A Great 200 Mile Drive
Today, October 20th, is my release date from Federal Bureau of Prisons custody. I thoroughly enjoyed my 200-plus mile drive from Coeur d’Alene, ID to home with Mary Ann at our log home on the Middle Fork of the Clearwater River, a wild and scenic river in the Idaho Panhandle. This date is the beginning of my non-lawyer consulting practice, under the name FioreWealthPlanningConsulting. More will be posted on this website about my consulting practice and availability on tax and estate planning projects using over 40 years of experience.
I sincerely thank Coeur d’Alene estate planning attorney Marc E. Wallace, and his associate, Mary Cusack, for allowing me to be a consultant to their firm during my 6-plus weeks of “halfway house”. North Idaho is a beautiful area and the people and their estate planning needs are handled well by the Wallace firm. I recommend a visit to Lake Coeur d’Alene and surrounding area for anyone interested in beautiful scenery and great people!
Mary Ann and I are so grateful for all the support we have received from family and friends. And this is continuing, with our children putting on a big party for us at home in Syringa on October 28th. Of course, it now is time for me to get back to chores, and that wonderful Mary Ann has so expertly and patiently handled, the past nearly 16 months!
H.R. 5970 – Estate Tax Reform Stalled in the Senate!
In my 6th newsletter (August 24, 2006), I included a discussion of the question: “Is Permanent Estate Tax Reform Finally on the Way?” Details of the House-passed reform bill, H.R. 5970, were presented, including the gradual increase in the lifetime exemption for each estate to $5 million (2015). This would virtually eliminate the Federal estate tax, although there still would be plenty of reasons for estate planning.
Unfortunately, nothing yet has happened in the U.S. Senate on this bill – and Congress now is in recess to face constituents at home right up to the mid-term national elections in early November. So permanent estate tax reform still is “on the way”. It is my belief that H.R. 5970 or a similar bill should become law, if not this year, then early next year in the term of the new Congress. What is clear is that estate owners and their advisors must watch these legislative efforts and maintain as much flexibility as possible in estate planning.
New Gift Tax Valuation Case – Dallas
On September 28th, Tax Court Chief Judge John Colvin issued his opinion in Dallas v. Commissioner, a New Jersey-based gift tax case. The taxpayer and his advisors did not fare well, and in fact the court’s opinion is quite critical of the professionals, including the estate planning attorneys and appraisers. There are lessons to be learned here.
My initial article on Dallas was published by my good friend, Steve Leimberg, in his LISI Email Estate Planning Newsletter #1029 (October 3rd). Check out Steve’s newsletters and a lot of other helpful material on his website: www.leimbergservices.com.
Following is my revised article on the Dallas case – a primer on how not to carry out, defend and litigate a gifting plan. Appraisers and tax lawyers beware!
Owen’s Article on New Gift Tax Case
Has the Dallas sitcom returned? Is JR alive? Perhaps not, but the new New Jersey- based Tax Court opinion in Robert Dallas v. Commissioner, T.C. Memo. 2006-212, issued September 28, 2006, has both intrigue and humor. Unfortunately, the outcome was not taxpayer or advisor friendly!
The Dallas case discussion in this article includes focus on contradictory statements by taxpayer’s two estate planning lawyers and an appraiser who was unfamiliar with his own report! But also Tax Court Chief Judge Colvin revisits the issue of tax-affecting “S” corporation earnings for valuation purposes, an ongoing dispute among valuation appraisers. Finally, we are reminded of gift valuation appropriate to a “self-canceling” installment note (“SCIN”).
Dallas Case Summary
Given the fact findings by the Tax Court in Dallas, the generally negative result for the donor-taxpayer is no surprise. A clear and specific self-canceling note provision will not be disregarded for gift tax valuation of notes. Appraisers have to do their homework, providing supporting evidence for conclusions rather than merely giving the trier of fact bold assertions and unsupported conclusions. Further, a testifying appraiser must know his own report thoroughly and be able to explain it and help the court as trier of fact understand the report. This shouldn’t have to be stated as it states the obvious responsibility of an expert!
