Significant recent developments in estate planning.

• Author: Nager, Ross W.
• Position: Part 2

Part I of this article, published in October, covered gifts; disclaimers; debts, claims and administration expenses; powers of appointment; retained interests; and charitable deductions. Part II, below, addresses valuation, special use valuation and the marital deduction. The final installment will be published in the December issue.

Valuation

Amendments to family partnership agreements reduced partnership interests' transfer tax value.

No gift resulted from a corporate recapitalization in which the exchanged stock was undervalued by the IRS.

Estate could discount decedent's undivided one-half real estate interest only to the extent of the cost of partitioning the property.

Testamentary division of control block of stock resulted in a single controlling interest for estate tax purposes, but shares passing to surviving spouse were a separate minority interest block for purposes of computing the marital deduction.

On remand from the Tenth Circuit, Tax Court held that alternate valuation considers both time value of money and a reasonable adjustment for oil and gas production risks.

Discount in value of decedent's residence and farmland disallowed for agreement to pay children from proceeds of ex-wife's transfer to decedent of her one-half community interest in fee simple.

Taxpayer could not rely on Sec. 483 safe harbor interest rate on transfer of stock to trust in exchange for promissory notes.

Valuation of father's gifts of fractional interests to children reflected bad economy and local rent stabilization laws.

IRS's expert, not estate's, correctly used net asset value for decedent's nonoperating, closely held company stock.

* Amendments to partnership agreement reduce transfer tax value

In McLendon,(64) the decedent, who had cancer, held general partnership interests in two family partnerships. In May and August of 1985, he and his son (the other general partner) amended the partnership agreements to (1) eliminate provisions mandating liquidation on the decedent's death and (2) give the son sole management control over the partnerships and authorization to expel any partner contesting his managerial decisions.

On Mar. 5, 1986, the decedent established a trust for the benefit of his three daughters and named his son trustee. On the same day, the decedent, as annuitant, entered into a private annuity agreement with his son (individually) and the trust, under which the decedent sold a 25% remainder interest in his general partnership interests to the son outright and a 75% remainder interest to the trust. The initial annuity payment was $250,000. In setting the annuity, it was assumed that the decedent's remaining life expectancy under Regs. Sec. 25.2512-5(f) (Table A) was 15 years. The decedent died in September 1986.

The IRS asserted a gift tax deficiency of $31,142,507, plus interest and penalties, arguing that the private annuity transaction was really a part gift/part sale. The deficiency was based on the stipulated partnership liquidation value, less the value of the retained life estate (which the IRS calculated based on an estimated life expectancy of 0.65 years) and the $250,000 payment.

The Tax Court held that the annuity payment was substantially less than the value of the remainder interest, resulting in a gift. However, the court disagreed with the IRS's contention that the 1985 amendments should be ignored and that the partnership interests should be valued at net liquidation value.

Critique: In determining whether a gift occurred, the Tax Court focused on the value of the partnership interests, i.e., the bona fides of the annuity calculation. The court concluded that liquidation value was not an appropriate measure. Instead, the court found that the fair market value (FMV) of the partnership interests, rather than the aggregate value of the underlying assets, was the appropriate measure for transfer tax purposes. The parties stipulated this value to be between approximately one-third and one-half of liquidation value. Essential to the court's finding was the determination that the 1985 amendments were not driven solely by testamentary motives. The decedent wanted the businesses to continue after his death and was convinced that only his son could manage them. Further, in the absence of the amendments, the decedent was afraid that his daughters would seek dissolution.

The court held that the annuity was purely a testamentary device unsupported by economic substance. First, it noted that the general partnership interests were undervalued by almost $5 million for annuity calculation purposes. Second, the $250,000 initial payment bore no relationship to the actual annuity value, either under the court's or the decedent's asset value estimates. The court also noted that, other than the $250,000, no annual annuity payment was set out in the agreement. Finally, the Tax Court found that the decedent's reliance on the Regs. Sec. 25.2512-5(f) tables was misplaced, because his medical condition was such that he was not expected to survive more than one year beyond the transaction date. The court therefore held that the annuity should have been valued using a 0.65-year, rather than a 15-year, life expectancy.

