The U.S. Court of Appeals for the Eleventh Circuit recently affirmed a Tax Court’s ruling regarding a discount for lack of control and lack of marketability.1 The Tax Court had rejected an estate’s expert’s 31.7 percent discount conclusion and agreed with the Internal Revenue Service’s expert that the decedent’s 46.94 percent interest in Central Investment Corp.’s (CIC) voting shares and 51.5 percent interest CIC’s non-voting shares should be subject to a 7.5 percent combined discount for lack of control and lack of marketability.2 Further, the court determined that, because of the liquid nature of CIC’s investments, no interest deduction could be made for interest on a loan that raised funds to pay for tax liabilities and administration expenses.
Within the three months prior to the death of John Koons, his company, CIC, sold the majority of its operating businesses for over $350 million, plus another $50 million to settle a lawsuit with the acquiring company. The remaining businesses (which comprised four percent of CIC’s revenue) and the sales proceeds were placed in a limited liability company (LLC). At the valuation date, after certain distributions of a portion of the sales proceeds, the LLC held total assets of approximately $351 million, of which $322 million was cash. The net asset value of the LLC was approximately $318 million.
In the two months prior to the date of death, the decedent’s four children, as a condition of the sale, agreed to be bought out at the net asset value of the LLC. The redemptions were completed 58 days after the date of death. As a result of the redemptions, the estate held a 70.42-percent voting interest and a 71.07 percent non-voting interest (a combined 70.93-percent interest) in the LLC.
Importantly, the LLC member agreement limited discretionary distributions to 30 percent “of the excess of ‘distributable cash.’” However, this limitation could be removed by a majority vote of the voting members.
A year after the date of death, the LLC loaned $10.75 million to a revocable trust for the purpose of paying any estate or gift tax liabilities of the decedent. The terms of the loan required annual repayments of $5.9 million in principal and interest (interest of 9.5 percent annually) from 2024 until 2031. As a result of the protracted time frame, the total interest that would be paid on the loan would amount to $71,419,497. The estate deducted this amount of interest expense as an administrative expense.
The Eleventh Circuit’s Decision
The Eleventh Circuit noted that, prior to the date of death, as a condition to their agreement to the sale of CIC, the children required that the LLC redeem their respective interests at net asset value after the sale of CIC was completed. Moreover, the sale of CIC occurred prior to the date of death. The fact that the actual redemption of the children’s interests occurred 58 days after the date of death was a mere formality, and there was no meaningful reason that the children would have any legal standing to change, or would want to change, their minds regarding the redemption.
Importantly, the redemption would give the estate a 70.42 percent voting interest — enough to remove the restriction limiting distributions to 30 percent “of the excess of “distributable cash.’” As a result of the sale of CIC, there were more than sufficient liquid assets to make adequate distributions to cover both the necessary estate taxes and administrative expenses of the estate. Citing Estate of Keller,3 the Eleventh Circuit stated that: “Interest payments are not necessary expenses where (1) the entity from which the estate obtained the loan has sufficient liquid assets that the estate can use to pay the tax liability in the first instance; and (2) the estate lacked other assets such that it would be required to eventually resort to those liquid assets to repay the loan.” Accordingly, the Eleventh Circuit agreed with the Tax Court in rejecting the estate’s loan interest expenses.
Because the estate’s expert ignored the ability of the estate to control the LLC and believed that the estate couldn’t determine distributions, the Eleventh Circuit concluded that the Tax Court was also correct in rejecting the estate’s expert’s 31.7 percent discount conclusion.
In general, there were no surprises here. While, as of the date of death, the estate didn’t have control, it was a forgone conclusion that the estate would have control once the required redemption was completed. And, with liquid assets, there was no legitimate need to borrow funds to cover the estate’s expenses. As such, the denial of the interest deduction for an unnecessary “Graegin loan”4 was logical. However, given the unusually long term of the loan, it remains to be seen if an interest deduction would have been acceptable to the court if: (1) the underlying assets weren’t liquid, (2) the estate didn’t have control, but (3) the term of the loan was such that payments didn’t begin until far into the future, incurring large unpaid interest sums.
- Estate of John F. Koons, III – No. 16-10646; No. 16-10648, Eleventh Circuit (April 27, 2017).
- Estate of John F. Koons, III – T.C. Memo. 2013-94.
- Estate of Keller v. U.S., 697 F.3d 238, Fifth Circuit (2012)
- The term “Graegin loan” refers to the ability of an estate to deduct interest expenses as an estate administrative expense for loans made to the estate to pay estate taxes and other administrative expenses that arose as the result of the decision in Graegin v. Commissioner, 56 T.C. M (1988).