In Estate of Koons v. Commissioner (11th Cir. May 3, 2017), the U.S. Court of Appeals for the Eleventh Circuit recently upheld a Tax Court decision that denied the estate’s deduction for interest on a loan and disallowed a discount for lack of marketability.
John F. Koons, III died on March 3, 2005. At the time of his death, John owned 46.9 percent of the voting stock and 51.5 percent of the non-voting stock of Central Investment Corp. (CIC), a company he operated. The remaining CIC stock was owned by John’s four children (either directly or through trusts for their benefit) and by other family members. CIC’s primary business was bottling and distributing Pepsi products and selling vending machine items. CIC also owned unrelated assets not involved in that business.
Prior to John’s death, CIC sold its soft drink and vending machine businesses to PepsiAmericas, Inc. (PAS) for $352,400,000. As part of the transaction, CIC also received $50 million from PepsiCo, Inc. in settlement of a dispute over exclusivity rights. John planned to place the sale proceeds and CIC’s other assets in CI LLC, where they would be invested in new business ventures. CI LLC was managed by a Board of Managers, which had sole discretion to make distributions. The members, by majority vote, could take certain actions such as removal of the Board of Managers without cause, merger, liquidation or dissolution. Members were permitted to transfer their LLC interests to John’s lineal descendants only.
John’s children disliked this plan and conditioned the sale of their CIC shares to PAS on receiving an offer from CI LLC to redeem their interests following the PAS closing. The terms of the redemptions were set forth in a letter dated Dec. 21, 2004, and were accepted by the children prior to John’s death. However, the redemption offers didn’t close until almost two months after John’s death, and final redemption payments were made approximately two months after that.
The sale imposed certain continuing obligations on CI LLC, including a requirement that CI LLC hold at least $10 million in liquid assets and maintain a positive net worth of at least $40 million at all times. Following the sale, on Jan. 21, 2005, CI LLC made a pro rata distribution of $100 million to its members, of which $29.6 million was distributed to the John’s children. The amount of each redemption payment received by the John’s children was reduced by the amount received in connection with this distribution. Following the distribution, John amended his revocable trust to remove his children as beneficiaries and replace them with his grandchildren; this amendment would trigger a generation-skipping transfer tax on John’s death. John then transferred his 50.5 percent interest in CI LLC to his revocable trust. He amended CI LLC’s operating agreement to eliminate his children from the list of permitted transferees, to restrict distributions and to eliminate the Board of Advisors, of which they were a part.
Trustees Obtain Loan
Following John’s death, the estate’s liquid assets were insufficient to pay its tax liability. CI LLC had over $200 million in liquid assets and owned two operating companies, which accounted for 4 percent of its assets. The trustees of the revocable trust didn’t want to redeem any interest in CI LLC to pay the tax liability because they believed the large cash distribution would hinder CI LLC’s plan to invest in operating businesses. The trustees instead obtained a loan from CI LLC for $10.75 million, which bore interest at 9.5 percent. No payment was due on the note until 2024; at such time, interest and principal were scheduled to be paid in 14 installments. The interest payments on the loan were projected to total $71,419,497. Since the revocable trust’s primary asset was its interest in CI LLC, it was anticipated that it would use distributions from CI LLC to repay the loan.
On the estate’s tax return, the trustees claimed a $71,419,497 deduction for interest on the loan as an administrative expense. They also reported the fair market value of the revocable trust’s interest in CI LLC on John’s death to be $117,197,443, which was determined based on a valuation report prepared by Dr. Mukesh Bajaj. The Commissioner determined that the estate wasn’t entitled to a deduction for the loan interest payment and that the value of the trust’s interest in CI LLC should have been $148,503,609.
