U.S. v. Finely Hilliard, et al.

Fifth Circuit Affirms District Court and $83 Million in Unpaid Taxes and Interest Owed by Donees

The Fifth Circuit recently affirmed the district court’s decision and the imposition of unpaid taxes and interest on donees of shares sold at less than fair market value to the company owed by relatives of the donor. As Joe Brophy explains, this case illustrates the pitfalls of deathbed planning involving asset transfers below market value.

The Fifth Circuit decided November 10, 2014, the case of U.S. v. Finely Hilliard, et al. (114 AFTR 2d 2014‒6578) handing the gift recipients a significant loss because of an indirect gift of company stock (an over $83 million  gift resulting in $35 million gift tax plus close to $75 million in unpaid interest) because of a sale of company stock at below fair market value by the donor.

In 1995, J. Howard Marshall, II sold his stock in Marshall Petroleum, Inc. (MPI) back to the company at a price the government argued was significantly below market value. The remaining five shareholders in the company included a trust funded by stock for the benefit of his former wife and other family members, including his son and various trusts. He died soon after the indirect gift. It is not clear from the Fifth Circuit decision the method used to determine fair market value of the company stock sold by J. Marshall to Marshall Petroleum, Inc., and the amount paid to J. Marshall for his stock, which was stipulated to in an earlier case.

The Fifth Circuit Court to Appeals (“court” hereafter) held that the former wife of the donor and the trustees were liable as transferee for the unpaid gift tax. The court affirmed a lower court decision that the recipients of the gift remained liable for gifts made in 1995.

The court ruled “that Code Section 2501 imposes a tax on gifts ‘whether the gift is direct or indirect’ and includes the transfer of property (like stock) when the transfer was not for an adequate and full consideration.”

The donor is primarily liable for payment of gift tax; however, when the donor fails to pay the gift tax, the government has the right to sue the donee under the theory that the transferee got the asset and the tax follows the asset if not paid by the donor.

The artifice used by J. Marshall and his tax planners was to sell his stock in J. Marshall Petroleum back to the company at a price below fair market value resulting in transferring wealth to the remaining shareholders. The five remaining shareholders were family members who in turn benefitted by the net transfer.

The court held consistent with Helvering v. Hutchings, 312 US 393 (1941) that gifts to a trust were gifts to the trust beneficiaries for purposes of transferee liability.

The issue on appeal was whether interest is due on the unpaid gift tax going back to 1995.  The answer is “yes,” even though the interest due exceeded the amount gifted. Further, the court held that the government could collect against the donees, both the tax and the interest:

We hold that J Howard’s indirect gift was a transfer of a present interest. It is clear under our holding in Kincaid and the Treasury Regulations that a shareholder’s transfer of property to a corporation for less than full consideration is generally a gift to the individual shareholders.

The ex-wife argued that since she had been divorced for over 35 years from J. Howard Marshall and he remarried several times after their divorce that Treas. Reg. 25.2512-8 stating that “a sale, exchange or other transfer of property made in the ordinary course of business (a transaction which is bona fide, at arm’s length, and free of donative intent) will be considered as made for an adequate and full consideration in money or money’s worth.”  The Fifth Circuit concluded this  regulation did not apply and agreed with the Tax Court that a gift was intended.

This case also presented a number of related thorny tax issues, such as when is a trustee liable personally for payment to beneficiaries before payment to the IRS for unpaid gift taxes? One of the claims paid by the trustees was to a charity. The court ruled the trustees remained liable for distributing prior to payment of all government claims. Perhaps oddly, the trustees argued that they should not be held liable since the government had not asserted a claim at the time of distribution, meaning they had no knowledge, which reminds me why serving as a trustee has its hazards.

The dissenting opinion, written by Circuit Judge Priscilla R. Owen, argues that a conflicting decision was issued by the Third Circuit limiting the donee’s responsibility to the amount received in the gift. “The Government seeks to hold the Marshalls personally liable for almost $75 million over and above the value of gifts that were made to them. Most of the $75 million is interest.” A possible conflict between the circuit courts could give rise to a review by the Supreme Court.

The dissent continues, “In spite of the clear language of 6324(b,) the panel’s majority opinion concludes that section 6324(b), however, says nothing about any limit on the donee’s liability and the government’s ability to assess interest when the donee fails to fulfill his or her obligation to pay the donor’s unpaid gift tax.”

Estate planning has significant risks. Deathbed planning with possible asset transfers below market value must be reviewed.

Joseph D. Brophy, MBA, CPA/ABV, CVA, ABAR, CM&AA, is a former member of the AICPA’s IRS Practices and Procedures Committee and former chair of the Texas Society of CPAs’ Relations with IRS Committee. He is frequent writer for tax and valuation publications. He can be reached at jdbrophy@jdbrophycpa.com or (214) 522-3722.