• U.S. Court of Appeals for Eleventh Circuit upholds Tax Court’s valuation of closely held company and denial of deduction for loan interest—In Estate of John F. Koons, III v. Commissioner, No. 16-10646 (11th Cir. May 3, 2017), there were two issues on appeal: (1) whether the estate was entitled to a deduction for interest on a loan issued from a closely held company to pay the estate tax, and (2) the valuation of the estate’s interest in that company. John F. Koons, III died in the midst of several transactions relating to his family-owned company, Central Investment Corp. (CIC). CIC primarily bottled and distributed Pepsi products and sold vending machine items. John owned about 46 percent of the voting stock and 51.5 percent of the non-voting stock in CIC, and other family members, mostly his children, directly and indirectly through trusts, owned the rest. CIC became involved in a dispute that led to litigation in 1997. In a settlement between CIC and Pepsico, Pepsico agreed to buy CIC’s soft drink and vending businesses for nearly $400 million. John planned to place the proceeds he and his family received in a limited liability company (LLC) (CIC LLC) to be jointly invested. The children weren’t interested in holding interests in the LLC so they conditioned the sale of their CIC stock on receiving an offer from CIC LLC to redeem their interests after the closing of the sale to Pepsico. The offer to redeem the interests in the LLC was signed on Dec. 21, 2004, and the stock purchase agreement with Pepsico was executed on Dec. 15, 2004. But, the redemption transaction didn’t close until April 30, 2005, after John’s death on March 3, 2005. As a result of the redemption, John’s revocable trust ended up holding a 70.42 percent voting interest and a 71.07 percent non-voting interest in the LLC. After the sale, the LLC’s assets were primarily liquid investments, with just two small remaining operating businesses that accounted for 4 percent of its assets.
The estate lacked liquid assets sufficient to pay its estate tax liability, so the LLC loaned the estate more than $10 million in exchange for a promissory note bearing 9.5 percent annual interest, principal and interest to be paid in 14 installments that were deferred to begin 18 years later, in 2024.
On the estate tax return, the estate claimed a deduction for the interest on the loan and valued the revocable trust’s interest in the LLC at $117 million. The Internal Revenue Service issued a notice of deficiency disallowing the deduction and contesting the valuation of the interest in the LLC; the Tax Court ultimately sided with the IRS.
The Eleventh Circuit upheld the Tax Court’s decision that disallowed the interest deduction as an administrative expense under Internal Revenue Code Section 2053. It agreed that the interest deduction isn’t appropriate if the estate could pay its tax liability using liquid assets of an entity but instead elected to obtain a loan and then repay the loan using those same liquid assets. In this case, the LLC held liquid assets that it loaned to the estate, and the estate was ultimately going to repay the loan with distributions from the LLC. The revocable trust, owning a 70 percent voting interest, could have forced a distribution from the LLC at the outset, and because the LLC had over $200 million in liquid assets, a pro rata distribution would have provided sufficient assets for the tax payment. Therefore, the use of the loan was merely delaying the use of the assets to pay the taxes and wasn’t necessary. The estate argued that ordering a distribution of trust property would have been a breach of the revocable trust’s fiduciary duty as a majority interest holder under state law because it would have been a misuse of its power to promote its own interest. However, the court held that a pro rata distribution wouldn’t have been a breach of fiduciary duty because it would have benefited the minority interest holders as well. The court also didn’t accept the estate’s contention that the courts should defer to the business judgment of the executor as to whether the loan was necessary.
On the valuation issue, the estate contested several conclusions of the Tax Court. First, it argued that the Tax Court shouldn’t have valued the interest held by the revocable trust as a 70+ percent interest because on the date of John’s death, it wasn’t certain that the children’s interests were going to be redeemed (the redemption closed a month after his death). The Eleventh Circuit disagreed and held that the Tax Court didn’t make a clear error when it determined that the redemption would go forward, considering the redemption agreement had been signed, and there was other evidence that the children didn’t want to hold interests in the LLC.
The estate argued that in determining the value of the LLC interests, the Tax Court was incorrect to assume that the revocable trust could force a distribution of most of the LLC assets, claiming again that state law would prohibit a majority interest holder from doing so due to fiduciary responsibility. But, the Eleventh Circuit upheld the Tax Court again, holding that an action that benefits all the members doesn’t violate a fiduciary obligation.
Lastly, the Eleventh Circuit upheld the Tax Court’s decision to adopt the valuation methodology of the IRS valuation expert, finding that it was reasonable and not the result of clear error.
• Private letter ruling holds that improperly administered charitable remainder unitrust (CRUT) is a private foundation—In PLR 201714002 (Dec. 12, 2016), a beneficiary of a CRUT requested guidance on the tax implications of terminating a CRUT gone wrong. On the advice of his lawyer, a taxpayer established a CRUT in part to avoid capital gains tax on the sale of low basis assets. The CRUT provided for a unitrust payment to the settlor, and certain other persons, with a net income make-up provision. The lawyers preparing the trust incorrectly advised the taxpayer/beneficiary that he would be guaranteed a certain percentage unitrust payment every year; however, the trust limited the payment to the lesser of the unitrust amount or the trust’s net income. As it turned out, the trust’s net income actually was often less than the unitrust amount.
Several other errors were made. The lawyers advised the taxpayer that funding the trust wouldn’t be a completed gift because the taxpayer would retain the right to change the successor beneficiaries, but the lawyers didn’t include such a provision in the document, and the taxpayer failed to file a gift tax return. The trust was administered by including capital gains in the calculation of the trust’s net income so the payments to the income beneficiary were incorrectly inflated. The settlor also made additions to the trust after the initial funding, based on the incorrect advice from his lawyer that the trust property was excludible from his taxable estate (which it wasn’t due to his retained interest). The taxpayer died, and a successor unitrust recipient petitioned a local court to terminate the trust. The court issued a declaration that the trust was void ab initio, contingent on a ruling from the IRS that there wouldn’t be additional federal income tax consequences; otherwise, the court would declare the trust terminated.
The IRS held that the trust wasn’t void ab initio. It found that while it wasn’t operated properly as a CRUT (because it made distributions to the income beneficiary in excess of what should have been paid), it should be treated as a private foundation (PF). As a PF, if the trust were to distribute its assets to the unitrust beneficiary, it would be a taxable expenditure and, as the beneficiary was a disqualified person, an act of self-dealing and, further, possibly justify an involuntary termination by the IRS and assessment of further tax and transferee liability. To avoid the various excise taxes, the trust could terminate its PF status under IRC Section 5701(a)(1) by giving notice and paying the required tax. In addition, the trust was required to correct prior year income tax returns.