U.S. Tax Court Update

Notable 4th Quarter 2015 Cases, Part I of II

Part I of this article highlights notable 4th Quarter 2015 U.S. Tax Court Cases that will be of interest to valuation practitioners and business advisors. Estate of Purdue reminds us that taxpayers need to address 2036(a) concerns and establish a non-tax reason. In addition, the case reminds us that gifting an equity or LLC interest may not qualify as a present interest for gift tax purposes. Estate of Newberger involves the proper valuation of artwork, yet its holding is applicable to a business valuation opinion. Sumner Redstone v. Commissioner involves a family succession saga and highlights the importance of filing a gift tax return since the statute of limitations is left open. Readers should download the opinion to read about the valuation methodology employed and court’s critique of the expert’s report. In Part II, we will discuss DNA Pro Ventures, Inc. ESOP and Kardash. DNA Pro Ventures serves to stress the importance of following plan language and obtaining qualified appraisals in connection with ESOPs. Finally, Kardash v. Commissioner, involves a highly unusual Rule 161 motion where the U.S. Tax Court addresses insolvency and fraudulent transfers. This latter case is a decision that QuickRead covered in 2015 where the QuickRead article focused on how the expert established insolvency. In both parts, we have included excerpts here where the U.S. Tax Court discusses its views on what is a valuation.

Estate of Barbara Purdue v. Commissioner, T.C. Memo, 2015-249 (December 28, 2015)

Issues: Whether the value of assets transferred by decedent to a family limited liability company (LLC) is includible in the value of decedent’s gross estate under sections 2036(a) and 20359a).  Whether decedent’s gifts of the family LLC units made between 2001 and 2007 were resent interest gifts which qualify for exclusion under section 2503(b).

Facts: Decedent and husband (who predeceased petitioner in this matter) established a member-managed family LLC.  The draft of operating agreement detailed that the reason for forming the LLC included: (1) consolidate the management and control of certain property (a partial interest in Hawaii commercial real and various brokerage accounts holding marketable securities) and improve the efficiency of management by holding the properties in a single, flexible entity; (2) avoid fractionalization of ownership; (3) keep ownership of assets within the extended family; (4) protect assets from unknown future creditors; (5) provide flexibility in management of the assets; and (6) promote education of, an communication among, members of the extended family with respect to financial matters.  The IRS (Service) challenged the reasons and sought to include the LLC in decedent’s gross estate.

Between 2001 and 2007, decedent used the annual gift exclusion to gift LLC units to the extended family.

Controversy:

(1) The purpose of section 2036 is to include the value of testamentary inter vivos transfers in the value of a deceased taxpayer’s gross estate. United States v. Estate of Grace, 395 U.S. 316, 320 (1969).  Section 2036(a) generally provides that if a decedent makes an inter vivos transfer of property other than a bona fide sale for adequate and full consideration and retains certain enumerated rights or interests in the property which are not relinquished until death, the full value of the transferred property will be included in the value of the decedent’s gross estate.  Section 2036(a) is applicable when three conditions are met: (1) the decedent made an inter vivos transfer of property; (2) the decedent’s transfer was not a bona fide sale for adequate and full consideration; and (3) the decedent retained an interest or right enumerated in section 2036(a)(1) or (2) or (b) in the transferred property which he or she did not relinquish before death.  Estate of Bongard v. Commissioner, 124 T.C. 95, 112 (2005).

In the context of family limited partnerships, the bona fide sale for adequate and full consideration exception is met where the record establishes the existence of a legitimate and significant non-tax reason for creating the family limited partnership and the transferors received partnership interests proportional to the value of the property transferred.  Id. at 118; see, e.g., Estate of Mirowski v. Commissioner, T.C. Memo. 2008-74 (applying Estate of Bongard in the context of an LLC).  The objective evidence must indicate that the non-tax reason was a significant factor that motivated the partnership’s creation.  Estate of Bongard v. Commissioner, 124 T.C. at 118.  A significant purpose must be an actual motivation, not a theoretical justification.  Id.  A list of factors to be considered when deciding whether a non-tax reason existed includes: (1) the taxpayer’s standing on both sides of the transaction; (2) the taxpayer’s financial dependence on distributions from the partnership; (3) the taxpayer’s commingling of partnership funds with the taxpayer’s own; (4) the taxpayer’s actual failure to transfer the property to the partnership; (5) discounting the value of the partnership interests relative to the value of the property contributed; and (6) the taxpayer’s old age or poor health when the partnership was formed.  Id. at 118, 119; Estate of Jorgensen v. Commissioner, T.C. Memo. 2009-66, aff’d, 431 F. App 544 (9th Cir. 2011); Estate of Hurford v. Commissioner, T.C. Memo. 2008 278.

