Estate Tax And Goodwill From Boston Tax Institute

Lucien Gauthier has given me permission to reproduce his email blasts.  Here is the latest.


In Estate of Franklin Z. Adell v. Comm., TCM 2014-155 (08/04/14), in light of the fact that the goodwill of a C corporation was attributable to the son of the decedent with whom the corporation did not have a covenant not to compete and or other agreement, the Tax Court determined that the stock of the decedent was worth only 9.3M and not 26M as the government argued.  As far as I know, this is the first case involving personal goodwill in an estate tax context and the concept of personal goodwill appears to have saved the estate between 10M and 15M of estate taxes.  If you would like to learn more about how to use personal goodwill to save both income taxes and estate taxes, consider attending our 1/2 day seminar on 06/11 from 1:30pm-5:00pm in Waltham.  If you also would like to learn something about complete liquidations of S corporations and C corporations, consider attending our 1/2 day seminar entitled Complete Liquidations from 9:00am-12:30pm on 06/11 in Waltham.  Please remember that two 1/2 day seminars on the same day are only $225 and not $150 for each seminar!

I have not looked at the Adell case yet, but I think you may see something on it on forbes.com next week.  I sometimes leave out the notices about seminars from the BTI when I get behind in posting the blasts, but this one is timely.  Personal goodwill is a powerful technique that many people are unaware of, but it has stood up well in decisions.

Originally published on forbes.com.

Estate of Lois L. Lockett, et al. v. Commissioner, TC Memo 2012-123

One of the most fundamental principles of partnerships is that to have a partnership, you need partners.  That is plural.  So if someobody is getting 100% of everything, there may be a problem.  That is what the Lockett family found when it was denied any valuation discounts on the assets in the Mariposa partnership included in the Estate of Lois Lockett.

Sometimes I think the hardest thing about family limited partnerships is that they involve families.  That probably accounts for some of the difficulties in getting the Lockett family's partnership called Mariposa going.  Here is some of the story.  Lois Lockett, a widow, had two sons, four grandchildren, a step grandchild, two daughters-in-law and an ex-daughter-in-law.  Guess who the moving force was in getting the estate plan moving ?

Mary, Mrs. Lockett's ex-daughter-in-law, was a financial planner who had advised Mrs. Lockett and assisted with her financial affairs for a number of years. David Haga who had represented Mrs. Lockett from 1996, was her estate planning attorney, and Gerald Bernard was her accountant. On February 11, 2000, Mrs. Lockett created a revocable trust, the Lois L. Lockett Trust (Lockett Trust). The Lockett Trust document named Mrs. Lockett and Mary as cotrustees. Mary and Mr. Haga also recommended that Mrs. Lockett create a family limited partnership. The Lockett family being close, Mrs. Lockett decided to involve Joseph, Robert, and Mary in the creation of the partnership. With so many people involved, a good amount of indecision arose which stalled the orderly creation of the partnership.

Joseph and Robert thought it would be a good idea to hire their own lawyer.  Bring in another lawyer.  That is sure to speed things up.  It may have brought things to a head anyway.

On October 12, 2001, Mary wrote a letter signed by herself and Mrs. Lockett to Mr. Haga in reference to their September meeting. In the letter Mary expressed reservations about having Mr. Miller involved in the drafting of the partnership agreement, essentially requesting that his changes be ignored. Mary also recommended that she be named a general partner so that she could protect Mrs. Lockett's limited partnership interest. Mary recommended a number of other changes and stated that once those changes were made she would encourage Mrs. Lockett to sign the partnership agreement.

Joseph and Robert had always deferred to Mary's judgment when it came to their mother's finances. Mary had been the driving force behind the creation of Mrs. Lockett's estate plan and the formation of Mariposa. However, Joseph and Robert became suspicious of Mary's motives. They moved their mother to a new assisted living facility so that she would be farther away from Mary and closer to them. In January 2002 Joseph and Robert decided to exclude Mary from further involvement in Mrs. Lockett's financial affairs. On March 2, 2002, Mrs. Lockett executed a durable power of attorney removing Mary as her attorney-in-fact and appointing Joseph and Robert in her stead. On that same date, Mrs. Lockett executed a first amendment to the terms of the Lockett Trust removing Mary as cotrustee and appointing Joseph and Robert to serve as cotrustees.

There was still a lot of indecision, though.

The Mariposa agreement named Joseph and Robert as general partners and Mrs. Lockett, Joseph, Robert, and Trust A as limited partners. Even without Mary's involvement the indecision continued. At the time the Mariposa agreement was signed, Mrs. Lockett, Robert, and Joseph had still not agreed upon initial capital contributions or their percentage interests in Mariposa.

Ultimately Robert and Joseph would never make any contribution for their general partnership interests.  They subsequently tried to argue that there was an implicit gift to them of a 1% interest, that they provided services and later on that a contribution that Mrs. Lockett made in the amount of $125,000 was actually made on their behalf giving them an 11.68% interest.

When Mrs. Lockett died her interest in the partnership, which was listed as 100%, was valued at $667,000. The underlying assets were stipulated in the case as being worth $1,106,841.  There were discounts for lack of control and marketability.  The IRS tried to argue that there never was a partnership at all because there was no business conducted.  The Court did not buy that argument:

We agree there was minimal economic activity, but we find no requirement that an Arizona business engage in a certain level of activity. Moreover, we find that Mariposa was operated to derive a profit. Mariposa hired Mr. Russell to manage its portfolio of stocks, purchased real estate which it leased, and made loans requiring annual interest payments. Accordingly, we find that Mariposa operated a business for profit.

There was a problem, though, which turned out to be insurmountable.  I find the use of the passive voice here interesting - In May 2003 a decision was made to terminate Trust A. The dissoution of Trust A which involved the transfer of its interest in Mariposa to Mrs. Lockett is what made her a "100% partner".  What were they thinking ?  They must not have been thinking that they terminated the partnership, but that is what the IRS and, more importantly, the Tax Court ended up thinking:

Article 9.1 of the Mariposa agreement provided Mariposa would be dissolved upon the acquisition by a partner of all the interests of the other partners. Therefore, Mrs. Lockett's acquisition of Trust A's limited partnership interest caused the dissolution of Mariposa under Arizona law. On December 31, 2002, Mrs. Lockett became the legal owner of all of Mariposa's assets pursuant to Arizona law.

