Recent developments in estate planning: Part 2

This is the second part of a two-part article examining developments in estate planning. The first part, in the October issue, covered trust and gift tax issues. The current installment updates readers on estate taxation, as well as inflation adjustments. The general period covered is from July 2020 through June 2021.

Estate tax

Bona fide transaction

In Estate of Morrissette,¹ the Tax Court ruled that the cash surrender values of three split-dollar agreements were not includible in the decedent’s estate under Sec. 2036 (transfers with retained life estate) or 2038 (revocable transfers). The court further ruled that the values of the rights in the split-dollar agreements includible in the decedent’s gross estate were not subject to the special valuation rules under Sec. 2703 but were significantly undervalued for estate tax purposes.

Facts: According to the Tax Court’s factual findings, Arthur Morrissette and his wife, Clara, had three sons, Buddy, Don, and Ken. In 1943, Arthur started a moving company, Interstate Group Holdings Inc. (Interstate). Once the sons were teenagers, they began to work at Interstate. The relationships between Arthur and his sons and among the sons were plagued by a history of strife, fighting, and contention. Although Arthur had considered selling Interstate in the late 1980s, he eventually concluded that he wanted Interstate to stay within the family. At this time, Buddy had become Interstate’s CEO and had already become instrumental in orchestrating Interstate’s tremendous growth that would continue over the next three decades.

After learning that their father had planned to sell Interstate, Ken and Don told their father that they no longer wished to work for, or own interests in, Interstate. Arthur regarded Ken and Don’s request as disloyal but offered to buy out their interests. Ken and Don opined that Arthur, with Buddy, “unfairly lowered” the buyout price and took steps that “caused [Ken and Don] financial hardship.” In 1995, Clara persuaded Arthur to forgive Ken and Don and invite them back into the business. In response, Arthur gave both sons executive positions within Interstate and nonvoting stock in the company. Arthur and Buddy retained all voting power. Buddy resented his brothers and felt cheated by his father’s decision to allow them back into the business.

In 1994, Clara formed a revocable trust (the CMM Trust) to hold her Interstate stock and, in 1995, Arthur followed suit, also creating a revocable trust (the AEM Trust) to hold his Interstate stock. Both the AEM Trust and the CMM Trust provided that the elder Morrissettes desired Interstate to be owned equally by each of their three sons following the elder Morrissettes’ deaths — except that Buddy should receive additional nonvoting shares for his previous loyalty. Additionally, the trusts further reiterated their desire that Interstate stay a family business. Following Arthur’s death, the AEM Trust distributed its assets to three trusts — one for the Interstate voting stock, one for the Interstate nonvoting stock, and one for real estate and marketable securities owned by the AEM Trust. Each of the newly created trusts was for the benefit of Clara and, eventually, the three brothers.

After their father’s death, the brothers’ relationships with each other continued to deteriorate. During this time, Buddy’s two sons began working for the business and were described as successful Interstate employees — each being groomed to run the business in the future. Buddy’s sons worried about Interstate’s succession and the long-term business plan. Each wanted to ensure a stable transition of the business in the future.

In addition to the family problems (and their impact on Interstate’s business), it was quickly becoming apparent that there was no plan to pay the estate tax that would be due at Clara’s death. The family became increasingly worried that they would have to sell Interstate stock to pay the estate tax — thereby destroying the elder Morrissettes’ goal of keeping Interstate a family business. Although cautioned otherwise, the brothers believed Clara’s estate would qualify for Sec. 6166 deferred estate tax payments but were worried that using Interstate’s profits to pay her estate tax would dilute the business and hamper further growth.

In 2005, Clara developed Alzheimer’s disease and dementia. In 2006, the family was introduced to an insurance agent who suggested, along with an estate planning attorney, estate planning strategies either to qualify Clara’s estate for Sec. 6166 deferral or to purchase life insurance through split-dollar arrangements sufficient to cover Clara’s estate’s estate tax. Following consultation with the insurance agent and attorney, the family decided to create a new multistep estate plan designed to cure deficiencies in Clara’s earlier planning. With the help of a court-appointed conservator, it was decided that Clara would create a dynasty trust for each child.