Tax Court Decision
Both Dr. Bajaj’s valuation and the Commissioner’s valuation declined to apply any discounts for lack of control; the difference in their opinions arose from their application of the lack of marketability discount. Dr. Bajaj applied a lack of marketability discount of 31.7 percent whereas the Commissioner’s valuation applied only a 7.5 percent discount. Among other issues, the two reports differed in their assessment of the likelihood that John’s children would receive the redemptions described in the Dec. 21, 2004 letter. The Tax Court agreed with the Commissioner’s valuation, determining that it was almost certain the redemptions would occur, that the offers for redemption were sufficiently detailed to be enforceable and that in the event of breach, specific performance would be the likely remedy. Further, as the majority interest holder in CI LLC, the revocable trust could order a distribution of most of the LLC’s assets by using its voting control to amend the agreement and eliminate the restrictions on distributions or to remove the Board of Managers. Since the revocable trust could force a distribution, the Tax Court reasoned its interest couldn’t be valued at less than the amount it would receive in the distribution.
The Tax Court also held that the estate wasn’t permitted to deduct the projected interest on the loan from CI LLC because the loan wasn’t necessary to the administration of the estate. At the time the loan was made, CI LLC had significant liquid assets and the revocable trust had a sufficient voting interest to compel a distribution to cover the tax obligation. Since the loan would ultimately be repaid using the revocable trust’s distributions from CI LLC, the Tax Court found that the loan merely delayed the use of distributions to pay the tax liability.
Eleventh Circuit Decision
The Eleventh Circuit upheld the Tax Court’s decision to deny the deduction for the projected interest on the loan from CI LLC. An estate may deduct expenses that are actually and necessarily incurred in the administration of the estate. Interest payments aren’t necessary if the estate would have been able to pay the debt using its liquid assets but instead elected to obtain a loan that would eventually be repaid using those same liquid assets. Thus, there are two situations in which interest payments aren’t necessary expenses of an estate: (1) when the entity from which the estate obtained the loan has sufficient liquid assets that the estate can use to pay the tax liability when it’s due, and (2) when an estate can pay its tax liability using the liquid assets of an entity, but elects instead to obtain a loan from the entity and then repay the loan using those same liquid assets. In the second scenario, the loan is considered an “indirect use” of the assets and therefore isn’t necessary.
In this case, CI LLC had sufficient liquid assets to pay the tax liability, and the revocable trust had voting control over the LLC such that it could have ordered a distribution. The estate argued that the revocable trust couldn’t have ordered a distribution because of the fiduciary duty imposed by state law. The court found that the revocable trust wouldn’t have breached any fiduciary duty by ordering a distribution; under Ohio law, a majority-interest holder may order a distribution that benefits itself as long as the minority interest holders also benefit (that is, as long as the distribution is made pro rata to all members).
The court also found that the loan was an “indirect use” of funds. The estate planned to repay its loan using distributions from CI LLC. Thus, the assets of CI LLC would be used to satisfy the estate’s tax obligations regardless of whether the estate used those assets to pay its tax liability immediately or obtained a loan and thereby paid its tax liability gradually. The court reasoned that it didn’t matter whether the loan would be repaid using a one-time disbursement or regular distributions; in either case, the same funds would be used to pay the tax liability, thereby rendering the loan unnecessary. Therefore, the loan had no net economic benefit aside from the tax deduction and wasn’t necessary.
Finally, the court rejected the estate’s argument that courts are required to defer to the business judgment of the executors. Although certain precedents indicate a willingness of courts to defer to the business judgment of an estate’s executors, courts aren’t required to do so in this context. Deferring to the business judgment of executors would essentially give blanket authority to take deductions without judicial oversight.
The Eleventh Circuit also upheld the Tax Court’s decision on the valuation of the revocable trust’s interest in CI LLC. The court agreed that the children’s redemptions would likely occur and that the revocable trust would be permitted to force a distribution of most of CI LLC’s assets. A proper valuation of the entity would need to account for these factors. The estate argued that under Ohio law, a majority interest holder owes a heightened fiduciary duty to minority interest holders, and such duty prevents the majority interest holder from distributing a majority of the LLC’s assets, thereby frustrating the purpose for which the LLC was created. The court found that although Ohio does impose a heightened fiduciary duty on majority shareholders, such duty simply prevents majority shareholders from abusing their power at the expense of minority shareholders. As long as all shareholders benefit equally, a majority interest holder may take actions such as distributing most of an entity’s assets.