The case also got into several loans that Mrs. Lockett made to her heirs.  Even though no payments were made on them, the ones that were supported by promissory notes were treated as loans rather than gifts.  I would have recommended that Robert and Joseph fund their general partner contributions from a source other than the loans, but it would certainly have been better if they had done that rather than not funding them at all.  Alternatively a well documented gift to them of a small interest in Mariposa might have done the trick.  Finally you have to wonder about the decision that was made to terminate Trust A.  I hope it accomplished some greater purpose than saving on filing one return.

You can follow me on twitter @peterreillycpa.

Tax Court Values Regional Media Empire

Originally Published on forbes.com on July 5th,2011

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Estate of Louise P. Gallagher, et al. v. Commissioner, TC Memo 2011-148

When Louise Gallagher died in 2004, she was the largest owner of Paxton Media.  Based in Paducah, Kentucky, Paxton owns 32 daily newspapers, numerous weeklies and WPSD-TV, an NBC affiliate serving parts of Kentucky, Illinois and Missouri. Ms. Gallagher’s 3,970 units constituted 15% of the value of Paxton Media Group LLC.  Her estate tax return included the units at a value of $34,396,000.  The IRS audited the return and after failing to settle issued a notice of deficiency based on a value of $49,500,000.  Both parties commissioned new appraisers.  The new appraisals were both lower, but almost as far apart $26,606,940 versus $40,863,000.  Then the estate hired another appraiser, who closed the gap a little with a value of $28,200,000.

I’m going to spare you the suspense here and tell you that the Tax Court came in at $32,601,640.  So the Government would have done better to accept the return as filed.  I have a theory, though, that the real function of the estate tax is to serve as a white collar jobs program.  With a little bit of luck we will be reading another case in a year or so about all the additional expenses that the estate will be deducting because of this litigation.  The analysis that the Tax Court went through to arrive at its value, is, however, instructive and I would like to share some of the highlights.  In the interest of score-keeping here is a list of the five appraisals with the names of the appraisers and the initials I’ll use in the discussion:

David Michael Paxton – (PMG’s President and CEO)(DMP) – $34,396,000                                                                                                                                                                          IRS – $49,500,000                                                                                                                                                                                                                                                                               Sheldrick, McGehee & Kohler, LLC (SMK) - $26,606,940                                                                                                                                                                                                      Richard C. May (RCM) – $28,200,000                                                                                                                                                                                                                                          Klaris, Thomson & Schroeder, Inc. (KTS) -  $40,863,000

 The Tax Court ended up accepting and working with the RCM and KTS appraisals noting where they differ:

The parties disagree over: (1) The date of financial information relevant to a date-of-death valuation of decedent’s units, (2) the appropriate adjustments to PMG’s historical financial statements, (3) the propriety of relying on a market- based valuation approach (specifically the guideline company method) in valuing the units, and, if appropriate, the proper manner of applying that method, (4) the application of the income approach (specifically the discounted cash flow valuation method), (5) the appropriate adjustments to PMG’s enterprise value, and (6) the proper type and size of applicable discounts.

Date of Financial Information

Ms. Gallagher died on June 27, 2004.  The KTS appraisal uses PMG’s internalfinancial statements prepared as of June 27, 2004 and data from public companies for the quarter ended June 30, 2004.  I’m guessing that PMG, which was an S Corporation, did June 27 financial statements in order to accommodate allocation of taxable income based on an interim closing of the books rather than the days method.   RCM maintained that someone valuing the company on June 27 would have been constrained to use PMG’s internal information as of May 30, 2004 and public company data for the quarter ended March 28, 2004.  The Court agreed with using the June numbers:

 Petitioner argues that the June information was not publicly available as of the valuation date, preventing a willing buyer and seller from relying upon it in determining fair market value. That is not to say, however, that our hypothetical actors could not make inquiries of PMG or of the guideline companies (or of financial analysts), which would have elicited non-publicly available information as to end-of-June conditions. Moreover, we understand Mr. Thomson’s testimony to be that the June 2004 financial information accurately depicts the market conditions on the valuation date, not that a willing buyer and seller would have relied upon the data. Importantly, petitioner has not alleged an intervening event between the valuation date and the publication of the June financial statements that would cause them to be incorrect.

I would observe here that in the sale of this type of business there might be an adjuster clause to take into account the actual values of items such as cash, receivables and payable as of the closing date, which of necessity will not be known on the closing date.

Appropriate Adjustments to Historical Financial Statements

A valuation like this is heavily based on a prediction of future EBITDA (Earnings Before Interest Taxes Depreciation Amortization).  The starting point will be the most recent earnings, but those earnings must be adjusted for non-recurring items.

The KTS appraisal made one adjustment to PMG’s income statements, subtracting a $7,895,016 gain on divested newspapers in 2000.

 The RCM appraisal made, among other adjustments, the following three adjustments to PMG’s earnings: (1) Reduced PMG’s 2000 earnings before interest, taxes, depreciation, and amortization (EBITDA) by a $7,900,000 gain on divested newspapers, (2) subtracted from both EBITDA and earnings before interest and taxes (EBIT) a 2003 $700,000 gain from a life insurance policy PMG inherited through an acquisition, and (3) subtracted from both EBITDA and EBIT a 2003 $1,100,000 positive claim experience from PMG’s self-insured health insurance.

Respondent objects to those three adjustments. We are unclear as to why respondent objects to the 2000 newspaper divestiture adjustment since his own expert, on whose appraisal he relies, made the same adjustment. We thus consider respondent to have acquiesced to the adjustment. However, we disregard Mr. May’s self-insured health insurance and life insurance policy adjustments because he provides no explanation as to why the gains were non-recurring.