Planning hints: The McLendon facts are extremely unfortunate. The decedent's health, together with the loose terms of the annuity agreement, clearly demonstrated that neither party perceived the private annuity to be anything more than an estate tax saving device. In fact, no attempt was even made to meet the formal requirements of an annuity. The $250,000 payment was more than $500,000 less than the payment required under a 15-year life expectancy.

However, it is comforting that the court rejected the concept of "partnership amendment in contemplation of death" and respected the independent significance of the amendments. Query whether such an act, accomplished contemporaneously with the creation of the private annuity, would have been treated differently. Because of its significance to business continuity, the six-month gap between the amendments and the annuity should not be viewed as significant. Finally, the amendments to the partnership agreements predated Sec. 2704, which can require valuation of a partnership interest without regard to certain restrictions on liquidation.

* Corporate recapitalization does not result in gift

In Hutchens,(65) in 1982, the decedent owned 86.79% of the voting common stock and 75.42% of the nonvoting common stock of his family business. The remaining shares were owned by his spouse and three sons. In September 1982, he implemented a preferred stock recapitalization under which he and his spouse exchanged their voting and nonvoting common for Class A and Class B voting preferred. His eldest son received voting common and the other sons received nonvoting common.

The Class A and Class B preferred were entitled to a noncumulative variable dividend based on a designated bank's prime rate. The dividends became cumulative to the extent of $3 per share on the later of the eldest son's thirty-fifth birthday or the decedent's death. On liquidation, the proceeds were first payable to the preferred shareholders at $100 per share, plus any declared but unpaid dividends. Finally, the Class A preferred's voting rights lapsed on the later of the eldest son's fortieth birthday or the decedent's death, but were restored solely to vote on payment of the dividends if the corporation was in arrears on dividend payments. Between the recapitalization date and the decedent's death, no dividends were declared.

In conjunction with the recapitalization, the decedent obtained an appraisal of the corporation and the preferred shares. The preferred shares' value roughly equaled the common shares' value surrendered in the exchange. Subsequent to the decedent's death, however, the IRS challenged this conclusion, asserting that a gift to the sons resulted from the recapitalization. The asserted undervaluation ranged from almost $15 million (in the deficiency notice) to almost $4.9 million (in the trial pleadings). The Tax Court held that no gift had occurred.

Critique: In valuing the preferred shares, the taxpayer's expert used four alternative approaches: the Black-Scholes option pricing formula (which the court rejected); a comparable pricing method; a discounted cash flow analysis; and an asset liquidation analysis. Under the latter two approaches, the expert argued that favorable economic events affecting the corporation's industry (e.g., increased demand for the company's product, a recent history of record earnings and the near-resolution of a product liability suit) enhanced the likelihood that the noncumulative dividends would be paid. The expert also argued that a sale of the business would result in net proceeds at least equal to the liquidation preference accorded the preferred stock.

The IRS's expert, on the other hand, stated that a willing buyer would purchase the shares only with a view toward liquidation and that he would discount the estimated liquidation proceeds by approximately 35% to account for financial and legal risks of the transaction.

In holding for the taxpayer that no gift had occurred, the Tax Court noted that business conditions supported the likelihood of future dividend payments. It concluded that a willing buyer would purchase the stock at par in anticipation of receiving such dividends, particularly when the going concern value of the business more than supported the liquidation preference.

The IRS also argued that the company's failure to declare noncumulative dividends constituted an ongoing gift to the common shareholders. The court noted that only the board of directors is vested with the power to declare dividends. The business's cyclic nature, the failure of a new product line and the pending product liability suit all were factors constituting an adequate basis for the company to retain cash in the business, rather than pay dividends.

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