United States: New Developments In Estate And Gift Tax Valuation Cases

A number of recent cases highlight particular issues in valuation of assets for purposes of the estate and gift tax. On July 6, 2015, the Internal Revenue Service settled Estate of Davidson v. Commissioner, T.C. Docket No. 13748-13. The IRS had alleged $2.8 billion in estate, gift and generation-skipping taxes owed, and the IRS settled for approximately $320 million in additional estate and generation-skipping tax, approximately $186 million in additional gift tax, and approximately $48 million in additional generation-skipping transfer taxes from lifetime transfers. In a separate case also on July 6, the taxpayers appealed to the U.S. Court of Appeals for the First Circuit the adverse decision of the U.S. Tax Court in Cavallaro v. Commissioner, T.C. Memo 2014-189, in which the Tax Court imposed gift taxes and interest exceeding $30 million on what was supposed to be a tax-free merger of two companies, one owned by the parents and one owned by three sons. Each of these developments, as well as others discussed below, involves the response of taxpayers to aggressive positions taken by the IRS in valuation cases.

Davidson involved certain transactions by William M. Davidson, the former owner of the Detroit Pistons and the president, chairman, CEO and owner of 78 percent of the common stock of Guardian Industries Corp., one of the world's largest manufacturers of glass, automotive and building products. In December 2008 and January 2009, Davidson engaged in transactions including gifts, substitutions, a five-year grantor retained annuity trust (GRAT) and sales that eventually paid him no consideration at all. These transactions were similar to those challenged by the IRS in Estate of Kite v. Commissioner, T.C. Memo 2013-43, in which no consideration was paid back to the grantor. At the time that Mr. Davidson made these transactions, he was 86, and the evidence suggested that his actuarial life expectancy was about five years. He lived for only 50 days after making the last transfer, and he died on March 13, 2009.

The consideration for some of Mr. Davidson's sales included five-year balloon unconditional notes at the applicable federal rate, five-year balloon self-canceling installment notes (SCINs) at the section 7520 rate with an 88 percent principal premium, and five-year balloon SCINs at the section 7520 rate with a 13.43 percent interest rate premium. Addressing Mr. Davidson's sales both in Chief Counsel Advice 201330033 (Feb. 24, 2012) and in its answer in the Tax Court, the IRS argued the notes should be valued, not under section 7520, but under a willing buyer-willing seller standard that took account of Mr. Davidson's health. Even though four medical consultants, two chosen by the executors and two chosen by the IRS, all agreed on the basis of Mr. Davidson's medical records that he had had at least a 50 percent probability of living at least a year in January 2009, the IRS saw the notes as significantly overvalued because of his health, and the difference as a gift. Combined gift and estate tax deficiencies, with some acknowledged double counting, were about $2.8 billion.

The Davidson estate filed its Tax Court petition on June 14, 2013 (Docket No 13748-13), and the IRS filed its answer on August 9, 2013. Trial was set by the court for April 14, 2014, but the parties jointly moved to continue it. In an Order on December 4, 2013, that motion was granted, jurisdiction was retained by Judge David Gustafson, and the parties were ordered to file joint status reports on September 14, 2014, and every three months thereafter.

This settlement was entered by the court on July 6, 2015. In this settlement, the gift taxes for prior years were increased by $186,626,788; the generation-skipping tax for lifetime transfers was increased by $48,604,482; the total estate tax was increased from $139,411,144 as reported on the estate tax return to $291,902,040; and the generation-skipping tax owed on the estate tax return was reduced by $450,000, from $29,071,193 to $28,621,193, for total estate and generation-skipping tax liability of $320,523,233.

It remains to be seen whether this is a victory for the IRS, a victory for the taxpayer, or a draw.

There are other cases pending in which the IRS has launched sweeping attacks on time-honored estate and gift tax techniques.

In two docketed cases widely discussed in 2014 and 2015,Estate of Donald Woelbing v. Commissioner (Tax Court Docket No. 30261-13, petition filed Dec. 26, 2013) and Estate of Marion Woelbing v. Commissioner (Tax Court Docket No. 30260-13, petition filed Dec. 26, 2013), the Tax Court has been asked to consider a sale by Donald Woelbing, who owned the majority of the voting and nonvoting stock of Carma Laboratories, Inc., of Franklin, Wisconsin, the maker of Carmex skin care products.