Why did the IRS attorneys object to an adjustment that their own expert had conceded?  They’re attorneys.  Objecting is what they do.  The more interesting question is why the RCM appraisal did not include any commentary on why the life insurance and health insurance adjustments were not recurring. Perhaps, being number crunchers, the appraisers thought it was apparent, as do I. The $1,100,000 in 2003 could have a substantial effect on the valuation, particularly if some sort of weighted average of EBITDA was being used.  I guess the advice that appraisers might take away from this is what I used to tell my kids when they were little – Use Your Words.

Guideline Companies

The Court found that the four public companies (Journal Register Co., Lee Enterprises, Inc., the McClatchy Co., and Pulitzer, Inc) used in the KTS appraisal were not similar enough to PMG and rejected this approach.  The companies are all much larger than PMG, included more specialty publications and three of them were beginning to enter develop on-line publications.

Discounted Cash Flow Valuation Method

The discussion here really gets into the weeds.  Which appraiser was better at projecting future newsprint cost is an example of something that must be resolved, so I will gloss over much of the discussion.  One issue that is significant is tax affecting the earnings.  This is an S corporation, so we shouldn’t really have to consider taxes – right? That’s pretty much how the Court saw it:

Mr. May tax affected PMG’s earnings by assuming a 39-percent income tax rate in calculating the company’s future cash flows, before discounting PMG’s future earnings to their present value. He also assumed a 40-percent marginal tax rate in calculating the applicable discount rate. In contrast, Mr. Thomson disregarded shareholder-level taxes in projecting both the company’s cash flows and computing the appropriate discount rate.

Mr. May failed to explain his reasons for tax affecting PMG’s earnings and discount rate and for employing two different tax rates (39 percent and 40 percent) in doing so. Absent an argument for tax affecting PMG’s projected earnings and discount rate, we decline to do so. As we stated in Gross v. Commissioner, the principal benefit enjoyed by S corporation shareholders is the reduction in their total tax burden, a benefit that should be considered when valuing an S corporation. Mr. May has advanced no reason for ignoring such a benefit, and we will not impose an unjustified fictitious corporate tax rate burden on PMG’s future earnings.

Here is another instance of an appraiser not using his words, although the tone of the decision seems to indicate that it would not have helped.

Both appraisers used a Weighted Average Cost of Capital to discount the projected cash flows.  The Court generally does not think that WACC is applicable to closely held companies, but allowed it in this case since the appraisers agreed on it in concept.  I won’t comment on the detail it went into in comparing the way each appraiser computed WACC other than to say that it kind of makes me suspicious that the Court came up with 10%, seeing how easy that makes the math, but that’s pretty cynical.

Enterprise Value

Having arrived at the value of the discounted cash flow, enterprise value is determined by adjusting for excess or inadequate working capital and subtracting debt.  Once again the RCM appraisal is faulted for not enough words:

We do not find Mr. May’s analysis to be persuasive. Mr. May once again failed to explain why the public companies that he deemed to be not comparable to PMG under the guideline company method provide a sufficient comparison upon which to base a working capital adjustment. We lend little weight to his seemingly contradictory positions. In addition, although explaining the need for a working capital adjustment under the guideline companies methodology, he failed to do so under the DCF method despite applying the adjustment to the results under both methods. For these reasons, we disregard his working capital deficit adjustment.

The RCM appraisal had also had an add-in to reflect the benefits of PMG being an S corporation.  The Court indicated that this was taken care of by its assumption of a 0% corporate tax rate.

There was also a small difference in the debt numbers based on timing and questions about how the stock options might affect enterprise value.

Discounts

There was not a lot of controversy here.  Although the Court did not think the studies the experts used were necessarily applicable to long term closely held companies, they both used pretty much the same studies, so the marketability discount of 31% allowed by the Court was not a significant adjustment either way.  Oddly the taxpayer’s expert did not have a minority discount while the government’s did.   Apparently the minority discount was built into the RCM method for computing discounted cash flow.  The Court ended up increasing the minority discount allowed in the KTS appraisal from 17% to 23%.

Conclusion

I find it intriguing that of the five valuations the one that the Court came closest to was the value on the return as filed.  They hadn’t even hired an appraiser for that one, but were using the valuation the company used for other purposes.  Even though the Court came out closer to the RCM appraisal, they more often than not seemed to like the conceptual approaches in the KTS appraisal, although sometimes the Court indicated that when the two appraisers agreed on something the Court would go along, but didn’t necessarily approve.  The clearest thing that came out is that its holding inGross v Comm to not tax affect S Corporation earnings does not require a lot of fancy math.  It appears that the RCM appraisal would have done better with more words  and less math.  After all Tax Court judges are lawyers.

Serial Guest Blogger Comments on Family Limited Partnership Case

Originally published on Passive Activities and Other Oxymorons on May 17th, 2011.
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Matt Erskine was my first guest blogger.  Now he is back with commentary on an important family limited partnership case.


Another Attack on FLPs: Jorgensen v. Comm’r. 107 AFTR 2011


Erskine Comment: The 9th Circuit Court of Appeals has taken another swipe at the use of Family Limited Partnerships for transferring stock between generations. In this case, the deceased, Erma V. Jorgensen, transferred stock to two Family Limited Partnerships. The Court affirmed the decision of the Tax Court which sided with the IRS position that the entire value of the stock in the FLP should be included in her estate and denied the use of the discounted value, as the Estate alleged.

The Appeals Court affirmed the Tax Court’s using the post-transfer operations of the FLP to determine that the deceased 1) retained some economic interest in the assets of the FLP and 2) the transfer to the FLP by the deceased was not a bona fide sale for good and adequate consideration.

The retained economic interest was based on the decedent writing $90,000 worth of checks from the partnership for her personal expenses (even though there was an attempt to correct this by her accountant when this “error” was discovered) and because $200,000 of her estate taxes where paid from the Partnership.

The bona fide sale defect was based on the facts that:

“The type of assets transferred (marketable securities) did not require significant or active management, there was some disregard of partnership formalities, and the nontax justifications are either weak or refuted by the record (including formation of a second family partnership to hold higher-basis assets for gift-giving purposes, purportedly for the same nontax justifications that the original partnership could have already served).”

This reinforces the high level of scrutiny that FLPs and FLLCs incur by the Courts and the Service and the requirement that not only the set up but the ongoing operations of the entities be done with exactitude to insure that the discounting is not disallowed.