As to tax-affecting the earnings of “S” corporations for earnings capitalization and market comparison (guideline companies) methodology, there remains confusion among appraisers. And petitioner’s experts in Dallas did not shed light on the subject. However, see for one well-known appraiser’s comments, “The FMV Valuation Alert”, October 2, 2006, authored by Lance S. Hall, ASA (info@fmv.com).
It is my view that tax litigation counsel must be more proactive in assuring clients that appraisers meet their professional responsibilities – to the courts as well as to the clients represented. Of course, this must be done without counsel “crossing the line” to interfere with the appraiser’s own responsibilities, including methodology selection, analysis and report writing.
Factual Summary
As the result of spin-off of portion of a specialty chemicals manufacturing business, taxpayer became the sole shareholder of “Dallas Group of America, Inc.” (DGA), an “S” corporation having both Series A voting common and 25,078 shares of Series B nonvoting common. Between 1992 and 2000, various gift and sale transactions of the Series B nonvoting shares, designed with estate planning in mind, reduced taxpayer to just over 7% thereof. Certain transactions in nonvoting shares are not the subject of this gift tax case, namely, (1) 1992 7-year GRATs for the two sons (Robert II and David) of taxpayer and his wife, and (2) distribution outright to each son of 544 share from the wife’s estate (she died January 24, 1999). She had been gifted 7,000 shares by her husband in 1998.
The husband’s gift tax case before Tax Court Chief Judge Colvin dealt with gift tax consequences of two sets of installment sales of non-voting shares in 1999 and 2000. These transfers were valued by taxpayer’s appraiser, Empire Valuation Consultants, Inc. (“Empire”), for the year 1999 transactions and then merely “updated” by the company’s own CFO for the year 2000. By the way, my experience has been such updating after an in-depth appraisal should be by the professional appraiser, and set out, in terms of years and additional fees, in the original engagement letter so the professional appraiser does his own work!
The Tax Court found that the two sons and their father agreed to the 1999 installment sale “at the price set by Empire”. Further, Judge Colvin determined that the taxpayer “wanted the notes to be deemed paid in full if he died before all payments were made”, noting in footnote 4 of the court’s opinion that “If the notes were deemed prepaid when petitioner died, the value of the notes would not be included in his estate.”
In effect, Judge Colvin implicitly approves of the self-canceling installment note (“SCIN”) technique. So a major issue in the case was the appropriate gift valuation of the SCINs. A self-canceling provision, quoted below, was included only in the 1999 notes. Therefore, the fair market value of DGA was at issue for both years, and the note value was an additional issue for the year 1999 promissory notes.
As could be predicted based on the court’s findings of fact and the trial testimony, the sale transactions were deemed “bargain sales” by the Service and by Judge Colvin. For 1999, the gift element was a double one – first the determined higher value of the DGA stock, and second the lower value of the notes!
The court then framed the issues as (1) whether the price for DGA nonvoting stock was an “arms-length price” in 1999 and 2000, (2) analysis of appraisal evidence presented by the parties, including valuation discounts and the issue of whether tax-affecting earnings of the “S” corporation was appropriate, and (3) the fair market value of the 1999 notes having a “self-canceling feature”.
As to the latter issue, i.e. the SCINs, the 1999 5-year promissory notes given by trusts for the sons, but signed by the sons (perhaps the trusts were revocable), each note included the following quite clear and unequivocal provision:
“In the event that Holder shall die before the Maturity Date, this note shall be deemed to have been paid, satisfied and discharged on the day before the date of the Holder’s death”.
It is also noteworthy that both 1999 and 2000 sales agreements included a share adjustment clause. However, as the court noted in footnote 19 of its opinion, this issue was deemed by Judge Colvin as not presented for his determination because counsel for petitioner-taxpayer failed in his rebuttal brief to respond to IRS’ opening brief argument that “share adjustment clauses are void because they are against public policy.” After several years’ delay, the McCord gift tax case recently was decided by the 5th Circuit. In the 5th Circuit proceedings in McCord v. Commissioner, 120 T.C. 358 (2003), reversed, 5th Circuit Court of Appeals, 461 F.3d 614 (August 22, 2006), the Service did not utilize the public policy and similar arguments in supporting the Tax Court’s opinion, which had ignored a defined dollar value clause. Presumably, such arguments still will be used by the Service in appropriate dollar defined value/share adjustment clause cases, even after its loss in the 5th Circuit.
