Redemption of stock is argued to have a net-zero effect on any given investor. That is (example borrowed), if you hold an 80% share of 10 million in cash, and the remaining 20% share is redeemed for 2 million, you'd now have a 100% share of 8 million, which is the same valuation as before. Hence the need for a corporation to redeem shares doesn't reduce the value of the shares.
Further, if someone else had bought the shares off of Michael, they'd be expecting to get the life insurance payoff in the valuation of the company, and so they'd be valuing it at the higher value.
Thomas (Connelly) argues that someone attempting to buy the value, separately, can't capture the value of those insurance proceeds, as those are about to be spent, and should be considered a liability for the company. (Clarence) Thomas rebuts this, saying that this is the same in essence as asking what the value of 77% of shares would be after the redemption had taken place, under the smaller valuation. But the relevant question in estate taxation is what the shares were worth at the time of Michael's death. (Clarence) Thomas further points out that this would lead one to think that Thomas (Connelly) would have a larger ownership share in a company with the same valuation, which doesn't make sense.
My own thoughts: my initial, reaction to the posing of the question was thinking that this was unfair for Connelly, as it felt like a liability, but as I read it, I was convinced that the court decided correctly. (Clarence) Thomas's arguments are persuasive.
Truck Insurance Exchange v. Kaiser Gypsum Co.
8-0. (Yes, eight. Alito recused himself.) Opinion by Sotomayor.
Unsurprisingly, there are many lawsuits due to damage from asbestos. This case dealt with whether an insurer would be able to "raise" and "be party to any issue" in bankruptcy. It is ordinary to put up a trust in such situations in order to pay for future claims against a bankrupt company. In this case, there was a plan in a proceeding of an insured company which handled outstanding claims that would be uninsured versus ones that would be insured differently. It provided more care to be sure that the claims would not be fraudulent when it would be uninsured. Truck Insurance Exchange wanted to be able to participate in the proceedings as an interested party in some relevant respects, as the bankruptcy code allows any "party in interest" to do so. The court does not rule on Truck's arguments about the case in particular, but does say that it is a party in interest, and so entitled to be able to object. This is a straightforward interpretation of the relevant portion of the bankruptcy code, as it was put in an open-ended manner. (The court also touches on legislative intent to back this up.)
There's probably a little more detail here that could be worked through, but I didn't entirely. This seems a sensible ruling, although I would be curious exactly how far "party in interest" can be made to stretch. Probably not excessively far.
Becerra v. Apache Tribe
5-4. Opinion written by Roberts, and joined by Gorsuch and the liberals (Kagan, Sotomayor, Jackson). Kavanaugh writes a dissent, joined by Thomas, Alito and Barrett.
This is a case dealing with Indian tribes and allocating money to them for healthcare costs. The majority rules that they should get more money. I still need to read most of the dissent, but presumably they disagree.
I'll write up this last case properly later, but I'll post this comment as is for now.
Apparently it's unclear why, or at least I haven't been able to find out why in a little websearching. But the best guess from Twitter is that Alito owns stock in one of the litigating companies.
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The Third Case
Okay, I'm back.
This act has to do with the allocation of funding from the Indian Health Service to tribes.
Tribes may opt to have the Indian Health Service manage their health care, or they may draw up a contract to do it themselves, with funding from the IHS. This case concerns the second option, where they contract to run it themselves, funded by the Indian Health Service.
Money is allocated from the Indian Health Service in two ways: first, the secretarial amount, which is the amount that the Health Service would be spending ordinarily. Secondly, contract support costs, which are used to pay for additional costs that the IHS would not incur. The example given is workers compensation mandated by state law, but which the federal IHS would not have to pay—in order to place the option of self-management of health care on equal footing, the IHS will give money for the extra cost.
Additionally, tribes can collect money from third parties, like Medicare, Medicaid, and private insurers. This money can be spent on anything health-care related, including, but not limited to, what the IHS money can be spent on.
The question of this case is whether the IHS is obligated to provide contract support costs for funding from the other sources.
Roberts, and the court, affirms; Kavanaugh denies. (A rare disagreement between those two justices.)
Thus stated, the answer would seem to be an obvious no, that's something separate. But there is one (okay, more than one) complicating factor: medicare and other funding is often, but not exclusively, used for the same programs supported by the IHS, and, at least in the two tribes here, the contract made with the IHS includes the collection of funds from the third parties. (but as I read the cited section, does not dictate how those third-party funds are to be spent). And, the tribes aver, in their cases, the money was all spent towards the program governed by the contract. The model contract, given in the ISDA, requires that money earned in carrying out the contract must be used to "further the general purposes of the contract. And so, the medicare funding is judged by Roberts to fall under the contract, and so requires that contract support costs be paid for that money.