Next, Clara’s CMM Trust would enter into split-dollar life insurance arrangements with each of the dynasty trusts. The split-dollar arrangements provided that each dynasty trust would purchase life insurance on each dynasty trust’s beneficiary’s brothers (e.g., Buddy’s trust would purchase life insurance on Ken’s and Don’s lives). The total value of the insurance purchased, including additional riders, was $58.2 million. The premiums on the policies equaled $30 million. The arrangements stated that the CMM Trust would provide each dynasty trust an amount necessary to pay the insurance premiums and, in exchange, the CMM Trust was entitled to receive the greater of the amount of the premiums paid or the cash surrender value of the insurance policy at the insured’s death.

The CMM Trust had no ownership interest in the policies and could not force the dynasty trusts to surrender the policies. The parties to the split-dollar arrangements could terminate the agreements by mutual consent (the mutual termination restriction), and the agreements would terminate on bankruptcy, receivership, or dissolution of either party. Concurrently, the dynasty trusts and each of the brothers signed a new shareholder agreement severely restricting the transfer of Interstate stock.

Following Clara’s death, the CMM Trust transferred the split-dollar arrangement rights to the respective dynasty trusts equal to Clara’s remaining generation-skipping transfer tax exemption and sold, subject to a note receivable, the remaining value of those rights to the dynasty trusts. On Clara’s federal estate tax return, the estate reported the discounted value of the split-dollar agreement rights at $7.479 million — considerably less than the initial amount provided to the dynasty trusts ($30 million).

The IRS issued a notice of deficiency for tax and penalty based on its opinion that the value of the split-dollar agreement rights was underreported. The issues before the Tax Court were: (1) whether Sec. 2036 or 2038 applied to the transfers made as part of the split-dollar arrangements; and (2), if not, whether Sec. 2703 applied to require that the valuation of the split-dollar agreement rights disregard the mutual termination restriction.

Sec. 2036 and Sec. 2038: The IRS argued that Secs. 2036 and 2038 should apply to the transfer of the life insurance premium amounts from the CMM Trust to the dynasty trusts and that the value of the split-dollar rights should be at least the amount of transferred premiums ($30 million), if not the surrender value of the underlying policies ($32.6 million).

Generally, Secs. 2036 and 2038 require that a decedent’s estate include inter vivos transfers (i.e., transfers made during the decedent’s lifetime) where the decedent retained certain rights or powers over the transferred property. The Tax Court noted that Secs. 2036 and 2038 apply if each of the following three conditions is met:

1. The decedent made an inter vivos transfer;
2. The transfer was not a bona fide sale for adequate and full consideration (the crux of the issue here); and
3. The decedent retained an interest in, or a right or power over, the transferred property that she did not relinquish before her death.

After briefly considering whether Clara maintained rights to the split-dollar advance interests, the court focused on the “bona fide sale” exception (that is, whether the transfer was a bona fide sale for adequate and full consideration).

In determining whether the bona fide sale exception applies to a transfer, the Tax Court first noted that the exception has the same meaning for both Sec. 2036 and Sec. 2038, and, therefore, should Clara meet the exception for one of the sections, both would be satisfied. The bona fide sale exception has two prongs: The sale must be for a legitimate and significant nontax purpose, and the sale must be made for adequate and full consideration in money or money’s worth. Of course, as a prerequisite, there must be a “sale.”

The IRS argued that there was not a sale in the current transaction because the dynasty trusts did not pay consideration to the CMM Trust in exchange for the advancement of premiums. The court determined that neither the Code nor its regulations define “sale”; however, both the regulations and prior court decisions indicate that “sale” is broadly defined and could include things that might not otherwise be sales in a traditional sense. As such, the court held that there was a sale because the CMM Trust transferred property to the dynasty trusts in exchange for rights under the split-dollar life insurance policies, including the right to payment of death benefits.

After determining there was a sale, the Tax Court next considered whether there was a legitimate and significant nontax purpose for the transaction. Notably, the court mentioned that a taxpayer’s seeking to save estate tax (if it is not the taxpayer’s predominant motive) does not preclude a finding of a bona fide sale because nontax purposes are often intertwined with testamentary objectives (i.e., estate tax savings). The court concluded that Clara’s long-standing desire to keep Interstate within the family and have it passed to future generations is a legitimate nontax business reason to enter into the split-dollar arrangements.

Further, the court recognized that Clara’s earlier estate planning did not properly accomplish this goal, nor did it provide a succession plan that properly utilized the family members’ institutional knowledge and skill at running Interstate. The split-dollar arrangements allowed the brothers to inherit and continue Interstate’s operations without the burden of significant estate taxes at Clara’s death.