According to the Tax Court petitions, Mr. Woelbing sold all of his Carma nonvoting stock in 2006 to a grantor trust in exchange for an interest-bearing promissory note in the amount of $59 million, the fair market value of the stock determined by an independent appraiser. The installment sale agreement provided that if the value of a share of stock was determined to be higher or lower than that set forth in the appraisal, whether by the IRS or a court, then the number of shares of stock purchased would automatically adjust so that the fair market value of the stock purchased equaled the amount of the note. The trust's financial capability to repay the promissory note without using the stock itself or its proceeds exceeded 10 percent of the face value of the promissory note, including three life insurance policies on Mr. and Mrs. Woelbing's lives that were the subject of a split-dollar insurance arrangement with the company. The policies had an aggregate cash value of about $12.6 million, which could be pledged as collateral for a loan or directly accessed through a policy loan or the surrender of paid-up additions to the policies. At the time of the sale transaction, two sons of the Woelbings executed personal guarantees in the amount of 10 percent of the purchase price.

Mr. Woelbing died in 2009, and the IRS challenged the 2006 sale in connection with its audit of his estate tax return. The IRS basically ignored the note, doubled the value of the stock at the time of the gift to $117 million, again increased the value of the stock at the time of Mr. Woelbing's death to $162 million and included that value in his gross estate, and asserted gift and estate tax negligence and substantial underpayment penalties. For gift tax purposes, the notices of deficiency asserted that the entire value of the stock was a gift at the time of the sale, either because section 2702 applied to ignore the note or because the note in fact had no value anyway. For estate tax purposes, the IRS asserted that Mr. Woelbing retained for his life the possession or enjoyment of the stock or the right to designate the persons who shall possess or enjoy the stock under section 2036 and the right to alter, amend, revoke or terminate the enjoyment of the stock under section 2038.

Thus, besides simple valuation, the Tax Court might be obliged to address the adjustment clause, the possible reliance on the life insurance policies and guarantees to provide "equity" in the trust to support the purchase, and the applications of section 2702 to the sale and sections 2036 and 2038 after the sale.

Similarly, in Estate of Jack Williams v. Commissioner (Tax Court Docket No. 29735-13, petition filed Dec. 19, 2013), the IRS challenged a partnership owning real estate and business and investment assets with a wide variety of arguments, including disregarding the existence of the partnership and treating transfers to the partnership as a testamentary transaction at the decedent's death; undervaluation of the partnership assets; lack of a valid business purpose or economic substance for the partnership; the decedent's retained enjoyment of the partnership assets; restrictions on the right to use or sell the partnership interest ignored under section 2703(a); liquidation restrictions ignored under sections 2703, 2704(a) and 2704(b); and any lapse of voting or liquidation rights in the partnership treated as a transfer under section 2704(a). The IRS and the taxpayer recently settled the case.

The everything-but-the-kitchen-sink approach reflected in these late-2013 Tax Court petitions, especially the Woelbing petitions, has chilled transactions that had been commonplace in estate planning, including installment sales to grantor trusts. Recent Administration proposals for legislation to reduce the benefits of sales to grantor trusts, even though they may not gain traction in Congress, serve to reinforce the perception of increased animus toward these transactions.

On July 6 as well, in a gift tax case, the taxpayers appealed the adverse decision of the Tax Court in Cavallaro v. Commissioner, T.C. Memo 2014-189.

In 1979, Mr. and Mrs. Cavallaro started Knight Tool Company. Knight was a contract manufacturing company that made tools and machine parts. In 1982, Mr. Cavallaro and his eldest son developed an automated liquid dispensing machine they called CAM/ALOT. Subsequently, in 1987, Mr. and Mrs. Cavallaro's three sons incorporated Camelot Systems, Inc., which was a business dedicated to the selling of the CAM/ALOT machines made by Knight. The two companies operated out of the same building, shared payroll and accounting services, and collaborated in the further development of the CAM/ALOT product line. Knight funded the operations of both companies and paid the salaries and overhead costs for both.

