Fifth Circuit reverses Tax Court and reinstates estate’s discounts for fractional interests in artwork—In Estate of James A. Elkins, Jr. v. Commissioner, No. 13-60472 (Sept. 15, 2014), the U.S. Court of Appeals for the Fifth Circuit reviewed the Tax Court’s opinion issued last year in Estate of James A. Elkins, Jr. v. Comm’r (140 T.C. No. 5, March 11, 2013). The estate valued James’ various partial interests in artwork by applying a 44.75 percent discount to the pro rata value of each partial interest. The Internal Revenue Service determined that no discount should apply and issued a deficiency notice. The parties stipulated the value of the artwork itself. Judge James S. Halpern of the Tax Court analyzed the willing buyer-willing seller test and the testimony by the experts but, in the end, determined that, in all likelihood, the other co-tenants (James’ children) would purchase a willing buyer’s interest. Because the willing buyer would likely be able to sell his interest to the co-tenants, the court held that a 10 percent discount would be appropriate to reflect the small uncertainties as to whether the children would purchase the interests and for what price.
The Fifth Circuit agreed with the Tax Court’s analysis in many respects but couldn’t accept its application of a 10 percent discount, mainly because there was no evidence or reasoning for that amount. First, the Fifth Circuit noted that the IRS had the burden of proof. The IRS “put all its eggs in one basket” by arguing that there should be no discount at all and didn’t provide evidence of any alternative discount that could apply. Therefore, the Fifth Circuit held, if the Tax Court wasn’t convinced by the IRS’ position, the judgment should have been for the estate. It held that the Tax Court had no evidentiary basis or factual or legal support for its 10 percent discount. It found that the estate’s experts weighed the relevant factors and characteristics of the co-tenants, and their opinions were credible. As a result, the estate was entitled to a refund of over $14 million, plus interest.
The Fifth Circuit noted that the Tax Court’s analysis of the willing buyer-willing seller test veered off track when it began to consider the motivations of James’ children as the co-tenants and their interest in buying out any hypothetical willing buyer to consolidate their ownership. The Tax Court had held that a large discount wasn’t justified because a willing buyer would know how interested the Elkins children would be in buying him out—and could capitalize on that knowledge. The Fifth Circuit reasoned the opposite would occur: It would be hard to resell the interest to the Elkins children or others, given how “sophisticated, determined and financially independent” the Elkins children were.
The Tax Court had held that Internal Revenue Code Section 2703(a) would apply to disregard the co-tenancy agreement for valuation purposes. However, while it didn’t directly address the issue of restrictions, the Fifth Circuit seemed to take them into account, as it noted that the restrictions on partition, alienation and possession “exacerbated” the willing buyer’s ability to cash in on his investment.
• Tax Court memorandum holds parents made gift to sons on a non-arm’s-length merger of two family-run companies—In Cavallaro v. Comm’r, T.C. Memo. 2014-189, the Tax Court held that the taxpayers, William and Patricia Cavallaro, made gifts to their three sons as a result of a merger of two family-run businesses. The Cavallaros weren’t highly educated (William didn’t complete high school, and Patricia finished high school and one year of secretarial school), but after William gained some expertise in tool making, they started their own machine tool business, Knight Tool Co. (Knight), in 1976. Their business was primarily to make custom tools to order.
Their sons graduated from college and, ultimately, returned to help run Knight. The family was interested in trying to move out of the custom order business and, perhaps, develop their own product. In 1982, after visiting a customer, William and his son, Ken, decided to try to create a liquid-dispensing machine (named CAM/ALOT) that could be used in the production of computer circuit boards. Knight started making the machines but wasn’t profitable at first because of mechanical and design problems. As Knight continued to lose money, William and Patricia decided that the company had to put the CAM/ALOT project aside.
However, their sons continued to work on improving the machine. In 1987, the family hired an attorney who incorporated a new company, Camelot Systems, Inc. (Camelot), in which each of the three sons owned 50 of the 150 total shares. The three sons each contributed $1,000 to the business initially but never made additional capital contributions. They continued to make changes to the design and, eventually, were able to produce more effective machines. The opinion describes the sons as marketers and businessmen, but not engineers. Instead, the court notes that the Knight engineers developed the improvements. It characterized the relationship as one in which Knight owned the machine tool intellectual property and production and was using Camelot as a sale agent.
The opinion noted that Camelot simply transmitted orders to Knight, without any cost or risk for non-payment (that is, Camelot paid Knight a price for the machine comprised of Knight’s cost plus overhead, but Camelot was only billed by Knight once a customer had paid). Camelot had no employees for almost 10 years and no bank accounts or books of its own. All individuals who worked on the CAM/ALOT machines were on the Knight payroll and received wages from Knight (including the sons). Knight claimed research and development tax credits based on its work on the machines, and the only trademark for the machine was in Knight’s name. The Tax Court found that Knight “provided the equipment and personnel for making the machines, paid the bills and bore the risk; but profits were disproportionately allocated to Camelot.”
Eventually, it became desirable to merge the two companies to expand the sale of CAM/ALOT machines in Europe. In the process of structuring the merger, the Cavallaros consulted with accountants and estate-planning attorneys in the mid 1990s. The team had to determine which company owned the CAM/ALOT technology. The estate-planning attorneys concluded that the technology had been transferred to the sons in 1987, when the family hired the attorney who prepared the organizational documents for Camelot, and they convinced the accountants of this position. There was no paperwork that documented this transfer, but the estate-planning attorneys prepared affidavits for the family to sign describing the meeting and their intent.