The Tax Court next considered whether the sale was for adequate and full consideration in money or money’s worth. In doing so, the court noted that adequate and full consideration has previously been defined as an exchange of roughly equivalent value that does not deplete the estate. Clara’s estate argued that adequate and full consideration existed because the transaction satisfied the “economic benefit regime” as provided in Regs. Sec. 1.61-22. The court quickly dismissed the estate’s argument because the cited regulation does not apply to the estate tax — it only applies for income tax purposes.

The IRS argued that adequate consideration is determined under the “willing buyer/willing seller” standard, but the court also dismissed that argument because the bona fide sale exception does not require an arm’s-length transaction, and the court held further that an intrafamily transaction can be a bona fide sale. Additionally, the court determined that adequate consideration does not mean fair market value (FMV).

Finally, in reviewing the transaction, the court concluded that both parties’ experts agreed that investment choices may be made for reasons other than maximizing financial return and that, in the current instance, Clara received value other than the immediate financial value. Based on the above, the court held that she received adequate and full consideration based on the split-dollar arrangements’ repayment policies and the included interest earned.

Having found that there was a bona fide sale, the Tax Court concluded that Secs. 2036 and 2038 did not apply to the split-dollar arrangements.

Sec. 2703: After determining that the value of the inter vivos transfers by Clara was not includible in her estate, the Tax Court next considered the FMV of her split-dollar rights stemming from the life insurance arrangements. In doing so, the court first considered whether the special valuation rule of Sec. 2703 applied, requiring the mutual termination restrictions to be disregarded. Specifically, Sec. 2703(a) states that the value of an asset includible in an estate shall be determined without regard to any option, agreement, or other right to acquire or use the property at a price less than FMV or any restriction on the right to sell or use the property. However, Sec. 2703(b) provides an exception where the restriction is:

1. A bona fide business arrangement;
2. Not merely a device to transfer property to a decedent’s family at less than adequate and fair consideration; and
3. Comparable to similar arm’s-length agreements.

Here, the court concluded that the Sec. 2703(b) exception applied. The court had previously held, in response to motions for summary judgment (Estate of Morrissette, 146 T.C. 171 (2016)), that the special valuation rule would apply to disregard the mutual termination restriction unless the Sec. 2703(b) exception was found applicable.

With respect to the first prong of the exception, the Tax Court determined that the split-dollar arrangements were a bona fide business arrangement designed to correct previous estate planning, past family fighting, and Interstate’s future management within the family. In considering the second prong, the court noted that review of the split-dollar arrangement was limited to whether the mutual termination restriction — not the entire split-dollar agreement — was a device to transfer property for less than fair and adequate consideration.

Whether the restriction is a device depends on the fairness of the consideration received at the execution of the transaction. The court held that the restriction was not a device because the split-dollar agreements contained reasonable repayment terms, guaranteed interest, and other nonfinancial benefits that, in totality, equaled adequate and full consideration.

In considering the third prong, the court noted that it looked to whether the restriction would have been part of a transaction between unrelated parties. The court, after considering the brothers’ acrimonious relationship and history of fighting about Interstate’s ownership, determined that the agreements were arm’s-length, finding that a mutual termination restriction similar to the ones in the split-dollar agreements at issue would be acceptable in a transaction between senior executives at a closely held corporation.

Accordingly, the court determined that the requirements of the Sec. 2703(b) exception had been met and, therefore, Sec. 2703 did not apply. Thus, the decedent’s estate’s split-dollar arrangement rights were valued based on the FMV of the rights using the traditional valuation concepts under the willing buyer/willing seller standard.

Fair market value: Although the Tax Court concluded that the special valuation rules of Sec. 2703 did not apply regarding the value of Clara’s estate’s rights in the split-dollar arrangements, the FMV of those rights was still an issue before the court. Although the court did not determine the exact value of those rights, it did set parameters (including the use of the discounted cash flow method) for the parties to determine their value. In light of those parameters, the court determined that Clara’s estate had grossly misstated the FMV of those rights and imposed penalties.

Estate valuation

In Estate of Jackson,² the Tax Court ruled, for the most part, in favor of the estate of Michael Jackson regarding the value of the estate’s intellectual property.