In 1994, Mr. and Mrs. Cavallaro sought estate planning advice from a big four accounting firm and a large law firm. The professionals advised Mr. and Mrs. Cavallaro that the value of CAM/ALOT Technology resided in Camelot (the sons' company) and not in Knight and that they should adjust their estate planning. Mr. and Mrs. Cavallaro and their three sons merged Knight and Camelot in 1995 and Camelot was the surviving entity. Part of the reason for the merger was to qualify for Conformite Europeenne, which means European conformity, so that the CAM/ALOT machines could be sold in Europe. In the 1995 merger, Mrs. Cavallaro received 20 shares, Mr. Cavallaro received 18 shares, and 54 shares were distributed to the three sons. In valuing the company, the accounting firm assumed that the premerger Camelot had owned the CAM/ALOT technology. The Tax Court found that Camelot had not owned the CAM/ALOT technology, and as a result, the Tax Court found that the appraiser overstated the relative value of Camelot and understated the relative value of Knight at the time of the merger.

In 1996, Camelot was sold for $57 million in cash with a contingent additional amount of up to $43 million in potential deferred payments based on future profits. No further payments were made after the 1996 sale. Three issues were under review by the tax court:

  1. Whether the 19 percent interest received by Mr. and Mrs. Cavallaro in Camelot Systems, Inc., in exchange for their shares of Knight Tool Company in a tax free merger, was full and adequate consideration, or whether it was a gift.
  2. Whether Mr. and Mrs. Cavallaro were liable for additions to tax under Section 6651(a)(1) for failure to file gift tax returns for 1995, or whether the failure was due to reasonable cause.
  3. Whether there were underpayments of gift tax attributable to the gift tax valuation understatement for purposes of the accuracy related penalty, or whether any portions of the underpayment were attributable to reasonable cause.

With respect to the valuation issue, the Cavallaros offered two experts regarding the value of the combined entity. One expert valued the entity at between $70 million and $75 million and opined that only $13 million to $15 million of that value was attributable to Knight. A second appraiser valued the combined entity at $72.8 million.

The IRS retained its own appraiser. This appraiser assumed that Knight owned the CAM/ALOT technology. He valued the combined entities at approximately $64.5 million and found that 65 percent of that value, or $41.9 million, was Knight's portion.

In reaching its decision on the gift tax liability, the Tax Court noted that the 1995 merger transaction was notably lacking in arm's length character and Camelot may have been a sham company. It also discussed how the law firm in 1995 had tried to document the ownership of the CAM/ALOT technology by the sons but that such documentation was insufficient. The Court did not accept the testimony of the accounting firm. It noted that the IRS had conceded during the litigation that the value of the combined entities was not greater than $64.5 million and that the value of the gift made in the merger transaction was not greater than $29.6 million. As a result, the Tax Court concluded that Mr. and Mrs. Cavallaro made gifts totaling $29.6 million in 1995.

The Tax Court rejected the imposition of penalties for failure to file a gift tax return and accuracy-related penalties. It found that in both instances, Mr. and Mrs. Cavallaro had been advised by an accountant or lawyers and that there was reasonable cause for the failure to file a gift tax return and failure to pay the appropriate amount of tax. It noted that Mr. and Mrs. Cavallaro relied on the judgment and advice of the professional advisors and that the CAM/ALOT technology had been owned by the sons' company since 1987 (and thus was not being transferred in 1995). In documenting its finding of reasonable cause to avoid the penalties, the Tax Court went into great detail about Mr. and Mrs. Cavallaro's lack of formal education beyond high school and that they had built the business themselves.

In their appeal, the Mr. and Mrs. Cavallaro argued that the IRS had no basis for alleging that Camelot was a sham corporation and that the Tax Court had been wrong with respect to which assets were owned by Knight as compared to Camelot. This is a case in which the IRS took an aggressive position and it will be interesting to see how the First Circuit decides this case.

These developments come as IRS review of gift tax returns filed for 2012 is hitting top speed. Most of those gift tax returns will be entering the third year of the three-year statute of limitations in 2015. With the then-lifetime gift tax exemption of $5.12 million headed for a return to $1 million if Congress failed to act, we know that many of these 2012 gifts were large, leveraged, imaginative, often done in haste, often accompanied by some form of defined value provision, and sometimes edging close to the boundaries of the reciprocal trust doctrine in the case of married donors. The public discussions of the 2012 gift tax landscape were interesting. The gift structures and related transactions we heard discussed were interesting. The gift tax returns—nearly 370,000 of them according to IRS statistics—must be interesting, which is the last thing we want a tax return to be. It is very possible that 2015 will bring word of more aggressive audits and that 2016 will see Tax Court petitions for which the Woelbing and Williams petitions were just a warmup.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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