Overall, I cannot see that FLPs should be relied upon now that they are under both legislative and court attack for any long term tax planning.

PAOO Comment - I'm not sure that I go all the way with Matt on rejecting FLP's as a valid tool.  For one thing they  frequently would be a good idea even if there were no discounts.  Jorgensen was definitely a case of poor execution.  In my post on the original case I mention the son's difficulty in "getting his head around" the idea that the partnership wasn't just like a bank account.  The most recent Jorgensen decision was in my backlog of draft posts.  I am planning on looking at it along with a couple of other cases.  Be sure to check out the Erskine and Company blog.

Blame it on the Scrivener

Originally published on Passive Activities and Other Oxymorons on May 16th, 2011.
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Xianfeng Zhang v. Commissioner, TC Summary Opinion 2011-21

This was a substantiation case.  They mentioned the famous Broadway producer, but only to say that his rule didn't apply.  Taxpayer won on home office, but all his travel expenses were disallowed:

Petitioner testified that he took three separate trips to China for business purposes in 2006—one in June lasting approximately 90 days, another in September lasting approximately 60 days, and a third that began in December 2006 and ended sometime in 2007. Petitioner entered into evidence three airplane tickets for flights from both Beijing to Los Angeles and Los Angeles to Beijing. The dates on the airplane tickets are not consistent with the dates or periods of travel to which petitioner testified. Although petitioner's passport bears customs stamps from both the United States and China, some of the stamps are illegible. The stamps that are legible do not correspond with the dates petitioner testified he was in China for business.

Petitioner did produce several receipts that appear to be for automobile and lodging expenses in China. The receipts, however, are in Chinese and do little to explain petitioner's business activities. The receipts do not satisfy the strict substantiation requirement of section 274(d). Petitioner has failed to substantiate the travel expenses he claimed for his trips to China. Therefore, we sustain respondent's disallowance of petitioner's deduction for travel expenses.

ESTATE OF ANTONIO J. PALUMBO v. U.S., Cite as 107 AFTR 2d 2011-1274

This one looked kind of interesting, not least in part because the dollars are pretty big - over eleven million.  Mr. Palumbo had a will that left the residue of his estate to a charitable trust.  Then his attorney redid his will and there was a "scrivener's error" - poor Bartleby gets blamed for everything.  The new will didn't have a residuary clause.  Managing to die intestate with a valid will is quite a feat, but that's what his son contended.  Finally there was a settlement between the son and the charitable trust. Then the IRS gets into the act and says the settlement doesn't qualify for the estate tax charitable deduction.  The taxpayer won, although the court ruled in late April that the government's postion had enough justification that the Estate could not get attorney's fees.

SMITH v. U.S., Cite as 107 AFTR 2d 2011-1228

Mr. Smith, on the other hand, did get attorney's fees of $78,167.02.  The IRS put him though a lot in resisting his refund claims including claiming that he hadn't filed them and then admitting that they did.  They contested both his net worth (if over $2,000,000 you don't get fees) and that their postion had been justified at some point or other even though they ended up caving.

Desmond D. Conyers v. Commissioner, TC Summary Opinion 2011-25

This was an innocent spouse case where the spouse claiming relief was the husband and the wife was deceased.  The only income on the joint return had been from his roofing business which he pretty much controlled.  His story was:

At trial petitioner testified that sometime after respondent's examination he became aware of large sums of cash withdrawn from two of his bank accounts and that he now believes that his wife had been taking money and fixing the books to support a drug and alcohol addiction. He also testified that payment of the tax in issue would cause him such hardship that his only option would be to file for bankruptcy.


The Court wasn't buying it:

Other than this brief and conclusory testimony, petitioner produced no evidence to support these allegations. In the light of the facts indicating that petitioner knew about the operations of his business and its substantial income, we cannot find that petitioner has proven that he is eligible for relief under section 6015(f).


Abdul M. Bangura v. Commissioner, TC Summary Opinion 2011-23

This seems like a pretty run of the mill clueless taxpayer substantiation case.


In connection with the audit of his 2004, 2005, and 2006 tax returns, petitioner told the examining agent that he was not required to provide the Internal Revenue Service with any records or documentation other than those which had been submitted with his income tax returns. Indeed, petitioner never provided the examining agent with documents of any kind with respect to years 2004, 2005, and 2006 during the audit for those years. Nor did petitioner respond to the IDR for 2007.

 The agent really piled it on assuming that there must have been gross receipts to pay the unsubstantiated expenses.


Although the examining agent used the business expenses set forth on Schedule C in reconstructing petitioner's income, he determined that deductions for these expenses should be disallowed for lack of substantiation. The examining agent also determined that for 2007 petitioner was liable for an addition to tax pursuant to section 6651(a)(1) for failure to file a timely return and an accuracy-related penalty pursuant to section 6662(a).

The Court at least gave the taxpayer a break on that.

Consequently, we hold that the examining agent may not use petitioner's disallowed Schedule C expenses to reconstruct his income. Because of this error, respondent must recalculate petitioner's 2007 unreported income.

When it came to the penalties, though, the Court did not find his argument about being somebody just starting in business and learning through honest mistakes at all compelling.

Yet when asked by the examining agent to provide documentation to substantiate his claimed business expenses, he failed to do so. Petitioner asserted that this was not negligence; rather, “it's more or less when you're starting out doing something, like a medical doctor doing operations or maybe a lawyer representing somebody in the courtroom, you have a lot to learn. You do make mistakes here and there.” We find petitioner's cavalier attitude unacceptable.

Here is the punch line.  The taxpayer was a CPA.  I can hear the Wandering Tax Pro laughing out loud in New Jersey right now, even if he is "down the shore".

Check This List Before You Check Out

Originally published on Passive Activities and Other Oxymorons on May 7th, 2011.
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Erskine Company the Post 2010 Tax Act Checklist April 15, 2011


This blog is entering a new stage.  I have been soliciting guest posts and some have come in..  I have some promises too.  You know who you are, I won't forget.  I am very gratified to have as my first guest blogger, Matthew F. Erskine

Matthew Erskine is the managing partner of this fourth generation law firm. He focuses his estate planning and trust services practice on serving business owners, professionals, individuals, families, collectors, and inheritors of significant assets. Helping his clients and their families achieve their goals by providing customized solutions. Matt carries on his family’s tradition of integrity, continuity, and service.