Facts: As stated in the Tax Court’s findings, beginning in the mid-1960s when he was still a child, Michael Jackson was the lead vocalist for the Jackson 5 and began touring across the United States as the band ascended the Billboard Hot 100 Chart. Around 1980, Jackson, then a solo artist, founded the Mijac Music (Mijac) catalog — a catalog that comprised the publishing rights and copyrights for compositions of numerous composers and those written by Jackson himself. That same year, Warner Bros. Music became the administrator of Mijac by way of New Horizon Trust (NHT III) and would continue in that role through the singer’s death.

On the heels of several solo albums and tours, Jackson became a worldwide celebrity who attained unprecedented bargaining power over his recording company. His personal fame meant there were numerous requests for merchandizing licenses for his “image and likeness.”

In 1985, after recognizing the opportunities that his financial success created, Jackson began targeting copyrights in musical compositions and purchased the ATV Music Publishing Catalog (ATV), which, among other items, owned at least 175 Beatles songs, for $47.5 million. Jackson’s “eccentric” spending habits began to ramp up as well: for example, he purchased a chimpanzee and a hyperbaric sleeping chamber. In 1993, his reputation began taking a hit as Jackson was accused of child molestation, and he had to cancel his Dangerous World Tour as a result of the negative press.

After the allegations, brands were less interested in associating themselves with Jackson, and by 1998, the pop star, falling further into debt, began to borrow significant sums against his share of Sony/ATV, which merged as a result of a deal he made in 1995 to combine the ATV catalog with Sony’s music-publishing business. After 1998, his borrowing against the Sony/ATV interest had risen to $185 million, and he became increasingly reclusive. He did very few shows after 2001 and refinanced his financial position as his primary loan was secured by both Sony/ATV and his own musical catalog. Jackson’s team contacted dozens of banks to get the refinancing money, which resulted in Jackson’s receiving loans worth close to $370 million.

From 1998 to 2007, Jackson borrowed against his interest in Sony/ATV. In 2006, Sony conditioned its approval to use his interest as security on Jackson’s agreeing to sell 50% of his interest. In 2007, Jackson transferred his 50% interest in Sony/ATV to New Horizon Trust (NHT II), a Delaware trust. The trust, after refinancing by Barclays, held $300 million of debt, and Jackson agreed to redirect his distributions from Sony/ATV to an interest-reserve account.

Jackson left the United States for a short period of time but then came back. The pop star had rearranged his management team and news of criminal allegations had subsided, and, in 2009, he agreed with concert promoter AEG Live to go on a tour outside the United States. AEG Live agreed to pay Jackson $5 million in advance, among other generous perks. However, on June 25, 2009, Jackson died after an injection of drugs administered by his personal physician in what was later ruled an accidental homicide, less than three weeks before his tour was set to begin. At the time of his death, each of the three assets that are the subject of this case was distressed. Jackson’s image and likeness were not producing any significant income, his interest in Sony/ATV secured $303 million in loans, and his interest in Mijac secured over $72 million in debt.

After his death, Jackson’s estate submitted an estate tax return that was audited by the IRS. Upon conclusion of the audit, the IRS issued a notice of deficiency that adjusted the estate’s reported value of a group of specific assets — mostly intellectual property. The IRS then determined that the estate had underpaid the estate tax by roughly $500 million and assessed $200 million in penalties.

The estate and the IRS resolved all of the disputes of the IRS audit except for the value of three intangible assets on the estate tax return:

1. Jackson’s image and likeness;
2. His interest in NHT II, which held his 50% ownership interest in Sony/ATV; and
3. His interest in NHT III, which held his interest in Mijac.

The estate contended that the value of these assets was low at the time of Jackson’s death, while the IRS argued that it was much higher. In support of its valuation of the three assets, the estate used four experts — two regarding Jackson’s image and likeness, one for Sony/ATV, and one for Mijac. The IRS relied on one expert witness on the subject of all three assets.

Image and likeness: The first asset that the Tax Court analyzed was Jackson’s “image and likeness” as the term was defined under California law. The estate reported Jackson’s image and likeness as having an FMV of $2,105 as of the date of his death while the IRS determined it was $434,264,000. In ascertaining the estate’s valuation, one of the estate’s experts, Mark Roesler, projected out a decade of posthumous revenue from the exploitation of Jackson’s image and likeness, and from some associated trademarks.

Roesler considered three main factors in determining a 10-year projection of revenue: (1) pre-death revenue; (2) post-death rights; and (3) growth and decline rates using pre-death marketability and a potential post-death “boom” opportunity. Using the income method, another of the estate’s experts, Jay Fishman, used Roesler’s projections as the foundation for his valuation of Jackson’s image and likeness. Fishman calculated future cash flows and discounted the revenue streams to present value and determined a higher value for the asset than the estate had initially stated on its return, $3,078,000 instead of $2,105.