The dissent disagrees, arguing that they are separate, and so should not be funded.
Kavanaugh makes five main arguments that his interpretation is correct: first, the statutory authorization for contract support funding doesn't mention the third-party income. Second, the activities for which contract support is allocated, per statutory texts, must be to comply with the contract and support the contracted program. Then, connectedly, also in his second point (I don't quite follow the tie here) everyone agrees that this doesn't apply to money from sources like the general treasury, so there is no real reason to think that would apply to money from the third-party sources. Third, the statute specifies that the costs have to be "directly attributable" to the self-determination contracts. Fourth, the statute giving contract support explicitly precludes contract support associated with contracts from other parties than the IHS. Fifth, the statute treats 3rd party revenue as supplemental, and therefore separate.
Additionally, Kavanaugh argues that the tribes might not even want it, as is—one of the bases for the majority's decision is that the money is now restricted and governed by the contract, whereas before they would have been able to use that money for things that they could not have used IHS money for, such as building new facilities. Kavanaugh reads the proper source dictating how funding can be used to be the statute authorizing reception of third-party funding itself (where it must be for general health care purposes), rather than from the model contract in the statute making IHS contracts, which was earlier and more restrictive.
I'm not entirely sure myself. Both make a decent case, I think, that the spending would be governed by their preferred statute.
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I think the insurance case is more intuitive if you think about it slightly differently: what would the company have been worth if Thomas Connolly had exercised his option to buy his brother's shares? Does anyone dispute it would have been worth the $6.86M? The company got the life insurance payout regardless of whether it would eventually have to pay it to either brother's estate, right? So Thomas Connolly's position implies that if he bought the shares they would be worth the $5.8M but if the company bought the shares they were only worth $3M.
At the moment of Michael's death the company gained an asset with about $3M of value. Eventually the company had to pay that money to fulfill an obligation, but that fact was by no means certain.
At a very high level, the entire structure here -- life insurance to the company's benefit to de-facto benefit a specific shareholder -- seems like an end-run around inheritance taxes from just gifting the shares in the estate. Even if you just gave the shares from the estate to the company to retire, I assume it would get taxed.
I guess the limits of that are a bit more fuzzy: if this was a broadly-held public company that benefit to shareholders would be a bit less clear, although plausibly still true.
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they probably needed to impair the shares so the company has an explicit option to purchase back the shares at an evaluation that didn't include the life insurance payout. it sounds like only the company was forced to do something by the contract so then clearly the shares became worth more and the company underpaid for the shares.
The amount paid for the shares is irrelevant here since the case is about Michael's estate tax obligation, which requires him to pay taxes on the value of his assets at the date of death. The value of the company on that date includes the value of the life insurance proceeds. The defendant was arguing that the buyback requirement created an offsetting liability that diminished the value of the stock Michael held.
the question was about how much the shares were worth to the estate. so if the company had an option to buy the shares back at a different price then the value of the shares to the estate would be impaired. the fair value of a share might be $20 but that doesn't matter if the company has a contract that says they have the option to purchase the shares back at $10. The shares are only worth $10 then. however, i doubt this works around estate law tax. like if you enter into some kind of contract with someone who is about to die to purchase stuff from the estate at reduced value after they die without proper consideration then i'm sure there is something in estate tax law that treats this as a distribution from the estate for tax purposes.
The value of the estate for tax purposes is market value, not realized value. Often they're the same, as in the case when the property is sold in an arm's length transaction, but discounted sales to insiders are always suspect. Consider that most estate assets are what could be termed "maximally impaired" in the sense that they're given away for free. This doesn't make the value zero. You can't offer your nephew the option of purchasing your Picasso for a hundred bucks and claim that that's all it's worth for estate tax purposes. The fact that the company only paid 3 million for the shares is irrelevant, and is why the estate has an independent valuation done as part of the audit. The case was about whether the accountant who did the valuation correctly treated the redemption requirement as a liability, and the court ruled that he didn't.
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Simple, they should've just got a 0.77 * (3 + 3.86) = 5.28 million dollar insurance policy instead, so his estate could get 77% of the value and the business could stay together. Oh wait, then they would need a 0.77 * (5.28 + 3.86) = 7.04 million dollar policy...