Tax Court Weighs In – Forcefully!
A. Arms-length Price – Not This Time!
First, Judge Colvin dealt forcefully with taxpayer’s contentions that the prices on the 1999 and 2000 sales of DGA Series B nonvoting stock to the sons (or their trusts) were (1) “set by Empire, an unrelated third party appraiser”, or, in the alternative, (2) supported by the testimony of taxpayer’s appraisers. On the first contention, the court, after pointing out the close scrutiny of intrafamily transfers expressed in a presumption of gifts, fixed upon several facts indicating gifts, estate planning motives for the sales, the 1999 notes’ self-canceling provision, the share adjustment clauses in all the notes, and the absence of any negotiations on the sons’ part.
See, however, the recent gift tax case of Huber v. Commissioner, T.C. Memo. 2006-96, in which Tax Court Judge Goeke pointed out the failure of IRS to come up with “any case law that holds that negotiation is a necessary element of an arms-length transaction”. However, in Dallas, after concluding the sales agreement prices were not “arms-length prices”, the court then turned to the valuation experts.
B. The Appraisal “Experts” – Taxpayer Loses Out!
Here the taxpayer was in real trouble! In addition to Empire, taxpayer presented the valuation report of Management Planning, Inc. (“MPI”) and at trial Robert P. Oliver and Joseph C. Hassan testified on behalf of MPI. Two appraisers with respondent IRS’ appraiser, Valuation Economics, Inc. (“AE”) and Scott A. Nammacher of Empire, also presented testimony at trial. Judge Colvin included in his opinion a helpful chart summarizing the several appraisers’ report positions and conclusions - including as to valuation methods and cap rates, the “S” corporation tax-affecting issue, an issue over an excess executive compensation adjustment, and the usual minority and marketability discount questions.
Judge Colvin made clear he found the AE report and its appraiser testimony cogent, thorough and more convincing than the Empire and MPI reports and testimony. The most damning criticism by Judge Colvin then was levied at Robert Oliver of MPI (who since this case trial apparently has retired from MPI):
“Oliver was substantially unfamiliar with the MPI report. The MPI report contained passages lifted verbatim from the Empire report. We give Oliver’s testimony little weight.” [emphasis added]
Enough said, I suppose; however, certainly taxpayer’s counsel should have seen this problem coming with the MPI expert during the trial preparation phase of the case, and then sought to avoid the problem, if possible.
C. Valuation Methodology and Tax Court Conclusions
1. Both of taxpayer’s appraisers, Empire and MPI, tax-affected DGA’s corporate earnings by reason of its “S” election, reduced net earnings by 40% and 35%, respectively. Respondent’s appraiser, AE, included no such adjustment yet AE used earnings capitalization and guidelines company transactions as valuation methods.
Appraiser Lance Hall, referenced above, believes the approach should have been (1) to value DGA shares on a tax-affected basis “for more appropriate comparability” of DGA with comparative guideline companies, but then also (2) to “explicitly value the tax shelter” provided by the S election of DGA – with a lower value for DGA being the result as only enough cash was distributed to pay shareholder level income tax on S earnings.
Judge Colvin found that the testimony of Empire’s Nammacher (MPI’s Oliver having been given little weight, as previously stated) provided insufficient evidence to support petitioner contentions that potential buyers of DGA stock would either not be qualified “S” shareholders or would cause termination of the election.
Further, the court gave no credit to Nammacher’s statements about his own tax-affecting earnings practice, the alleged results of an “unofficial poll” of appraisers at a “recent unidentified conference”, or the ASA’s Board of Review’s alleged rejection of test answers or reports of ASA certification candidates that fail to tax-affect “S” corporation earnings. Finally, the court found reliance on a Delaware state case on a “fair merger price” or “fair value” was not relevant to an issue on the Federal transfer tax “hypothetical willing buyer-willing seller” standard of value. In short, Empire presented no “hard evidence” in support of its position! See Gross v. Commissioner, T.C. Memo. 1999-254, aff’d 272 F.3d 333 (6th Cir. 2001), denying “S” corporation tax-affecting where the corporation regularly paid out to shareholders substantially all its net earnings.