Who needs a review of their Estate Plan due to the New Tax Laws?

All clients should have their estate plan reviewed if:

1. Their net worth is $3.5 million ($7 million for a couple) or higher,

2. They own stock or other interest in a closely held company,

3. They own a significant amount of artwork, collectibles, commercial real estate, legacy real estate compounds or other unique assets,

4. They own an interest in a Family Limited Partnership or Family Limited Liability Company, or

5. They may inherit any of these assets.

The Questions to ask:

1. Is the estate plan drafted for maximum flexibility?

a. Look for either a large QTIP or Clayton QTIP election being allowed in the estate tax return,

b. Look for a disinterested independent trustee who has broad powers to distribute income, principal, powers of appointment and to terminate superfluous trusts as the tax laws change.

2. Is the possible use of disclaimers outlined?

Thanksgiving Without Mom Almost Costs $3,000,000

Originally published on Passive Activities and Other Oxymorons on March 21st, 2011.
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Estate of Sylvia Riese, et al. v. Commissioner, TC Memo 2011-60

One of the things I often say about sophisticated estate planning techniques is that when they fail, it is often a failure of execution rather than conception.  Someone comes up with a sound plan, the documents that will execute the plan are drafted and then somewhere along the line things are not executed in accordance with the plan.  In this case the taxpayers came out OK anyway, but it still represents a cautionary tale.

The case concerns a QPRT - (Qualified Personal Residence Trust).  The technique allows a taxpayer to make a gift of a future interest in their residence.  During the term of the trust they continue to live in it and are treated for income tax purposes as if they own it.  At the end of the term it is treated as being owned by the benerficiaries or a trust for their benefit.  The advantage of the arrangement is that the donor gets to use todays value of the residence (and we all know real esate only goes up).  In addition since it is ownership of the house in the future that is being gifted the value is discounted to take into account the time value of money. (Remember when money used to earn interest).  The disadvantage is that at the end of the term the donor has to start paying rent, if she wants to keep living in the house.  The purpose of the preceeding discussion is to give context for this cautionary tale.  It is not a comprehensive discussion of the QPRT technique.

Mrs. Riese appears to have had some good estate planning done for her:

Mr. Tucker represented decedent with regard to estate planning and other matters.  In 1999 Mrs. Grimes mentioned to him that decedent was agreeable to some additional estate planning with respect to the residence. In response, Mr. Tucker and Mrs. Grimes began considering the establishment of a QPRT for decedent. Mr. Tucker sent a letter dated September 17, 1999, to Mrs. Grimes explaining the Federal gift tax costs and some of the benefits of establishing a QPRT for decedent. Mrs. Grimes then visited decedent and explained the contents of the letter to her. Decedent asked Mrs. Grimes whether she would directly benefit from the establishment of a QPRT. Mrs. Grimes explained that establishing a QPRT would result in a lower estate tax liability but also that decedent would have to pay gift tax on the transfer and pay rent to live in the residence after the QPRT expired. Decedent agreed that a QPRT would be acceptable and gave Mrs. Grimes permission to proceed.


There was good execution on the front end:

On April 19, 2000, decedent established the Sylvia Riese QPRT (the QPRT) under section 25.2702-5, Gift Tax Regs., and executed a deed transferring the residence thereto. Decedent reported the transfer of the residence to the QPRT on Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, for tax year 2000.

Things went awry when the trust reached its termination date.  At that point the trust should have deeded the property to the remainder beneficiaries (new trusts in this case).  The new owner or owners then should have taken responsbibility for paying all expenses related to the property.  Since Mrs. Riese was still living in the property she should have signed a lease and started paying rent.  That's not exactly what happened.

The QPRT agreement states, in pertinent part, that if the settlor (i.e., decedent) survives the termination date of the QPRT, the QPRT shall terminate and the balance of the trust fund (i.e., the residence) shall be distributed 50 percent each to two trusts, known as the 1997 Property Trusts (the Property Trusts), which decedent established in 1996 for the benefit of Mrs. Grimes and Ms. Zipp. The QPRT terminated by its terms on April 19, 2003. Decedent (or the QPRT) did not execute a deed transferring the residence to the Property Trusts.

Mrs. Grimes never discussed rent directly with decedent after the QPRT terminated. However, around the termination date Mrs. Grimes called Mr. Tucker inquiring about how to determine the proper amount of rent to charge decedent. She testified: “I knew she'd agreed to it and, you know, I didn't—I didn't want to feel like I was badgering her. And so I called *** [Mr. Tucker].” Mr. Tucker explained to her that fair market rent could be determined by contacting local real estate brokers and that this could be done by the end of the year (i.e., December 31, 2003). Mr. Tucker entered a “tickler” in his pocket calendar to remind himself to call Mrs. Grimes by Thanksgiving to make sure everything was taken care of.

The significance of Thnaksgiving is unclear.  Perhaps the plan was to get Mom to sign a rent check before the turkey was carved.  Sadly, Mrs Reis did not even make it to Haloween as she suffered a stroke and died on October 26, 2003.  She would not be able to sign a rent check covering the period that she was a tenant rather than an owner as the ball descended in Times Square as Mr. Tucker apparently had planned.

It is unusual for landlords to let people live in a house for 6 months without paying any rent.  The IRS contended that Mrs. Reis had not really given the house away.  People realize that they can't take it with them, but their preference is to control it till slightly before their last breath and then have it go to their heirs without being included in their taxable estate.  There are laws in place to frustrate this natural desire and the laws will take note of implicit understandings.

The Tax Court ended up cutting the family quite a bit of slack:

We find as a matter of fact that there was an agreement among the parties for decedent to pay fair market rent, the amount of which was to be determined and payments to begin by the See Diaz v. Commissioner, 58 T.C. 560, 565 (1972) end of 2003. (basing analysis upon evaluation of the entire record and credibility of witnesses). The Secretary had not issued any regulations or guidance as to how and when rent should be paid upon the termination of a QPRT. We believe that doing so by the end of the calendar year in which the QPRT expired would have been reasonable under the circumstances.

