• Merger negotiations aren’t relevant to the value of public shares used to fund GRAT—Baty v. Commissioner (U.S.T.C. Docket No. 122-1621, June 23, 2021, March 24, 2022) involves a valuation controversy in the context of funding a grantor retained annuity trust (GRAT). Daniel R. Baty funded a GRAT with shares of a publicly traded company (Company) while serving as Company’s chairman of the board and amid negotiations between Company and other third parties regarding Company’s potential merger/acquisition. Negotiations regarding the merger began in the first half of 2013, and Daniel participated in them. Daniel funded a 2-year GRAT using shares in Company on Jan. 14, 2014 and valued the contribution to the GRAT based on the mean of the high and low public share price of Company’s shares on the date of contribution (that is, the methodology espoused in Treasury Regulations Section 25.2512-2(b)). The terms of the GRAT represented the annuity payments as a percentage of the initial value of the asset contributed (that is, the annuity payments were “self-adjusting”).
A merger agreement between Company and a competitor was ultimately reached, with the terms of the deal finalized weeks later in mid-February 2014, and the deal was publicly announced on
Feb. 20, 2014. The merger wasn’t completed until July 31, 2014, after the parties worked through shareholder approval, regulatory approval, third-party consents and other hurdles.
The Internal Revenue Service assessed a tax deficiency premised on the notion that the contribution to the GRAT shouldn’t have been valued based on the mean of the high and low share price on date of contribution but rather on the trading price when the merger actually took place (more than six months later). Because of the facts at hand and the gross underpayment in the annuity payments, Daniel was liable for an intentional undervaluation (and couldn’t avail himself of provisions relating to incorrect valuations and the adjustment clause in the GRAT as to the annuity payments), was subject to gift tax on the full value of the transfer to the GRAT (due to the annuity failing to be a “qualified annuity” under Internal Revenue Code Section 2702) and was subject to penalties. In Chief Counsel Advice 201939002, the IRS Chief Counsel responded to the facts of the case by formally opining that a pending merger must be taken into account in valuing shares of a publicly traded company for gift tax purposes (citing Treas. Regs. Section 25.2512-2(e)).
Ultimately, Daniel filed a motion for summary judgment in favor of using the mean high and low trading price of Company stock for valuation purposes, and the government conceded to Daniel prior to issuance of a decision on the motion. In his motion, Daniel argued that: (1) the valuation methodology was well established for cases involving publicly traded stock in the gift tax context and specifically cited cases that noted that public stock prices reflected potential merger negotiations, (2) events taking place subsequent to a gift can’t be used to value the gift in hindsight,
(3) the “hypothetical willing buyer” that’s used as the touchstone for gift tax valuation wouldn’t have known about the merger negotiations, (4) Treas. Regs. Section 25.2512-2(e) is inapplicable, (5) the merger wasn’t “practically certain” to occur, as was the case in the “anticipatory assignment of income” cases cited in CCA 201939002, and (6) the IRS’ proposed valuation methodology is unworkable.
• IRS issues proposed regs on calculating deductible amounts of certain expenses by estate—On June 24, the IRS issued proposed regulations (proposed regs) (REG-130975-08) under IRC Section 2053. The proposed regs provide guidance on proper use of present value principles in determining amounts deductible by an estate for funeral expenses, administration expenses and claims against the estate. Specifically, the proposed regs require calculating the present value of an expense that’s deductible under Section 2053 that isn’t paid or expected to be paid on or before the third anniversary of decedent’s death. That is, there’s a 3-year grace period before a present value calculation must be made with respect to a Section 2053 deductible expense. The present value calculation is subject to adjustment if the actual date of payment differs from the estimate used. The present value calculation will be made using the long-term or mid-term applicable federal rate in the month of death depending on the expected date of payment. The proposed regs also require a supporting statement showing calculations of present value to be filed with the decedent’s Form 706.
The proposed regs further provide guidance as to the deductibility of interest expenses accruing on taxes and penalties owed by an estate. They say that interest that accrues on estate tax deferred under IRC Section 6166 (for example, deferral available for certain estates holding interests in closely held businesses) would no longer be deductible. Interest under IRC Section 6601 for late tax federal payments won’t be deductible and considered actually and necessarily incurred unless due to the executor’s negligence or disregard of applicable rules or fraud, supplanting the rules in Revenue Ruling 79-252 and Rev. Rul. 81-154.
Interest on other loans incurred by the estate will be deductible provided the interest satisfies the existing requirements in Treas. Regs. Sections 20.2053-1(b)(2) and 20.2053-3(a) (that is, the interest must be “bona fide” and “actually and necessarily incurred” in the administration of the estate). Interest accruing on loan obligations incurred by an estate would follow these same rules—such interest is deductible to the extent it’s “bona fide” and “actually and necessarily incurred.” However, the proposed regs set forth factors that support a finding that an interest expense is “bona fide” (under Treas. Regs. Section 20.2053-1(b)(2)). Two of the factors noted are: (1) the terms of the loan (whether between related or unrelated parties), including any prepayment penalty, are reasonable given all facts and circumstances and are comparable to an arm’s-length loan transaction, and (2) the loan term doesn’t extend beyond what’s reasonably necessary. These new factors greatly reduce the deductibility of interest on “Graegin loans” because such loans aren’t prepayable and may not have terms comparable to an arm’s-length transaction.
Treas. Regs. Sections 20.2053-4(b) and (c) allow an estate to deduct the value of claims and counterclaims in a related matter and the value of unpaid claims totaling not more than $500,000. The proposed regs set forth new requirements for an appraisal with respect to such deductions. Previously, the appraisal requirements were tied to the requirements of a “qualified appraisal” for a charitable donation under IRC Section 170. Under the proposed regs, post-death events occurring before a deduction is claimed as well as events reasonably anticipated to occur must be taken into account for valuing the deduction. Certain individuals and entities who are related to the decedent are also disqualified from acting as appraiser.
The proposed regs also include new requirements as to the deductibility of a decedent’s personal guarantee. For such a guarantee to be deductible, the decedent must have received consideration reducible to money value in exchange for the guarantee.