To ascertain the value of Jackson’s image and likeness, the IRS’s expert, Weston Anson, considered five “foreseeable opportunities” that he believed were present at Jackson’s death: (1) themed attractions and products; (2) branded merchandise; (3) a Cirque du Soleil show; (4) a film; and (5) a Broadway musical. Anson argued that these were potential opportunities that a reasonable investor could develop and that would create revenue attributable to Jackson’s image and likeness. When valuing these opportunities, Anson’s definition of “image and likeness” encompassed a rather expansive bundle of synergistic rights, including U.S. trademarks, state or common law trademarks, copyrights, licensing rights, endorsement rights, franchising rights, and international trademarks. Also employing the income approach, Anson determined the value of Jackson’s image and likeness to be $161 million.

The Tax Court rejected the entirety of Anson’s analysis, noting that it was mere “fantasy.” The court stated that Anson valued the wrong asset, included unforeseeable events in his valuation, and miscalculated the assets’ value. First, the court noted that under California law no right of publicity protection is given to certain assets (e.g., plays, books, magazines, newspapers, musical compositions, audiovisual works, and radio or television programs). Anson’s valuation did not account for these exceptions, which greatly inflated the final calculations. As the court stated, while Jackson’s assets would work together to raise each asset’s value (i.e., synergistically), that did not necessarily mean that the value of one asset could be substituted for the value of another. The court also chided Anson’s overbroad description of the asset he was valuing, noting that his decision to broaden the rights he valued was conscious and an overt attempt to reach a higher valuation number.

Next, the Tax Court found that Anson incorrectly included revenue streams that were not foreseeable at Jackson’s death. Regs. Sec. 20.2031-1(b) defines the FMV of an asset as limited to what a buyer and seller would have reasonable knowledge of at the time of a decedent’s death. Moreover, although case law advises one to consider that the reasonably informed hypothetical buyer will ask a hypothetical willing seller for information not publicly available, the court stated that foreseeability cannot be subject to hindsight. The court found that although revenue streams were potentially traceable to Jackson’s image and likeness, they were not foreseeable when he died, and, thus, should not be considered in the estate’s gross value.

Finally, the Tax Court found that Anson’s analysis reflected “faulty” math. Notably, Anson’s future cash flow projections did not account for management expenses, and his approach to determining the discount rate was not fully developed.

Although the Tax Court generally agreed with the estate’s valuation experts, it adjusted the estate’s calculation to remove “tax affecting” and recalculated the method of discounting future income back to present value. With these adjustments, the court concluded that the value of Jackson’s image and likeness at the date of death was $4,153,912.

NHT II: The second asset the Tax Court analyzed was Jackson’s interest in NHT II (which held his 50% ownership interest in Sony/ATV), which the estate valued at zero and the IRS valued at $206.3 million. The value of NHT II was the value of Jackson’s interest in Sony/ATV, less the liabilities of NHT II (primarily, the amount of the loans secured by Jackson’s interest in Sony/ATV).

To determine the value of NHT II, the estate retained the services of Alan Wallis. To value the interest in Sony/ATV, Wallis used two valuation methods to determine its value — the market approach and the income approach. Under the market approach, Wallis compared Sony/ATV to comparable companies and transactions. By viewing Sony/ATV as an operating music-publishing company, Wallis calculated its earnings before interest, tax, depreciation, and amortization (EBITDA) as a key figure in his calculation. For the income approach, Wallis projected Sony/ATV’s future cash flows and based his projections on Sony/ATV’s own internal projections as of 2009. After deducting NHTs liabilities from the value he determined for Jackson’s interest in Sony/ATV, Wallis concluded that Jackson’s interest in NHT II was worth nothing (technically it was worth negative $139.2 million) at the time of Jackson’s death.

The IRS again used Anson as its expert, and, like Wallis, Anson valued Jackson’s interest in Sony/ATV through both the income and market approaches. In contrast to Wallis, in his market approach, Anson viewed Sony/ATV as a music catalog rather than an operating music-publishing company. This meant that he calculated the venture’s enterprise value by its net publisher’s share (NPS) and not EBITDA. Anson’s income approach also differed from Wallis’s in using Sony/ATV’s historical financial data to predict future cash flows. Anson made no discounts based on lack of control or marketability but did make a discount based on Sony’s option to buy half of Jackson’s interest in Sony/ATV. After deducting NHT II’s liabilities from the value he determined for Sony/ATV, Anson concluded that Jackson’s interest in NHT II at his death was $206.3 million.