We separate the bona fide sale exception into two prongs: (1) whether the transaction qualifies as a bona fide sale; and (2) whether the decedent received adequate and full consideration.  Estate of Bongard v. Commissioner, 124 T.C. at 119, 122-125; see also Estate of Bigelow v. Commissioner, 503 F.3d 955, 969 (9^th Cir. 2007) (“In * * * [the family limited partnership] context, we consider the ‘bona fide sale’ and ‘adequate and full consideration’ elements as interrelated criteria.”), aff’g T.C. Memo. 2005-65.

(2) The parties disagree as to whether the gifts of [of the Family LLC] interests are present interests and thereby qualify for the annual gift tax exclusion under section 2503(b). The estate bears the burden of proving that the gifts qualify for the annual exclusion.  See Rule 142(a); Hackl v. Commissioner, 118 T.C. 279, 289, (2002), aff’d, 335 F.3d 664 (7th Cir. 2003).  Section 2503(a) defines “taxable gifts” as the total amount of gifts made during the calendar year, less certain deductions.  Section 2503(b) provides an inflation-adjusted annual exclusion of $10,000 per donee for gifts “other than gifts of future interests in property”, that is, for present interest gifts.  The term “future interest” includes “reversions, remainders, and other interests or estates, whether vested or contingent, and whether or not supported by a particular interest or estate, which are limited to commence in use, possession, or enjoyment at some future date or time.”  25.2503-3(a), Gift Tax Regs.  A present interest, however, is “[a]n unrestricted right to the immediate use, possession, or enjoyment of property or the income from property”.  Id. para. (b).  The terms “use, possess, or enjoy” connote the right to substantial present economic benefit, that is, meaningful economic, as opposed to paper, rights.  Hackl v. Commissioner, 118  T.C. at 291 (discussing Fondren v. Commissioner, 324 U.S. 18, 20-21 (1945)).

Therefore, to qualify as a present interest, a gift must confer on the donee a substantial present economic benefit by reason of use, possession, or enjoyment (1) of property or (2) of income from the property.  Id. at 293.  The property in these cases is an ownership interest in limited liability company interests.  A gift in the form of an outright transfer of an equity interest in a business or property, such as limited partnership interests, is not necessarily a present interest gift.  Id. at 292; see also Price v. Commissioner, T.C. Memo. 2010-2.  Rather, we must inquire, among other things, “whether the donees in fact received rights differing in any meaningful way from those that would have flowed from a traditional trust arrangement.”  Hackl v. Commissioner, 118 T.C. at 292.

When determining whether a gift is of a present interest, we examine all facts and circumstances as they existed on the date of the gift.  See, e.g., Fondren v. Commissioner, 324 U.S. at 21-22.  Thus, on each date of gift, the estate must show from all the facts and circumstances that, in receiving the PFLLC interests, the donees thereby obtained use, possession, or enjoyment (1) of the limited partnership interests; or (2) of income from those interests within the meaning of section 2503(b).  To ascertain whether rights to income satisfy the criteria for a present interest under section 2503(b), the estate must prove, on the basis of the surrounding circumstances, that:  (1) the PFLLC would generate income, (2) some portion of that income would flow steadily to the donees, and (3) that portion of income could be readily ascertained.  See Calder v. Commissioner, 85 T.C. 713, 727-728 (1985); see also Hackl v. Commissioner, 118 T.C. at 298; Price v.

Commissioner, T.C. Memo. 2010-2.

Held:

1. Legitimate non-tax reason found. Bona fide sale and adequate consideration prongs satisfied.
2. Gift of the equity interest satisfied the present interest.

 

Estate of Newberger v, Commissioner, T.C. Memo. 2016-246 (December 22. 2015)

Issues: What is the proper value of three pieces of art (paintings, including one by Picasso)?

