The ancient Chinese proverb “May you live in interesting times” rings true
for estate planners. The estate tax post-2010 remains unresolved. Important Tax and
Circuit Court valuation decisions are viewed by some as inconsistent. Proven planning
strategies are often reexamined and those already in place revisited.
What do we see or hear at MPI? The IRS is auditing more gift tax returns, targeting
family asset-based entities, checking to see if Section 2036 (retained life interest) can
be applied and possibly questioning valuation discounts.
The IRS is perhaps emboldened by its successes in Strangi, Bongard and other 2036
cases. However, when the facts are good and 2036 is not involved, valuation is the issue
and the appraisal is on trial. In these times of heightened IRS scrutiny, it is more
important than ever for clients to proceed with a strong appraisal.
The validity of an all cash family limited partnership funded by the decedent three
months before death was never challenged. Valuation discounts were the only issue. The
estate used a 53.5% discount (25% minority interest and 38% lack of marketability) while
the IRS was at 25.2% (12% and 15%). Judge Vasquez’ decision was 32.2% (12% and 23%).
The Judge noted that a lack of marketability study of private placement transactions by
Dr. Mukesh Bajaj divides the transactions into three groups according to discount size.
The decedent’s partnership was found to be in the middle group from which a 20%
discount was selected. An upward adjustment of 3% was made to account for the following
factors specific to the partnership:
- it will never be publicly held
it has a right of first refusal to purchase the interests
COMMENT: A 32.2% discount for an all cash partnership is a good result. This
Tax Court decision is confusing, since the judge disregards the taxpayer’s reliance
on restricted stock studies (because they involve private placement transactions of public
companies), but then relies on the Bajaj study, which is also based on private placement
transactions involving publicly traded operating companies.
The Section 2036(a) “bona fide sale for adequate and full consideration”
exception gets most of the attention in this case’s majority, concurring and
dissenting opinions. The IRS had assessed a $53,000,000 estate tax deficiency by virtue of
its contention that the decedent’s contributions of stock in his electronic materials
packaging company (EMPAK) to a new holding company (WCB Holdings) and family limited
partnership (BFLP) were transfers of a retained interest, did not meet the bona fide sale
exception and should be ignored.
Recognizing that EMPAK’s potential for growth would be enhanced by positioning it
for an outside liquidity event, Mr. Bongard arranged for the transfer of the family’s
EMPAK stock to WCB Holdings in exchange for voting (Class A) and nonvoting (Class B)
membership units. The next day he and a family trust funded BFLP with a portion of their
Class B units for a 99% limited partnership interest and 1% general partnership interest,
respectively. Mr. Bongard died unexpectedly two years later.
The Court reviewed recent 2036(a) decisions, including Harper, Strangi, Kimbell,
Thompson and Stone, and concluded that the WCB Holdings exchange was
motivated by a “legitimate and significant nontax reason” (positioning EMPAK for
a corporate liquidity event) and therefore satisfied the bona fide sale exception of
Section 2036(a).
On the other hand, the BFLP transfer was viewed as a “recycling of value”
transaction (as in Harper and Thompson) because Mr. Bongard’s relationship to his
Class B units did not really change. Estate tax savings appeared to be the motivating
factor for creating BFLP, an entity that had no “investment plan,” never
“functioned as a business enterprise” and performed no “meaningful economic
activity.” The Court went on to find an implied agreement to retain enjoyment of the
transferred units under Section 2036(a)(1).
COMMENT: Since the transfers were one day apart and presumably part of an
overall plan, assigning a different motive to each transfer seems unrealistic. Having a
good non-tax reason in the mix should have allowed the Court to approve both transfers.
Should the full amount of potential capital gains taxes be deducted in calculating the
net asset value of a C corp investment holding company which owns marketable securities?
If a historic security sales turnover rate of 6% per year would likely continue and an
appraiser is to value the interest of a decedent who could not have forced liquidation,
Judge Gerber would limit the deduction to the present value of the future capital gains
tax liability.