To find a reasonable value for NHT II, the Tax Court looked at both the market and income approaches. The court found that the IRS’s expert’s market approach calculation was flawed because he valued Sony/ATV as a music catalog and not as an operating business in the music-publishing industry. It found that the estate’s expert’s calculation was flawed because he did not use appropriate relevant transactions in his analysis because none were available. Because of the lack of a relevant transaction that would allow a proper calculation of the NHT II interest’s value under the market approach, the court determined the income approach should be used for the valuation calculation.

While the court had problems with both experts’ income approach calculations, it in general found the estate’s expert’s calculations more reliable. After making various adjustments to the calculations, the court came up with a value of $213 million for Jackson’s interest in Sony/ATV. The amount of NHT II’s liabilities exceeded this amount by $88 million, so the court determined that Jackson’s interest in NHT II had a value of $0.

NHT III: The third asset that the court analyzed was Jackson’s interest in NHT III, which held his interest in Mijac. The estate valued the interest in NHT III at roughly $2.2 million, and the IRS valued it at $114.2 million. In assessing NHT III’s value, the estate used the services of Owen Dahl, who used the income approach to identify five sources of income for Jackson: (1) Jackson’s compositions that he also performed that were released before his death; (2) Jackson’s compositions that he did not perform that were released before his death; (3) major works by other songwriters; (4) minor works by other songwriters; and (5) Jackson’s unreleased compositions that he performed.

Anson valued Jackson’s interest in Mijac using only the income approach. His major disagreement with Dahl was about the size and duration of a post-death boom in demand for Jackson’s music, as well as the number of unreleased compositions that he thought the singer had left behind. Ultimately, Anson valued Jackson’s interest in NHT III at roughly $114 million.

In assessing Mijac’s value, the Tax Court stated that this was the most difficult of Jackson’s assets to value because its income derived from five different groups of songs, each of which produced income from three different sources, and sometimes distinctions were required to be made between domestic and international income. In addition to Mijac, Jackson assigned to NHT III the income he earned from his writer’s share of performance revenue from Broadcast Music Inc. (BMI). Thus, the court had to project future revenue streams from BMI to see how it earned money for Mijac and NHT III.

Because BMI paid income directly to Jackson, the Tax Court included it in its valuation of NHT III because, as the estate conceded, Jackson agreed to direct this money into NHT III to service its debt. The court disagreed with Anson’s analysis for projecting income from BMI, as he based it entirely on his interpretation of royalty data that was provided to him by accounting firm Moss Adams, instead of the actual royalty payments. Dahl, unlike Anson, understood that there were two sources of revenue for NHT III deriving from BMI. However, he also did not adequately explain his projection of revenue from BMI’s payments for the publisher’s share of the compositions that Mijac owned. Ultimately, the court decided that Jackson’s interest in NHT III was valued at roughly $107.3 million, which was more in line with the IRS expert’s value of $114.2 million.

Although the Tax Court disagreed with the estate’s valuation of Mijac and NHT III, it found the estimates reasonable given the facts and circumstances and acknowledged that the estate relied on Moss Adams as the appraiser of value in good faith. In total, the court found the assets in question to be worth approximately $111.5 million. This amount is significantly more than the estate’s determination of $5.3 million but much less than the IRS’s determination of $482 million. In addition, the court denied the $200 million in penalties due to understatement of value that the IRS assessed against the estate, noting that the estate had taken the necessary steps to value some of its assets and relied on legitimate experts to determine the correct value of the assets.

Estate tax charitable deduction

In Estate of Warne,³ the Tax Court reviewed an estate’s valuation of majority and minority interests in family-owned limited liability companies (LLCs) that held real estate. The court also addressed minority-interest discounts to the available estate tax charitable deduction for LLC interests passing to two charities.

Thomas and Miriam Warne, husband and wife, began investing in real estate in the 1970s and continued to do so throughout their lives. By the time of Thomas Warne’s death in 1999, all their properties had been transferred to one of five separate LLCs. The most significant LLC was Royal Gardens LLC (Royal Gardens). The LLCs also held various leased fee interests associated with the properties. The LLCs’ operating agreements contained provisions placing restrictions on the transfer and dissolution of an interest. Moreover, other LLC provisions vested considerable power in the majority interest holder.