However, the court wasn’t convinced. It noted that the machines were manufactured at Knight’s risk, on its premises and using technology developed by Knight employees, and the only public registrations of intellectual property were in Knight’s name. In a footnote, the opinion highlights that the companies’ accountant altered financial statements from 1991, which originally reflected that Camelot sold the machines produced by Knight, to state that Knight provided the machines “owned” by Camelot. The companies’ tax filings from 1990 to 1993 also indicated that Knight manufactured machine tools, and Camelot sold them.
The companies merged in 1995. William and Patricia received 20 shares each of the new company; their sons received 54 shares each. An accountant valued the two companies and determined that the merged entity was worth between $70 million and $75 million, with Knight worth between $13 million and $15 million. A year later, the company was sold for $57 million, with an agreement for additional deferred payments (that, ultimately, were never paid). The IRS audited the companies’ potential income tax returns and, after investigating the transaction, issued notices of deficiency determining that: (1) Camelot had no value prior to the merger, and (2) through the merger, William and Patricia each had made gifts of over $23 million to their sons.
The Cavallaros presented experts at trial to value the companies. Their experts assumed that Camelot owned the CAM/ALOT technology and that Knight was a contractor for Camelot. As a result, the value of Knight’s portion of the merged company was less than 20 percent. The IRS expert assumed that Knight owned the technology; therefore, he attributed 65 percent of the value of the merged company to Knight.
The court held that the 1995 merger wasn’t an arm’s-length deal. It found that any unrelated party would have required Camelot to produce documentation that it owned the technology, and when Camelot couldn’t produce such proof of ownership, it would have paid much less for the company. And, if Knight had been dealing with an unrelated party, it wouldn’t have simply disclaimed its ownership of the technology, particularly when all indicia showed that it was the owner of CAM/ALOT. Nor were there any arm’s-length negotiations.
In terms of valuing the companies, both of the taxpayers’ experts assumed that Camelot owned the technology. The court disagreed with this assumption and disregarded their valuations. As a result, because the taxpayers didn’t uphold their burden of proof, the court upheld the IRS determination of the gifts at trial (even though the court acknowledged that some aspects of the IRS expert’s valuation of the companies were flawed). The result was that William and Patricia made gifts totaling $29.6 million due to the merger with a small silver lining: The court held that penalties didn’t apply because William and Patricia had, in good faith, relied on a competent tax advisor.
• IRS disregards court reformation of trust to obtain income tax benefits, holding trust must recognize income on funding pecuniary bequest from an IRA—In Private Letter Ruling 201438014 (Sept. 19, 2014), the IRS ruled on the income tax consequences of funding a pecuniary bequest from an individual retirement account payable to a decedent’s trust. The decedent named the trust as the beneficiary of the IRA. The trust provided for pecuniary bequests to two charities, and the non-IRA assets weren’t sufficient to make the bequests. According to the ruling, a state court reformed the trust to ensure that the trust’s distribution of IRA assets to the two charities “would be treated as direct bequests to the charities rather than income in respect of a decedent” and, alternatively, qualify for the charitable deduction under IRC Section 642(c). It’s not clear how the state court reformed the trust, but perhaps it modified the trust to require payment of the IRA to the two charities in kind.
IRC Section 691 provides the rules regarding income tax liability for income in respect of a decedent (IRD). IRAs, as retirement plans, are IRD. Under IRC Section 691(a)(1), IRD is included in the income of the person who, by reason of the decedent’s death, receives the IRD. If that person transfers the IRD in a sale or other exchange, the person must recognize the greater of the fair market value of the IRD or the consideration paid for such IRD as income under Section 691(a)(2). There’s an exception in the Treasury regulations to the general rule that provides that if IRD is transferred by an estate to a specific or residuary legatee, only the specific or residuary legatee is taxed on the income.
If a trust recognizes income related to the IRD, it may be eligible to deduct the income under Section 642(c), if its provisions require such gross income to be paid for charitable purposes pursuant to the governing instrument.
The IRS held that the transfers of IRA assets to satisfy the charitable bequests were deemed sales of such portions of the IRA. As a result, the trust was required to include such amounts in its income under Section 691(a)(2). Then, citing relevant case law, the IRS determined that it wasn’t bound by the state law reformation. It explained that the reformation didn’t resolve a conflict with respect to the trust terms but was simply to obtain a more advantageous tax result. Therefore, because the reformation wasn’t the result of a conflict, the IRS wasn’t bound by it, and the “governing instrument” under Section 642(c) was the original trust instrument and didn’t direct that the trustee pay the pecuniary legacies from the gross income. Without that provision, the trust wasn’t entitled to a deduction under Section 642(c).
This ruling is a helpful reminder that trust provisions relating to charitable bequests need to be carefully drafted. It may be tax efficient to use retirement plans to fund a charitable bequest because the plans will otherwise be subject to income tax in the hands of other beneficiaries. However, for the trust to avoid recognizing the income, the bequests of retirement plans should be paid in kind and framed as a specific or residuary bequest or, at the least, based on a fractional formula. Or, if IRD funds a pecuniary bequest, the trust must include the proper provisions to satisfy Section 642(c), so that the trustee may deduct the income. Better still, fund a charitable bequest directly through the beneficiary designation.