Unlike many cases involving the transfer of a personal residence where the decedent continued to live in the residence until death, see, e.g., Estate of Van v. Commissioner, T.C. Memo. 2011-22 [TC Memo 2011-22], the existence of an implied agreement in this case is negated by the express agreement among the parties for the payment of rent. Many factors, e.g., the creation of the QPRT, the payment of gift tax upon the transfer of the residence to the QPRT, the several instances in which decedent agreed to pay rent, the fact that Mrs. Grimes called Mr. Tucker upon the QPRT's termination to find out how to determine the amount of rent to charge, and Mr. Tucker's corroborating testimony, all lead us to find that there was no agreement or understanding that decedent would retain an interest in the residence for life without paying rent.

We believe that Mrs. Grimes, on the advice of counsel, intended to and would have determined fair market rent by the end of 2003 and decedent would have paid rent. We believe further that Mr. Tucker would have made sure a lease was executed, rent was determined, and all appropriate changes were made to effect the change of ownership. Unfortunately, decedent died unexpectedly in October before any of this occurred.

There was a deficiency of over $3,000,000 involved in this case so I'm willing to wager that the litigation cost was substantial.  Although the taxpayer prevailed (They lost on some other small issues) it must have been kind of nerve racking.  It could have been avoided if when the gift was made in April of 2000, a plan had been made to sit down with Mrs. Reis in say February of 2003 to go over what would be happening in the next couple of months.  The rent determination, the transfer, the lease and the initial rent payment should have all been done in April 2003.

Other practitioners might read this case and come to the opposite conclusion saying that it proves that waiting till the end of the year to clean everything up is just fine based on:

The Secretary had not issued any regulations or guidance as to how and when rent should be paid upon the termination of a QPRT. We believe that doing so by the end of the calendar year in which the QPRT expired would have been reasonable under the circumstances.


I would disagree with that analysis.  There is no reason to take chances like that with so many dollars at stake.

Survey Says - No Discount For Family Limited Partnership

Originally published on Passive Activities and Other Oxyomorons on December 13, 2010

_________________________________________________________________
LEVY v. U.S., Cite as 106 AFTR 2d 2010-7205, 12/01/2010

Sometime in the last millennium there was a TV situation comedy called Angie.  It was about the early days of a marriage between a fellow from a very wealthy Philadelphia family and a waitress from a family of more modest circumstances.  In one of the episodes the two families compete on the game show Family Feud.  Family Feud is a wonderfully egalitarian contest.  Unlike Jeopardy, which requires you to come up with the one correct answer (Expressed in the form of a question)  the questions in Family Feud are matters of opinion.  If you get one of the top five or ten answers (something like that) that were determined by a survey you get some points.  The more common the answer you come up with the more points it is worth.

I forget how the Angie episode worked out in its entirety, but at least early on the husband's wealthy family (including the butler of course) was getting creamed.  People in the survey did not have champagne and caviar for snacks or start the day by checking stock prices.  At one point the host goes up and explains to them that the survey answers come from average people not the ultra wealthy.  They don't get it.  The lawyers for the Estate of Meyer Levy might have learned something from watching that episode, but they were probably studying hard in law school or taking polo lessons, the better to meet wealthy clients, while I was squandering my time learning life's lessons by watching television.

The case was a family limited partnership case.  Family limited partnerships can be a good idea for a multitude of reasons.  They are particularly attractive to people, who not, yet, having come up with a way to take it with them, want to control it all till they draw their final breath without having it all included in their taxable estate.  There's also the asset protection and as they say on Seinfeld yada yada yada.  The thing that people get excited about, though, is the discounts.  That's what the IRS gets excited about too.  Take a bunch of stuff and put it into a family limited partnership.  Say its a million dollars worth of stuff.  Now give 10% of the partnership to your kid.  How much is the gift worth ?  $100,000 ?  Do you think I would pay $100,000 for it ?  Of course not..  As a limited partner I don't get to vote.  On top of that your kid doesn't even have the right to sell it to me.  You have to hire a valuation expert to value the limited partnership interest (I sometimes think the estate tax is, in reality, a white collar jobs program).  She'll tell you its worth something like $65,000, more or less, depending on well yada yada yada. The IRS doesn't like this and is constantly attacking it.

Until recently they focused on poor execution which I discussed at length in one of my early blog posts.  Assets aren't really transferred to the partnerships.  Personal bills are paid directly by the partnership.  Distributions are not made in proportion to partnership ownership.  Tax returns are not filed or not done correctly.  In a more recent case, Fisher, discounts were not allowed for a single asset partnership, because it lacked business characteristics.  There was no discussion of flawed execution.

No discount was allowed to the Estate of Meyer Levy for the sale of its Plano real estate that was in a partnership.  The estate appealed the verdict alleging error on the part of the trial court.

The Estate argues that the trial court erred when it allowed the admission of

 (1) evidence of the ongoing negotiations over the sale of the property, specifically the offers and proposals;
(2) evidence of the listing price of the property, and the ultimate sale price of the property;
 (3) valuation testimony by the Government's expert based on flawed methodology; and
(4) opinion testimony by a lay witness and hearsay testimony.

Wow.  In a valuation case they considered what people were offering for the property and what it actually sold for.  That's pretty outrageous.  You see the problem was it wasn't a judge that had to think about these things.  It was a jury.  Who ends up on a jury ?  I'm not sure exactly. I suspect that they have more in common with the people Family Feud surveys for its answers than the people I run into at tax conferences.


The Estate contends that the jury arbitrarily disregarded unequivocal, uncontradicted, and unimpeached testimony of an expert witness, bearing on technical questions of causation beyond the competence of lay people. The Government counters that the jury had the partnership agreement in evidence from which it could have determined that there was no lack of control or marketability.

