Estate of Powell v. Commissioner, 148 T.C. No. 18 (May 18, 2017)—A Failed Deathbed FLP

and other Court Cases for Valuation and Litigation Support Professionals

Valuation practitioners may want to spend a few hours reading a recent U.S. Tax Court case where the valuation of intangible assets was squarely addressed. This QuickRead article highlights the facts and three issues addressed in the decision.

[su_pullquote align=”right”]Resources:

Current Update in Valuations

Valuing Family Limited Partnerships—Overview of Recent Case Law

Valuation of Intangible Assets: A case analysis of TCS Ltd.

Tax Issues In Litigation-Based Valuations

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Estate of Powell v. Commissioner, 148 T.C. No. 18 (May 18, 2017)

Issue: Whether there was an estate or gift tax deficiency owed on this transfer to a limited partnership formed by decedent’s son.  If there was, on what basis?

Facts: On August 8, 2008, decedent’s son acting on behalf of decedent (D), transferred cash and securities to a limited partnership in exchange for a 99% limited partnership interest.  The limited partnership agreement allowed for the entity’s dissolution with the written consent of all partners.  On that same day, D’s son, purportedly acting under a power of attorney, transferred D’s LP interest to T, a charitable organization for L’s remaining life.  D died on August 15, 2008.

The Service issued notice of deficiency for $5,870,226 in the Federal estate tax return and a deficiency of $2,961,366 for 2008.

Procedural Highlights: The Service moved for partial summary judgment, arguing that:

1. The value of the cash and securities transferred from decedent’s revocable trust to the limited partnership was includible in the value of decedent’s gross estate under section 2038(a);
2. The value of those same assets is includible in the value of D’s gross estate under either paragraph (1) or (2) of section 2036(a); and
3. The value of the limited partner interest in the limited partnership was includible in the value of her gross estate because her son did not have authority to transfer that interest to a charitable lead annuity trust (CLAT) before D’s death.

The net effect of the Service’s argument, if successful, was to increase D’s gross estate by $10,022,570.

Held: Partial Summary Judgment granted on the Service’s motion on two of the three grounds.  First, it found that the transfer of cash and securities to the limited partnership was subject to a retained right “to designate the persons who shall possess or enjoy” those assets “or the income therefrom” within the meaning of sec. 2036(a)(2).  Second, the Court found that the purported transfer to the CLAT of the 99% limited partnership was either void or revocable because the purported transfer to the CLAT, if valid, occurred within three years of decedent’s death.  Accordingly, the date-of-death value of cash and securities transferred to the limited partnership is includible in the value of the gross estate to the extent required by either section 2036(a)(2) or 2035(a).  This left moot the question of whether enjoyment of those assets was subject to change at the date of D’s death through the exercise of a power described under sec. 2038(a).

In this case, the facts given indicate that doctors had reservations about D’s capacity before the transfer to the limited partnership.  In addition, the decision states that:

Decedent’s gift tax return for 2008 reported a taxable gift of $1,661,422 as a result of the purported transfer to the CLAT of her 99% limited partner interest in NHP.  The amount of the taxable gift—that is, the remainder interest in the CLAT given to decedent’s sons—was computed on the basis that the trust corpus (the 99% limited partner interest in NHP) was worth $7,516,773.  The value assigned to the limited partner interest, in turn, was based on an appraisal conducted by Duff & Phelps, LLC.  In determining the value of the limited partner interest, Duff & Phelps applied a 25% discount for lack of control and lack of marketability.  Duff & Phelps attached as an exhibit to its appraisal a statement of NHP’s Polaris account as of August 8, 2008, which shows a balance of $10,022,570.

While the Service argued for inclusion under 2036(a)(1) and (a)(2) of the transfer to the limited partnership, the Court decided the question based on sec. 2036(a)(2) stating that, “[b]ecause we agree with respondent that the transfer of cash and securities to NHP was subject to a right described in section 2036(a)(2), we need not consider respondent’s argument regarding section 2036(a)(1).”  The Court in a footnote also underscored the narrowness of the decision, adding:

Because we express no view on whether the transfer of decedent’s cash and securities to NHP was subject to a right described in sec. 2036(a)(1) (or whether enjoyment of those assets was subject to change on the date of decedent’s death through the exercise of a power described in sec. 2038(a)), it does not follow that, had NHP’s limited partnership agreement been drafted in a way that prevented the application of sec. 2036(a)(2), decedent’s gross estate would have been reduced by any discount applicable in valuing the limited partner interest issued in exchange for those assets.