Frazier Jelke owned 6.44% of Commercial Chemical Co. whose assets were $179 million in
marketable securities and $12 million cash. The potential tax on built-in gains was $51
million. The IRS determined the present value of the tax to be $21 million. Judge Gerber
went along with the IRS and distinguished the Dunn case (301 F.3d 339) where the Fifth
Circuit said an asset-based valuation approach necessarily assumes liquidation on the
valuation date and therefore requires a dollar for dollar reduction for the entire amount
of tax. Some of the Judge’s comments on Dunn are:
“We are not bound or compelled to follow the holdings of a Court of Appeals to
which our decision is not appealable.”
“The Court of Appeals’ reasoning and holding in Estate of Dunn
applied to a majority interest. There is no need to express agreement or disagreement with
the automatic use of an assumption of liquidation when using an asset-based approach to
value a majority interest, because we are valuing a small minority interest . . .
insufficient to cause liquidation.”
The estate’s valuation expert applied 25% and 35% discounts for minority interest
and lack of marketability, respectively, while the IRS expert was at 5% and 10%. Judge
Gerber’s decision of 10% and 15% (23.5% combined) seems to favor the IRS.
COMMENT: A 15% lack of marketability discount is quite low in our experience.
We have seen several important Tax Court decisions involving Section 2036 and family
limited partnerships in the last few years. Perhaps in reaction to those cases, lawyers,
accountants and trust officers for the Schutt/DuPont family developed a significant record
of their advice, discussions and meetings concerning tax and non-tax reasons for
establishing two Delaware business trusts (Schutt I and Schutt II) funded with $91 million
in DuPont and Exxon stock. When the IRS argued that Porter Schutt retained a life interest
in his $42 million share of contributed stock, his advisors’ paper trail was key in
helping the Tax Court find that Section 2036’s “bona fide sale” exception
had been satisfied.
In March 1998 Mr. Schutt and various DuPont family trusts of which he was advisor and
Wilmington Trust Company trustee contributed DuPont stock to Schutt I and Exxon stock to
Schutt II. Mr. Schutt, a buy and hold investor, wanted to maintain the family’s large
holdings in DuPont and Exxon and was “displeased” with sales of the stock by
family members, preferring that they live on their income. Creation of the Delaware
business trusts had the potential of extending termination dates of the trusts at
Wilmington Trust Company and allowed Mr. Schutt to perpetuate his investment philosophy.
This important non-tax reason was very well documented in memos and letters during a
planning period which began in late 1996. Mr. Schutt died in April 1999.
Some of Judge Wherry’s responses to an IRS argument that Mr. Schutt’s main
focus was on tax savings are:
“….the record fails to reflect that such issues predominated in
decedent’s thinking and desires.”
“Rather, there is a notable focus on matters such as decedent’s desire for
investment control.”
“Regardless of whether Schutt I and II transactions should be subjected to
heightened scrutiny appropriate to intrafamily situations, the record here is sufficient
to show that the negotiations and discussions were more than a mere façade.”
COMMENT: Based on stipulated estate tax values for Mr. Schutt’s interests
in the trusts, the total discount from net asset value was approximately 32%.
The Noble estate sold its 11.6% interest in Glenwood State Bank for $1.1 million 14
months after death, having turned down an earlier offer of $878,000, and yet relied, in
part, on two small (1% and .7%) and much lower-priced pre-death transactions in its
determination of fair market value for estate tax purposes.
The Court agreed with the IRS that the $1.1 million sale was the “best
indicium” of fair market value at the time of death since it was within a reasonable
time of (“near”) the valuation date, was at arm’s length and no
“material change of circumstances” occurred between the two dates.
The Court’s only adjustment to the sale price was to discount the proceeds for
inflation. The estate incorrectly thought case law supported the notion that relevant
transactions must be pre-death and sellers need not be knowledgeable nor their shares
comparable in size to those being valued.