The record contains ample evidence to support the jury's verdict valuing the property at $25 million. The Estate listed the property, and eventually sold the property, for $25 million. It was immediately resold for $26.5 million. Sophisticated developers with no stake in the current litigation engaged in ongoing negotiations for the property for prices in the $20–25 million range. The Estate's expert testified that the market in Plano remained relatively flat during the period between Levy's death and the sale of the property. Also Jordan testified regarding the value of the property. Any of these provides sufficient support for the jury's verdict on the property.

The jury verdict regarding the discount also finds support in the record. The partnership agreement itself would be sufficient evidence. The jury could have rationally found that no discounts for lack of control or marketability were merited because the Estate controlled the general partner interest, which had nearly unfettered control over the Partnership's assets. The trial court did not abuse its discretion when it denied the Estate's motion for new trial.

I'm not a lawyer and I don't even play one on TV.  I prepare and review tax returns and do tax planning.  I also represent people who are being audited by the IRS, but there I'm generally dealing with accountants.  If my clients end up in Tax Court and win I'll still think that I lost.  I am fairly certain though, that it was the choice of the estate's lawyers to bring this matter to a jury.  To have that privilege, they had to pay at least part of the tax in order to be able to sue for refund in district court.  They could have instead gone to Tax Court where they would have had people who dealt with "technical questions beyond the competence of lay people" all the time and frequently allow discounts.  Somehow though they thought they would do better with a jury.

Apparently though the government lawyers saw to it that the jury found out that the Estate got $25,000,000 and these simple minded people thought that might be indicative of whatever the estate had was worth.  I suppose there was some sort of trial strategy that would keep this information undisclosed.  In which case the jury would have had to weigh the government's yada, yada, yada against the Estate's yada, yada, yada.  There might have been some logic to that.  If I was playing Family Feud and the question was "Name a class of people that are very popular" I would venture neither multi-millionaires or IRS agents.  If the question was "Name a class of people that are despised"  I think I might score higher with "IRS agents".  I mean no disrespect to IRS agents, their unpopularity is inherent in their jobs.

In  a refund suit in district court either the government or the taxpayer can ask for a jury.  I haven't been able to figure out which it was.  I did find that the executor had been a potential candidate for mayor of Austin Texas and the late Mr. Levy had established a fairly well known charitable foundation.  So there may have been a feeling that there was a home town advantage.  There was also a sense in which the Estate was playing with the house's money if it was the one that gambled on a jury, as is noted in a footnote:

Although we have declined to set aside the jury's verdict of zero discount, we note that the actual discount applied in taxing the Estate was thirty percent. Given the valuation found by the jury, it would have had to find a discount of larger than thirty percent for the verdict to make a difference to the judgment in this case.


I don't know whether this case will have a chilling effect on family limited partnerships or not.  My cumulative sense is that you should only do them if you think they are a good idea anyway.  Oddly enough, that will make it more likely that you will succeed on the discount issue.  I think the key planning point to take away from the case is the Court's comment that it would have been reasonable to find a zero discount because of the Estate's general partnership interest.

Read This Before You Bundle Grandma Onto the Plane

Originally published on PAOO December 30, 2009 just two days before the year without an estate tax.  The end of that year promises to be a trope in many murder mysteries for years to come.

I just read in the Wall Street Journal that many people are being kept on life support in the expectation of living till the effective date of estate tax repeal.  I doubt its enough to create a power surge in the grid when all those plugs are pulled on January 1, but it is a real phenomenon.  Being one willing to go from the ridiculous to the ridiculously absurd, it occured to me that in order to be as safe as possible, you might want to equip a hospital plane to get to a more favorable time zone.  Which way should you fly ?

A lot of people would think to go East.  After all we are GMT - 5 making it later as we fly East.  That's what a lot of people think.  Don't be one of them.  Head west.  Only don't stop in LA or Hawaii or even Samoa.  Get to Fiji.  Actually Tonga is good enough.  That puts you in GMT + 12, which is as good as it gets.  Kiribati is even closer, but I never even heard of that till just now.  But wait.

It doesn't do you any good.  According to Revenue Ruling 66-85 your time of death for estate tax purposes is based on the time zone where the estate tax return is to be filed.  That's the rule for US citizens residing in the US.  Revenue Ruling 74-24 gives a different rule for US citizens living overseas.  There is is based on their domicile at time of death.  Now your domicile is not where you are at any point in time.  It is not necessarily even where you spend most of of your time.  "Home is where the heart is".  In the United States states with high income tax rates think that nobody, in their heart, ever leaves them.  Don't get me started on this one.

According to the latest 706 instructions all estate tax returns are filed in Cincinatti, Ohio.  That would mean that all you have to be able to do is hang on till the ball finishes dropping in Times Square.  Unless you are domiciled in the Yukon.  The commentator from whom I got these cites says that sombody from LA who dies in New York goes by West Coast time, so there is a little bit of doubt in my mind.  Maybe you should hang on till the calendar turns in Samoa to be totally free from doubt.

At any rate forget about chartering the plane.  I doubt it is practical but if you could establish domicile in Fiji between now and then you would be in the best shape possible.  Maybe send a couple of cases of Fiji water to everybody in the family.  That wouldn't be enough, but every little bit helps.

Devil is in The Details

Originially published on PAOO December 29, 2009.

In June of 2007, the Estate of Sylvia Gore joined the ranks of failed Family Limited Partnership. The case is worthy of consideration, because it illustrates clearly why the partnerships fail. If you are going to set up a family limited partnership it is critical that you consult with a well qualified attorney. The attorney will create a package, more or less thick, of documents, more or less mysterious and will see that you sign them with witnesses, notarized, with an extra copy in her safe in case you lose yours. That’s service. That’s follow through. Valuation discounts are what tends to be at stake when the IRS attacks Family Limited Partnerships. Having had great service from your attorney, you probably think that when people lose it is because they didn’t hire a good attorney. Perhaps the documents weren’t witnessed. Maybe one of the incantations in the mysterious documents was missing. Maybe there wasn’t an extra copy in the safe, after they lost theirs.