2. On an adjustment for possible excess executive compensation, the same result occurred: “… we have no more reason to assume changes in DGA’s executive compensation policies than we have to assume changes in dividend paying policies or a change in its S corporation status”, Judge Colvin thus expressing disagreement with Empire on all these points.
3. And now what about discounts from “enterprise value”? First of all, Judge Colvin concluded that any additional discount of a minority stock position for the nonvoting character of the shares (MPI had opined a 5% discount) is too speculative. Minority interest discounts of 15% for nonoperating assets, as opined by AE and Empire, were accepted, as not disputed by petitioner. The AE minority interest 20% discount for operating assets likewise was accepted by the court.
As to a marketability discount, the parties were far apart – petitioner advancing MPI’s 40% discount and respondent going with the AE 20% marketability discount. Judge Colvin agreed with the AE conclusion, sharply criticizing MPI for failing to use current data, that is, discount studies for the period that included the year 1999 and year 2000 transactions – during which, MPI admitted, the discount rate plunged to 13%!
4. Yet in spite of all the negative judicial reactions to taxpayer’s experts, the DGA minority stock positions transferred in 1999 and 2000 were valued by the Tax Court at $751 and $801 per share, respectively, as opposed to AE’s concluded values of $1,004 (1999) and $1,026 (2000). So apparently in the DGA enterprise value determinations by the court, not discussed in detail in the opinion, taxpayer received some real benefit. So all was not lost!
D. Self-Canceling Provision of 1999 Notes
As previously noted, the 1999 self-canceling installment note issue was assumed by the Tax Court to involve a gift-tax valuation issue, namely, the requirement of reducing the face amount of each note by a factor recognizing that, for a payee in his late 70s, there is an actuarially determinable possibility the notes by their terms never would be paid. Thus, even if the DFG shares were valued properly, the notes and cash paid – all property received in the exchange – were not equivalent value. Experienced tax practitioners always have been concerned about the necessity to place a “premium” on SCINs, with resulting higher interest costs.
The SCIN technique was considered perhaps first in Moss v. Commissioner, 74 T.C. 1239 (1980), acq’d in result, 1981 C.B. 2. Rather recently, Costanza v. Commissioner, T.C. Memo. 2001-128, reversed, 320 F.3d 595 (6th Cir. 2003), involved the Tax Court refusing to recognize a SCIN (likely due to poor drafting). But the 6th Circuit sent the case back to the Tax Court to determine if the SCIN involved a “bargain sale” and thus a gift element.
This is just what Judge Colvin did in Dallas, and taxpayer offered no testimony on 1999 note values to counter that proffered by the respondent IRS. So the court found for the Service. A premium, negotiated by the parties, must be added to a SCIN to insure a “fair market value” exchange.
The taxpayer’s two estate planning lawyers apparently were in the same law firm at the time of the 1999 sales agreements and note transactions. However, by the time of trial in the Tax Court, they had parted company, so perhaps it is not surprising each one at trial remembered the self-canceling provision somewhat differently. One lawyer testified that inclusion of the self-canceling provision was meant to be a gift to the taxpayer’s sons in the event of taxpayer’s death, meaning not at the outset in 1999. The other lawyer stated he drafted the 1999 notes and “… he meant for the self-canceling clauses to require the 1999 notes to be deemed paid if petitioner died before they were paid.”
These “lawyer-speak” statements didn’t help the taxpayer. Obviously, they carried no weight with Judge Colvin, who stated: “Petitioner may not disavow the self-canceling clauses. They are not the result of mistake, undue influence, fraud or duress.” Thus, the Tax Court agreed with the IRS-determined 25% value reduction from the face of each 1999 note, petitioner having presented no contrary evidence.