In 2012, Miriam Warne gifted her children minority interests in the LLCs. At the time of her death in 2014, the family trust was the majority interest holder of the LLCs, owning the LLCs in the following amounts: 78%, 86%, 73%, 87%, and 100% (Royal Gardens). The value of the family trust was included in Miriam’s gross estate. Additionally, the family trust agreement provided that the interest in Royal Gardens was to be left to two separate charitable organizations: 75% to the family’s foundation, and the remaining 25% to a church.

On Miriam’s estate tax return, the values of the majority interests in the LLCs owned by the family trust were listed as: $18,006,000, $8,720,000, $11,325,000, $10,053,000, and $25,600,000 (Royal Gardens), for a total value of $73,704,000. Those values were determined by valuing the underlying real property interests owned by each LLC and then applying lack-of-control and lack-of-marketability discounts to the LLC interests. The estate also listed the value of the 75% of Royal Gardens interest donated to the foundation as $19,200,000, and the 25% to the church as $6,400,000. Combined, the amounts equaled the full value of the 100% ownership interest in Royal Gardens that was shown as being included in the estate.

The IRS determined multiple deficiencies, including deficiencies related to the value of the leased fee interests held by several of the LLCs, deficiencies related to the discounts applied to the majority interests held by the family trust in several of the LLCs, and a deficiency for the reduced charitable contribution deduction related to the split donation of Royal Gardens.

The primary issues addressed by the Tax Court were: (1) the date-of-gift value and date-of-death value of three leased fee interests that were owned by some of the LLCs; (2) the appropriate discount for lack of control and lack of marketability of the majority interest in the LLCs held by the family trust; and (3) whether minority-interest discounts applied to the 25% and 75% interests of Royal Gardens left to the two charities.

During trial, both the IRS and the estate presented appraisers to testify as to the value of the leased-fee interests to determine applicable lack-of-control and lack-of-marketability discounts for the estate’s majority interests. The estate argued that a combined 10% discount should apply, and the IRS argued that a 4% discount would be appropriate. During its analysis, the Tax Court emphasized the fact that the LLC operating agreements provided significant control to the holder of the majority interest, including the power to unilaterally dissolve the LLC and appoint and remove managers. The court cited previous cases with similar facts where no discount for lack of control was applied; however, the court noted that because the parties had previously agreed that a discount for lack of control should apply, the court would permit the discount.

The IRS’s expert used nine closed-end funds to estimate a lack-of-control discount of 2%. However, the estate argued that while discounts from closed-end funds could be used to devise minority-interest discounts, they could not be used to calculate discounts for lack of control for majority interests. The Tax Court agreed with the estate, noting that based on facts presented, the closed-end funds would not be appropriate for determining the lack-of-control discounts for the estate where its majority interests in the LLCs wielded considerable power. The court further stated that the closed-end funds were too dissimilar to the LLCs and more closely akin to minority interests. Thus, it rejected the 2% discount rate used by the IRS’s expert.

The estate’s expert compared premiums from completely controlling interests in companies with premiums from interests that lacked full control and concluded that a lack-of-control discount of 5% to 8% would be appropriate. This evaluation included the consideration of qualities unique to the LLCs, such as the likelihood of opposition and potential litigation in the event a majority shareholder chose to liquidate. The Tax Court generally found the estate’s expert’s method of determining the discount to be sound, except for his increasing of the discount rate based on the potential for litigation. The Tax Court cited Olson,⁴ which states that “[e]lements affecting value that depend upon events or combinations of occurrences which, while within the realm of possibility, are not fairly shown to be reasonably probable should be excluded from consideration for that would be to allow mere speculation and conjecture to become a guide for the ascertainment of value.” The court found that the likelihood of litigation from a majority shareholder’s liquidating and dissolving the LLCs was not reasonably probable and refused to factor it into the control discount. The court found that a lower lack-of-control discount rate of 4% should be applied.

Next, both experts presented their lack-of-marketability-discount valuations. The estate determined an appropriate range was between 5% and 10%, and the IRS concluded a discount of 2% was appropriate. The Tax Court accepted the estate’s conclusion, noting that the estate’s expert considered additional metrics and provided a more thorough explanation of his valuation process; however, the court believed that the lower end of the range was appropriate and found that a 5% lack-of-marketability discount should be applied.