Facts: Decedent died on July 28, 2009.  The 706 return was filed on October 28, 2010 on which it reported values relating to Tete de Femme (Jacqueline) by Pablo Picasso, Untitled by Robert Motherwell, and Elément Bleu XV by Jean Dubuffet.  Prior to her death, the artwork market declined in autumn 2008; 44 % of the artwork up for auction failed to reach its minimum or guaranteed price and was returned to the auctioneer or owner.

In December 2009, following Ms. Newberger’s death, Sotheby’s offered to sell the Picasso and guaranteed it would pay $3 million if the Picasso did not sell at auction.  Sotheby’s subsequently increased the guarantee to $3.5 million.  The estate chose Christie’s to auction the Picasso.  An auction date of February 2010 was set.  The estate was provided a guarantee to $4,784,689 and 60% of the hammer price exceeding that amount.  Christie’s listed the Picasso in its catalog with an expected sale price between $4,784,689 and $6,379,585 and provided the estate with an appraisal report stating the Picasso had a $5 million date of death value.

The Picasso sold at auction for $12,922,874.  The estate reported, on its Form 706, that the Picasso had a $5 million date of death value.

The estate used Sotheby appraisals on its Form 706 for the other two pieces of artwork.

Controversy:

The Service issued a notice of deficiency and determined that the Picasso had a date of death value of $13 million.  The Service also contended that the other artworks had a higher value.

The estate and respondent, respectively, contend that the Picasso had a date of death value of $5 million and $10 million.  The Picasso sold at Christie’s London Auction on February 2, 2010, for $12,927,874.  The estate’s experts ask us to disregard this sale because “[i]t was a fluke”, and the estate unconvincingly contends that this sale is not relevant because it could not have been reasonably anticipated on the date of death.  To the contrary, the sale of the Picasso may “be taken into account as evidence of fair market value as of the valuation date.”  See Estate of Jung v. Commissioner, 101 T.C. 412, 431-432 (1993); see also First Nat’l Bank of Kenosha v. United States, 763 F.2d 891, 894 (7th Cir. 1985).

Indeed, no evidence is more probative of the Picasso’s fair market value than its direct sale price.  See Ambassador Apartments, Inc. v. Commissioner, 50 T.C. 236, 242-243 (1968), aff’d, 406 F.2d 288 (2d Cir. 1969).  The estate’s experts’ failure to consider the sale of the Picasso renders their valuation wholly unreliable.  Respondent’s expert, after adjusting the $12,927,874 sale price downward to reflect July 28, 2009, market conditions, valued the Picasso at $10 million.  We agree with respondent’s expert.

As for the two other artworks, the court observed:

“The estate’s experts and respondent’s expert agree that the $1,426,500 sale of In Black and White No. 5, on November 11, 2010, was the best comparable relating to the Motherwell.  Although In Black and White No. 5 shares many 3 characteristics with the Motherwell (i.e., they were created in 1966, are the same size, and have a similar style and composition), In Black and White No. 5 was sold nearly 16 months after the date of death.  By that time, the artwork market had largely rebounded from its downturn.  Respondent’s expert did not make a market adjustment as she made relating to the Picasso and, inexplicably, valued the Motherwell at $1.5 million, an amount higher than the sale price of In Black and White No. 5, which sold after the market rebounded.  The estate’s experts, however, adjusted the $1,426,500 sale price of In Black and White No. 5 downward to reflect July 28, 2009, market conditions and valued the Motherwell at $800,000.  We agree with the estate’s experts.

The estate and respondent, respectively, contend that the Dubuffet had a date of death value of $500,000 and $900,000.  The best comparable relating to the Dubuffet was the November 14, 2007, sale of Jean Dubuffet’s Elément Bleu XIII (i.e., a similarly sized work from the same series) for $825,000.  Respondent’s expert’s contention that the Dubuffet’s value was higher during the market downturn than Elément Bleu XIII’s value before the market downturn is, in short, nonsensical.  We agree with the estate that Sotheby’s $500,000 appraisal (i.e., the value the estate reported on its Form 706) reflects the Dubuffet’s date of death value.”

Held:

The court agreed with the Commission with respect to the value of the Picasso and with the estate with respect to the other two artworks.