The follow through needed is not the extra hour in the attorney’s office. The follow through will be many hours year in and year out in your accountant’s office. The clue to this is in the importance attributed to the extra copy in the attorney’s safe. Why doesn’t the accountant who has to prepare the income tax return for the partnership have a copy? Why don’t you need to look at your copy from time to time too? Here’s why:

each partner's capital account is increased by (1) the amount of money contributed by him to the partnership, (2) the fair market value of property contributed by him to the partnership (net of liabilities that the partnership is considered to assume or take subject to), and (3) allocations to him of partnership income and gain (or items thereof), including income and gain exempt from tax and income and gain described in paragraph (b)(2)(iv)(g) of this section, but excluding income and gain described in paragraph (b)(4)(i) of this section; and is decreased by (4) the amount of money distributed to him by the partnership, (5) the fair market value of property distributed to him by the partnership (net of liabilities that such partner is considered to assume or take subject to), (6) allocations to him of expenditures of the partnership described in section 705(a)(2)(B), and (7) allocations of partnership loss and deduction (or item thereof), including loss and deduction described in paragraph (b)(2)(iv)(g) of this section, but excluding items described in (6) above and loss or deduction described in paragraphs


This is one of the magic incantations that will appear in your agreement. If you ask your attorney how that paragraph should be reflected on the partnership’s tax return, he is likely to tell you that he doesn’t prepare partnership returns. That’s what accountants do. Now go to your accountant and ask her what that paragraph means. Among the possible answers are “That’s some stuff the attorneys have to put in the agreement. Why don’t you ask him what it means?”

So what did Sylvia Gore and her advisers do or fail to do that cost the estate $1,071,650 in federal estate taxes. Plus ten years of interest. Not to mention the cost of their fruitless efforts in the Tax Court.

In 1995 Sydney Gore met with his accountant in the hospital where he expressed to her “his concerns about preserving the wealth he had accumulated through his life's work, protecting his assets from waste, and conserving them for future generations”. The accountant had an idea, a very good idea. Form a family limited partnership. She’d never advised any of her other clients to take that step, but it seemed to the right thing to do here. She knew that she had limits, though:

“Ms. Bowers had little experience with family limited partnerships and had never recommended one to a client before she made the proposal to the Gore children, so she recommended that Ms. Powell, Mr. Gore, and decedent retain an attorney to further advise them about a limited partnership”

Apparently it didn’t occur to anybody that an accountant with more than a little experience with family limited partnerships might be able to bring something to the table.

What happened from here can hardly be blamed on the accountant. The partnership opened a bank account into which substantial sums were deposited. There was an assignment of marketable securities to the partnership. Unfortunately, title to the securities was not transferred to the partnership. The dividends from the securities were not deposited in the partnership’s bank accountant. When Mrs. Gore’s bills need to be paid they were paid sometimes from her personal accounts other times from partnership accounts.

Eventually returns need to be filed, which is when Ms. Bowers came back on the scene. What she did was what most competent accountants would try to do. Observing that what actually happened was not anything near like what was supposed to happen, she attempted to fix it all with journal entries. This process relies on one of the great intellectual breakthroughs that built the modern world – double entry bookkeeping first documented in a mathematical treatise over 500 years ago. It provides a built-in check that shows that you captured everything. It all has to balance. Debits equal credits.

When a check is written we credit cash. Then we have to debit something. Well the check went to Mary, so we debit Mary’s capital account. Unfortunately, by the terms of the partnership agreement we were not supposed to make a distribution to Mary. So we debit “Due from Mary”. Joe, on the other hand was supposed to get a distribution. Well either we won’t worry about that since it’s reflected in Joe’s capital or, if we want the percentages to be where they should be, we will credit “Due to Joe” and debit his capital account. When it’s all done the amounts on our records will agree to the statements (adjusted for the fact that they may not have the right names on them) and “it will all balance.” Mary will owe the partnership and the partnership will owe Joe. We’ll straighten it out next year or we’ll keep making journal entries to keep it straight.

I have learned a hard lesson that many accountants never quite get. When it comes to this “everything’s in balance” routine, almost nobody else cares. Here is some of what the court had to say about Ms. Bower’s efforts:

“The GFLP accounting records prepared by Ms. Bowers purport to show that decedent transferred ….”

“The accounting records also purport to show that after decedent executed the assignment, decedent allegedly sold the Commercial Federal CD, the savings bonds, a Valley National CD, and one of the Treasury notes to GFLP in exchange for a note payable to her from GFLP …”

The word “purport” or one of its forms (e.g. “purporting”) occurs six times. Here is the problem. You can get into law school with a liberal arts degree. They don’t teach double entry accounting in law school. If it’s taught in high school, it’s to kids not on the college track. You certainly don’t need it for a liberal arts degree. Judges are lawyers. It all balances and they don’t care.

I have no reason to doubt that if I looked at all the statements and agreements, I’d have concluded that Ms. Bower’s journal entries straightened things out. Likely most other accountants would reach a similar conclusion when they see that the cash ties and “it balances”. Much to our professional frustration, almost nobody else, but especially the judge, cares. The meticulous journal entries that “straighten” everything out in our minds, in the mind of the judge “purport”.

Also this year, the Estate of Concetta Rector lost to the tune of $1,633,049 plus about five years of interest. Here is an excerpt:

“The estate attempts to downplay the significance of the direct use of RLP funds to pay decedent's personal expenses by attributing that use to “errors”. In the light of John Rector's extensive financial expertise and his testimony that it never occurred to him that RLP should be reimbursed for such “errors” after they were discovered, we find that this argument lacks credibility”
This is nothing new. If you study the cases where taxpayers lose FLP cases, you will, almost always, if not inevitably, find that the failure was not one of a flawed plan. The failure was not following the steps transaction by transaction. If somebody is entitled to a distribution and has bills to pay, you distribute to them and let them pay their own bills. All entities have accounts and the payments in and out are the ones that belong to that entity. If a mistake is made it is fixed by a transfer of funds, not a journal entry that creates an indefinite “Due to”.
The moral of the story is that in order for the plan to work you must have coordination between the attorney who prepares the plan and the accountant who will be preparing the relevant returns. If you don’t want to trouble yourself with what entity should pay what bill or accept what deposit, etc, let that piece be handled by your professionals, also, but again in an integrated manner. There has to be somebody who cares what account is used, because that is their job.