Conclusion

This is a majority decision written by Judge Halpern.  The facts are not good.  This is a deathbed transfer, plain and simple, effectively started one to weeks before decedent died.  Judge Lauber writing for another faction of the Court, but concurring in the outcome, wrote separately “to emphasize what the Court did not decide and to highlight what the Court need not have decided.”  This is a must read for not only attorneys but also for valuation and exit planning professionals since there were facts suggesting decedent lacked capacity to form the partnership.  There are ethics issues here.  The decision is another reminder that advance planning, which usually means giving up control and doing so before death, is imminent.  In addition, it is a reminder too that there are a host of other techniques, besides forming and funding a FLP, that can be used to reduce the federal estate and, where applicable, state tax exposure.

W. Zintl v. Commissioner, T.C. Memo, 2017-119 (June 19, 2017)

Issue: Whether the Service abused its discretion by valuing W. Zintl’s business as a going concern and on that basis, rejecting an Offer in Compromise (OIC) as substantially below the Service’s reasonable collection potential (RCP)?

Facts: Husband and wife formed a C corporation to provide commercial construction subcontracting services in Minnesota.  The Service sent a notice of intent to levy with respect to employment tax liabilities.  Taxpayers submitted a Request for a Collection Due Process or Equivalent Hearing.  In the forms, taxpayer indicated that the OIC was an alternative collection option.

Taxpayer submitted Form 656 and made an OIC of one million dollars, which included a profit and loss statement, balance sheet, and an appraisal by Hoff Appraisal Associates dated earlier in the year indicating a Forced Liquidation Value for taxpayer’s machinery and equipment of $1,155,000.  In a letter sent to the Settlement Officer (SO), taxpayer indicated that the accounts receivable balance as of early August 2013 was $3,359,920.  Taxpayer stressed in the letter to the SO that, “without the income flow from these receivables, the business could not operate” and that liquidation of “Zintl’s inventory, machinery, and equipment would end its ability to operate.”  At about that time, Zintl shared that it sold all of the assets it could spare (the “excess”) to satisfy an obligation to Citizens State Bank that was secured by its inventory and equipment.

The SO requested additional documents, including a valuation of the business as a going concern and a copy of the equipment appraisal listing the fair market value of the company’s physical assets.  The going concern value appraisal of the business was $2,100,000; the appraiser, Shenehon Co., in a report dated April 16, 2014, used the three approaches, “each which subtracted accrued payroll tax liability and interest of $4,190,290.”  At this time, the AR account exceeded seven million dollars.  The appraisal assigned no value to goodwill or include the accumulated penalties on the tax liability.  The appraisal also estimated the liquidation value for the company at negative $3,720,000.

In a letter that followed, the SO wrote, “[t]he appraisal estimated the value of the business to be $2,100,000 after allowing for the IS debt of $4,190,980.  In other words, the value of the business for purposes of OIC is estimated to be $6,290,980.  In determining the reasonable collection potential in an OIC, the IRS would generally reduce the asset values by 20%.  As a result, in this case, the reasonable collection potential is computed to be $5,032,784 ($6,290,000 x .8).”

Despite asking for an amended offer, none came.  Petitioner disagreed with the Service using W. Zintl’s going concern value.

Penalties continued to accrue and taxes owed increased too.  The SO advised petitioner that if it wanted to amend the OIC, it had to include all of the taxes owed and at least some of the interest and penalties.  He advised that the $5,032,784 RPC computed could be amended.  The communication that ensued noted that petitioner had been unable to secure financing to fund a five million dollar OIC, then, that petitioner anticipated receiving a loan of three million dollars that, if approved, would allow petitioner to increase its OIC to $3,200,000.  The latter was rejected because the “OIC had lapsed and the loan had not yet been approved.”  Shortly thereafter, the Service issued Notice of Determination rejecting petitioner’s one million dollar offer because the RCP exceeded that amount and sustaining the disputed collection actions.

Procedural Highlights: The case is before the U.S. Tax Court on cross-motions for summary judgment pursuant to Rule 212(a).  The issue is whether the Service abused its discretion by using a going-concern value to calculate the RCP?

Held: Motion denied; the Service did not abuse its discretion.  The case was remanded to the Office of Appeals for purposes of having it determine petitioner’s RCP.

Conclusion

The Court criticized petitioner and the SO’s RCP calculation.  In the section that follows, the Court addresses petitioner’s rejection of the going concern premise and the methodology applied by the SO to arrive at the RCP, and indirectly, the appraisal report.  This is not valuable to practitioners since there is little guidance on how to handle these matters.  It wrote:

In effect, petitioner asks us to decide that use of the going concern value of a business is never appropriate when the business being valued is the taxpayer.  We cannot so conclude, nor need we, because we find that SO’s calculation of RCP was faulty for a different reason: In calculating petitioner’s RCP, SO increased petitioner’s going concern value by the amount of the unpaid tax liability that the appraisal took into account in its calculation of value and based his determination of RCP solely on this modified value.