Lastly, the court reviewed whether discounts should apply to the 25% and 75% interests of Royal Gardens, which were left to the two charities. The estate insisted that discounts for lack of control and marketability were inappropriate and would subvert the public policy of motivating charitable donations. It argued that because 100% of Royal Gardens was included in the estate and the estate donated 100% of Royal Gardens to charities, the estate was entitled to a deduction of 100% of the value. Disagreeing, the Tax Court concluded that discounts should apply to the charitable contribution deduction. Citing Ahmanson Foundation, 674 F.2d 761 (9th Cir. 1981), a case involving property split as part of a charitable contribution, the court found that “when valuing charitable contributions, we do not value what an estate contributed; we value what the charitable organizations received.”

Thus, the Tax Court concluded that while the estate must include 100% of the value of Royal Gardens in the value of the estate, the estate may deduct only the 25% and 75% interests received by the respective charities. The parties had previously stipulated that in the event the court found (as it ultimately did) that a discount applied to the charitable contribution deduction, a 27.385% discount was appropriate for the 25% interest donated to the church, and that a 4% discount applied to the estate’s 75% donation to the foundation. Accordingly, this resulted in a reduction in the charitable contribution of over $2.5 million.

This holding in the case regarding the estate tax charitable contribution deduction reflects the disconnect between the value of an asset included in a decedent’s gross estate for estate tax purposes under Sec. 2031 and the value of an asset for purposes of determining the estate tax charitable deduction under Sec. 2055. Sec. 2031 values the interest includible in the estate while Sec. 2055 values the interest to be received by the charitable organization. In most instances, these values will be the same. However, they may be different; for example, in this case, where the entire interest was included in Miriam Warne’s estate but this interest was split between two charitable entities, reducing the estate tax charitable deduction due to minority-interest discounts. What the estate plan could have done was contribute the entire interest in the LLC to the foundation and have the foundation contribute 25% of the LLC to the church. In such case, the value of the estate tax charitable deduction would have equaled the value of the LLC interest includible in the gross estate.

Estate tax closing letters

On Sept. 28, 2021, Treasury and the IRS issued final regulations⁵ establishing a new $67 user fee for authorized persons to receive an estate tax closing letter. An authorized person includes a decedent’s estate or other person authorized under Sec. 6103 to receive and, therefore, to request an estate tax closing letter.

Prior to June 2015, the IRS generally issued an estate tax closing letter for every estate tax return filed. However, the IRS changed its practice beginning with estate tax returns filed on or after June 1, 2015, and now offers an estate tax closing letter only upon the request of an authorized person. The reasons cited for this change are: (1) the volume of estate tax returns filed increased due to the enactment in December 2010 of the portability of a deceased spouse’s unused applicable exclusion amount for the benefit of the surviving spouse; and (2) the IRS recognized that an account transcript with a transaction code and explanation of “421 — Closed examination of tax return” is available as an alternative to an estate tax closing letter.

The new $67 user fee applies to a request for an estate tax closing letter received beginning Oct. 28, 2021. Specific instructions for requesting the closing letter and paying the fee will be posted on Pay.gov and IRS.gov, the final regulations state.

Inflation adjustments

Rev. Proc. 2020-45 sets forth inflation adjustments for various tax items for 2021. The following may be of interest to estate planning professionals:

• Unified credit against estate tax:The basic exclusion amount is $11,700,000 for determining the amount of the unified credit against estate tax under Sec. 2010.
• Valuation of qualified real property in decedent’s gross estate:If the executor elects to use the special-use-valuation method under Sec. 2032A for qualified real property, the aggregate decrease in the value of the qualified real property resulting from electing to use Sec. 2032A for purposes of the estate tax cannot exceed $1,190,000.
• Gift tax annual exclusion: The gift tax annual exclusion for gifts of a present interest is $15,000. The gift tax annual exclusion for gifts of a present interest to a spouse who is not a U.S. citizen is $159,000.
• Interest on a certain portion of estate tax payable in installments: The dollar amount used to determine the “2-percent portion” (for purposes of calculating interest under Sec. 6601(j)) of the estate tax extended as provided in Sec. 6166 is $1,590,000.

Footnotes

¹Estate of Morrissette, T.C. Memo. 2021-60.

²Estate of Jackson, T.C. Memo. 2021-48.

³Estate of Warne, T.C. Memo. 2021-17.

⁴Olson, 292 U.S. 246 (1934).

⁵REG-114615-16, 86 Fed. Reg. 21246-02.