 

Sumner Redstone v. Commissioner, T.C. Memo. 2015-237 (December 9, 2015)

Issues: Whether a deficiency and additional taxes under section 6653(b) for fraud or alternatively under section 6653(a) are due by petitioner.  The focus of the parties’ dispute is whether petitioner’s 1972 transfer of shares to a trust for the benefit of his children were a “gift” for Federal gift tax purposes or was (as petitioner contends) a transfer for an “adequate and full consideration in money or money’s worth.”

Facts: The controversy involves a family business that grew from one drive-in theater in 1936 to multiple drive-in theaters and evolved considerably.  Father and his two children had interest in the various entities and these were consolidated with the business interests into a single entity, National Amusements. Inc., (NAI); NAI remains a closely held corporation headquartered in Norwood, MA.

In 1968 father developed a plan to retire gradually from active involvement in NAI’s operations.  To implement this plan, he decided to transfer a portion of his common shares to his grandchildren and to exchange the balance of his shares for preferred stock.

Family discord ensued.  Son was unhappy with father and brother’s role in the entity and wanted the right to sell his unregistered shares.  A settlement was ultimately reached.  The settlement provided that 66 2/3 shares son owned would be “free and clear of all trusts, restrictions, and encumbrances” and that the remaining 33 1/3 of NAI shares would be held by son to the benefit of his children.  Brother became trustee of two trusts for the benefit of son’s children; each owning 16 2/3 shares of common stock.

Brother subsequently made transfers to his children in 1972.  This is the controversy here; it arose since additional litigation ensued.  The opinion explains:

In 2010, apparently as a result of the O’Connor litigation, Sumner’s 1972 transfer of stock to the Brent and Shari Trusts came to the IRS’ attention.  It accordingly commenced, in May 2011, a gift tax examination covering petitioner’s 1972 calendar year.  IRS Revenue Agent Cha was assigned to conduct this examination.  The focus of his examination was petitioner’s potential gift tax liability related to the 1972 stock transfer.  Agent Cha was not aware, when conducting this examination, that the IRS had performed an earlier review of Sumner’s 1972 political campaign contributions.

Agent Cha’s examination lasted more than a year.  On several occasions, he requested documents that the IRS did not possess, and Sumner, through his attorneys, complied with each of these document requests.  Sumner did not complain, at any time during the audit, of a potential “second examination” in violation of section 7605(b).  He first raised the possibility of a “second examination” in early 2014, nearly a year after the IRS had issued the notice of deficiency.  That notice was issued on January 11, 2013, and Sumner timely petitioned this Court on April 10, 2013.

With respect to brother’s claim that he was excused from filing a gift return, the Court stated:

In Estate of Redstone v. Commissioner, 145 T.C. __, __ (slip op. at 31) (Oct. 26, 2015), we held that Edward’s June 1972 transfer of stock to his children pursuant to the Settlement Agreement was not a gift but was a “transfer of property made in the ordinary course of business.”  Sec. 25.2512-8, Gift Tax Regs.  We found that a genuine dispute existed concerning Edward’s ownership of NAI stock and that he was forced to relinquish his claim to ownership of 33 1/3 shares in order to obtain from Mickey and Sumner an acknowledgment of his ownership of the remaining 66 2/3 shares.  We held that Edward’s transfer of the disputed shares to trusts for his children, at Mickey’s insistence, was thus made for a “full and adequate consideration in money or money’s worth.”  Estate of Redstone v. Commissioner, 145 T.C. at __ (slip op. at 31) (citing section 25.25128, Gift Tax Regs.).

Brother’s transfer of shares in trust for his children was motivated by different reasons.

With regard to the valuation of the shares, the Court observed:

In sum, we find that the redemption price NAI paid Edward on June 30, 1972, is a reliable index of the stock’s value on July 21, 1972, when Sumner made his gifts.  Because we find this actual arm’s-length transaction to be the best indicator of fair market value, see Estate of Andrews, 79 T.C. at 940, we find it unnecessary to examine the results that could be generated under the “direct capitalization” and “guideline public company” methods, which Mr. Hastings alternatively employed.  (After applying a discount for lack of marketability, he determined under these approaches values of $2,433,608 and $2,997,054, respectively, for the 33 1/3 transferred shares.)