This modification to the value at first blush seems logical.  Reducing petitioner’s going concern value by its tax liability when determining how much of this tax liability petitioner can pay would seem to double count the tax liability and provide a boon to a business taxpayer whose tax debt is part of the business being valued.  It is this tax liability that will be satisfied with the OIC, after all.  The problem is that the going concern value is intended to give some indication of the value of petitioner as a continuing business, that is, what a third party might pay to buy petitioner as a whole, including all of its assets and liabilities.  No third party would buy petitioner without taking into account the unpaid tax liability.  And the record shows that petitioner could not obtain financing for the modified amount either.  This highlights the logical difficulty of using going concern value—which presumes that a taxpayer can sell itself—to determine RCP.  Nonetheless, we cannot conclude that consideration of the going concern value and the information in the appraisal is irrelevant or that the settlement officer may not consider this information, including the specific assets and liabilities, including the tax liability, on remand.  We also do not hold that petitioner’s offer was reasonable.  We hold only that SO’s rejection of petitioner’s OIC solely on the basis of his calculation of RCP that used petitioner’s going concern valuation but disregarded completely its tax liability was not reasonable on this record.

So, one can assume that in this case the forced liquidation value will not control when the Service derives the RCP and that the value lies somewhere around FMV under the going concern premise.

Lund v Lund, Court File No.  27-CV-14-20058 (District Court, Fourth Judicial District, June 2, 2017)

Issue: What is the value for a 25% interest in Lund & Byerlys?

Facts: Plaintiff who indirectly owned, through trusts, a 25% interest in the company sued seeking, among other things, an equitable buyout based on fair value standard.

Procedural Highlights: The plaintiff, not actively involved in the business, brought an action in Hennepin County District Court on December 8, 2014.  On August 10, 2016, the Court heard plaintiff’s motions for a buyout, amendment to her complaint to add a claim for punitive damages, and for other relief, and Defendants motion for summary judgment and exclusion of evidence.  The Court granted plaintiff’s motion for a buyout, denied the motion for leave to add a claim for punitive damages and for spoliation of evidence, dismissing plaintiff’s claims for breach of fiduciary duties and civil conspiracy, granting Defendants’ motion to exclude evidence, and staying consideration of Plaintiff’s claims for trustee removal and attorneys’ fees.

The minority shareholder sought an equitable valuation and alleged majority oppression in failing to structure an exit strategy.  The court conducted a valuation proceeding brought pursuant to Minn. Stat. §§302A.751 and 302B.833.  Trial heard testimony from two leading valuation experts.

Held: Plaintiff’s interest in the entities is held to total $45,225,000.

Conclusion

Citing from the decision, the following is said:

• “[Plaintiff] contends that the fair value of the Lund Enterprises is $321.6 million and that her 255 interest in Lund Entities is worth $80.4 million. …In support of this valuation, [Plaintiff] relies on expert Robert Reilly.”
• “Defendants counter with a total fair value of the companies of $91.3 million. …In support of these figures, Defendants rely on expert testimony and report of Roger Grabowski.”
• “Both experts are highly trained and experienced professionals. Both have testified and provided valuation reports in many trials, and contested valuation situations.  While the Court finds that both Reilly and Grabowski are unquestionably qualified to testify on the issue of valuation, the obvious, zealous advocacy in which they engaged on behalf of their respective clients compromised their reliability in this manner.”
• “When expert witnesses offer conflicting opinions, both of which have a reasonable basis in fact, ‘the trier of fact must decide who is right.’ In some circumstances, neither expert is right.”
• “The Court finds the total enterprise value of Lunds, Inc. is $144.5 million and the value of LFHI is $23.5 million.”
• “In granting the buyout and determining the fair value…the amount of the award to [Plaintiff’s] trusts, the Court must be mindful of the statutory obligation to ensure that the value is ‘fair and equitable to all parties’. Accordingly, the Court has reviewed the feasibility of the award and finds that the Lund Entities are capable of paying the award through a cash down payment of five percent and the issuance of unsecured subordinated promissory notes to the trusts for the remainder, payable over 20 years with a modest interest rate”; this rate was set at 2.75% which the Court opined was “reflective of the nature of the buyout” and at the time of the trial, close to the 20-year U.S. Treasure rate.

Roberto H Castro, JD, MST, MBA, CVA, CPVA, CMEA, BCMHV is an appraiser of businesses, machinery and equipment and Managing Member of Central Washington Appraisal, Economics & Forensics, LLC. Mr. Castro is also an attorney with a focus on business, estate, probate, and succession planning with offices in Wenatchee and Chelan, WA. In addition, he is Technical Editor of QuickRead.
Mr. Castro can be reached at (509) 679-3668 or by e-mail to rcastro@cwa-appraisal.com or rcastro@rcastrolaw.com.