Doing the algebra, they should've taken out a 12.92 million dollar policy (plus some extra for the taxes?) so that the business doesn't have to sell anything off while his estate gets 77% of the business. That makes perfect sense. /s
The basic idea is really strange. Apparently Michael owns 77% of the business and Thomas 23%. What's the difference between Thomas buying his brother's 77% and the business itself buying that 77%? If I own 23% of a business which otherwise owns itself then I am surely the 100% owner. Share buybacks are just share deflation.
I think it's a good ruling based on a tortured tax workaround. The business did own that life insurance policy, after all.
The difference is that the cash spent on the buybacks reduces the value of the company. To use the example from the case, suppose I hold an 80% share in a company whose only asset is 10 million in cash; that 80%share is worth 8 million. Redeeming the other 20% costs the company 2 million, so now I hold a 100% share of a company worth 8 million. The redemption hasn't affected the value of my shares. If, on the other hand, I purchased the 20% interest from the other investors, my shares, the company would still have 10 million in the bank, and my 100% share would be worth 10 million.
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Before his death: Company is worth 3.86 million dollars.
Literally the one second that you're calculating taxes: Company is worth 6.86 million dollars (or if they had planned properly and did the algebra, 16.78 million)
After his death: Company is worth 3.86 million dollars.
They could have set it up so that some external entity A) held the insurance policy, and B) had the obligation to destroy the shares once obtained. If they had, the second entity would obviously be worth zero dollars (because its assets match its liabilities perfectly) and the normal business would be worth 3.86M throughout.
Or if they had structured it as a survivor's benefit, so that Thomas got the money and the obligation to buy Michael out.
Or, or, or...
The intent was clear. Just let people make agreements without hopping through hoops.
There is no one second hypothetical here as there's no legal assumption that any of the events happened simultaneously — he dies, some time thereafter the insurance is paid out, and some time after that the company completes the redemption. In real life we're probably talking several months. At the time of Michael's death the company was worth 6.86 million, and it continued to be worth as much after his death.
And while the intent may have been clear, the means used had the effect of nearly doubling the company's value. It's easy to talk about intent, but eventually this devolves into "I intended to minimize my tax burden", and you end up having to give the benefit of the doubt to people who take actions wherein reducing the tax burden is clearly contrary to public policy. Practically any tax avoidance scheme, no matter how hard brained, becomes effective. The fact that convoluted schemes are often used is unfortunate, but it's the nature of the business.
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Can you just destroy shares you own? I would think the process would be something more like share "renunciation" which would have tax implications for the company whose shares you own.
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Wouldn't you need to include the net present value of the insurance plan, which would be nonzero before the death, and zero afterwards? Although that may not be the letter of accounting law in terms of marking asset values.
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There might be another wrinkle in the life insurance case. I think that example as a use of life insurance is on FINRA exams. Which is a self-regulatory organization. Which are sort of government sponsored but run by industry. So they can ban you from the industry and make you unhirable but you can’t sue for them for antitrust etc. If my recollection is correct you have this sort of government agency teaching their bankers that this use of insurance was correct and would produce those tax benefits. Now you have another government agency saying nope that’s wrong pay us.
Also it’s a bit weird because before the guy died the company did not have that money. After they did. But what occurred first? The guy died and that’s the value then the company gets 3 million because he died? Or the company gets 3 million because the guy died and now the company is worth more? It’s seems like a simultaneous event.
“A self-regulatory organization (SRO) is an organization that exercises some degree of regulatory authority over an industry or profession. The regulatory authority could exist in place of government regulation, or applied in addition to government regulation. The ability of an SRO to exercise regulatory authority does not necessarily derive from a grant of authority from the government.“
I think it’s clear these type of organizations could not exists without government support based on this definition. So I think it’s clear that things like FINRA are basically government run by industry. A lot like unions that wouldn’t exists without the government protecting them.
The company didn’t have cash before the guy died but it did have an asset in the form of the insurance contract.
But what is the insurance contract worth before he dies? They could be 20 year olds and hence the expected value is 0. They could even be 70 year olds and I guess you would say it has high expected value. They might owe future premiums which means the insurance has no guarantee of having value etc.
That the expected payout was a company asset wasn't at issue in this case. The issue was whether the redemption obligation created a liability that cancelled out that asset.
Yea maybe. Something seems off on how they structured it.
Also, note the estate sold the shares to the company for $3 million. So it seems like the estate got $3 million.
The surviving brother got a big gain but not thru the estate since the shares were sold to the estate for $3 million. It would seem as though the estate would have a short term capital loss if the asset was worth 5+ but sold the asset for $3.
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Agreed. The value is factual based on how much is left to pay and life expectancy. I’m not making a claim on how much the asset was worth but that likely there was some value.
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