The parties disagree about numerous inputs into these other methodologies, including NAI’s cost of equity, the appropriate “beta,” the company’s expected growth rate, and the universe of comparable companies.  These disagreements are not surprising because the valuation date was 43 years ago, the data available from public databases and NAI’s own records are inadequate, and it is difficult to find companies comparable to NAI in 1972, which was then (rather incongruously) an entertainment company with much of its value tied up in real estate.  Suffice it to say that the $2.5 million valuation we have determined on the basis of the June 1972 redemption price falls comfortably within the range of values that can be generated using various permutations of these other formulas.

With respect to the fraud and negligence penalties, the Court held:

Respondent contends that petitioner is liable under section 6653(b) for an addition to tax for fraud.  Respondent bears the burden of proving fraud by clear and convincing evidence.  See Goldberg v. Commissioner, 239 F.2d 316, 320 (5^th Cir. 1956), rev’g T.C. Memo. 1954-242.  Respondent contends that his “assertion of the fraud penalty is based on petitioner’s complete failure to explain why, given that he knew that there was no preexisting oral trust, * * * [he] did not report this gift and pay gift tax.”

Respondent has not met his burden of proof.  The oral trust may have been a fiction, but it was a fiction with real-world consequences.  Mickey passionately believed in the “oral trust” theory and, at his insistence, it became a central feature of the Settlement Agreement by which Edward’s litigation was resolved.  To please his father, Sumner adopted the same “oral trust” terminology when making a symmetrical transfer to his own children.  There is no evidence that Sumner embraced the “oral trust” concept in an effort to evade his Federal gift tax liabilities.

***

Respondent alternatively contends that petitioner is liable for additions to tax under section 6651(a)(1) for failure to file a gift tax return and under section 6653(a) for negligence.  In 1972 the Code imposed a five percent addition to tax on any underpayment attributable to “negligence or intentional disregard of rules and regulations.”  See sec. 6653(a).  The question of negligence is one of fact upon which the taxpayer has the burden of proof.  Marcello v. Commissioner, 43 T.C. 168, 182 (1964), aff’d in part, remanded in part, 380 F.2d 499 (5th Cir. 1967).

A taxpayer may show that his failure to file a return was not negligent if he relied in good faith on advice from a tax professional that no tax liability existed or that no return was required.  See Commissioner v. Am. Ass’n of Eng’rs Emp’t, Inc., 204 F.2d 19 (7th Cir. 1953) (no addition to tax where taxpayer was advised by a reputable tax attorney that he did not have to file a return); Haywood Lumber & Mining Co. v. Commissioner, 178 F.2d 769, 771 (2d Cir. 1950).

We find that petitioner made the requisite showing of a reasonable cause defense for both additions to tax.  Mr. Rosen, Mr. Isenberg, and the tax professionals at J.K. Lasser were competent tax advisers.  Collectively, they advised Sumner about his gift tax filing requirements on 34 occasions beginning in 1970.  Sumner sought and received their advice concerning the tax consequences of transferring stock to the Brent and Shari Trusts.  The evidence established that Mr. Rosen obtained advice from J.K. Lasser’s national office about this transaction; that this advice was memorialized in a letter or memorandum concluding that no gift tax return was required to be filed; that Messrs. Rosen and Isenberg concurred in this conclusion; and that Sumner relied on this advice in good faith.  We conclude that petitioner is not liable for an addition to tax for negligence or for failure to file a gift tax return.

Controversy:

1. Whether brother was excused from filing a gift tax return?
2. What is the value of the shares transferred by Brother to trust? Were the value of the shares involved in the initial dispute probative?  (petitioner contended that the sale was a forced sale and not reliable)
3. Whether petitioner is subject to fraud penalties? Other penalties.  Such as negligence?

Held:

The transfer was a taxable gift and petitioner is not liable for any additions to tax.

Roberto Castro, Esq., MST, MBA, CVA, CPVA, CMEA, BCMHV is Technical Editor of QuickRead. Mr. Castro is a Washington State attorney with a focus on business, bankruptcy, exit and succession planning, Wills, Probate, Trusts, and Gun Trusts. He is a member of WealthCounsel and NACVA. Mr. Castro is also managing member of Central Washington Appraisal, Economic & Forensics, LLC and a business broker with Murphy Business. Mr. Castro can be contacted by calling (509) 679-3668 or by e-mail to rcastro@rcastrolaw.com or rcastro@cwa-appraisal.com.