I. Disputes Involving Sales of Assets to Grantor Trusts Reach the Tax Court
In Estate of Woelbing v. Com’r, Docket No. 30261-13, filed on December 26, 2013, the IRS made several arguments seeking to negate the tax benefit sales of stock to grantor trusts based upon Rev. Rul. 85-13. That ruling stated that no realization event for federal income tax purposes occurs when a taxpayer sells an asset to a grantor trust. While the sale is invisible for income tax purposes, practitioners had concluded that the same was not the case for gift and estate tax purposes. Thus, sales to grantor trusts were made which were presumptively complete for transfer but not for income tax purposes. These sales shifted appreciation out of the grantor’s estate, while at the same time resulted in the income tax for the grantor trust being attracted like a magnet to the grantor. This permitted trust assets to appreciate without the imposition of yearly tax. An added bonus of this planning technique was that the payment of the income tax of the trust by the grantor was not deemed to constitute a gift to the trust.
Risks associated with this estate planning transaction had always been presumed to exist. However, it appeared that careful tax planning could minimize those risks. The IRS in Estate of Woelbing has fired the first salvo in contesting the sale of assets to “defective” grantor trusts, as has been their sobriquet.The IRS first argued that the promissory note received in exchange for the sale of stock was undervalued, and that the difference between the value of the Note and the actual value of the stock transferred constituted a taxable gift. The IRS then argued that that the stock should be included in the decedent’s estate under IRC §§ 2036 and 2038 as “retained” interests. Finally, the Service asserted that a 20 percent underpayment penalties amounting to more than $25 million should be imposed.
The principal hurdle that the taxpayer in Woelbing — as in other cases — must surmount, aside from ensuring that the formalities of the transfer are well documented, and that the transaction is bona fide, is that the promissory note received in exchange for the assets (i) constitutes debt rather than equity and (ii) is fairly valued. One way of ensuring that the Note is bona fide debt is transfer to trust sufficient assets such that there are sufficient assets to satisfy the Note even if the trust has an income deficit.In practice, the requirement of the promissory note comprising debt has been accomplished by making a gift of “seed” money into the trust prior to the sale. If the trust produces just enough income such that the Note is satisfied, it begins to look as if the transferor has retained an interest in the transferred assets such that Section 2036 comes into play. If ample trust assets assure that the terms of the Note will indeed be repaid without incident, the Note will more likely have independent significance. It will be interesting to see how Woelbing is decided. As insurance against a successful IRS argument that the promissory note is undervalued, trusts have been drafted to contain formula clauses shifting any excess value that could be deemed a taxable gift, to an entity for which a deduction was available.
* * *
Until Woelbing is decided, some have suggested that GRATs be used frequently, at least for extremely wealthy individuals. However, GRATs are like the Model T of estate planning — their time has passed. GRATs are much less effective as estate planning vehicles than are sales to trusts, and are generally inferior to other estate-planning strategies. While one well-known tax practitioner has suggested that GRATs be rehabilitated at least until one gets a sense of how disputes involving sales to grantor trusts will be resolved, this approach has little to commend it. The sensible approach, suggested by Dennis Belcher at the University of Miami tax conference in Orlando in January is that clients should be advised of the current litigation involving sales to grantor trusts, but having been made aware of the risk, are competent to make their own decision as to whether or not to fly into the turbulence hoping, as most do, that sales to grantor trusts will end up being vindicated for tax purposes.
Interestingly, other speakers at the Orlando conference noted that for all but fewer than one percent of taxpayers, sophisticated tax planning involving sales to grantor trusts (or GRATs for that matter) is no longer even necessary, given the combined spousal exemption amount which is now more than $10.86 million. Since 2012, 87 percent fewer federal estate tax returns have been filed. Although it may be a slight overstatement, it is clear that income tax planning has now taken center stage, and federal estate tax planning has been relegated in importance. New York state estate tax planning is still important, however, at least until 2019, when New York’s exemption reaches parity with the Federal exemption amount.
Despite efforts to abolish it, the federal estate tax appears to have a considerable life expectancy since it generates considerable revenues even though the tax reaches only a fraction of a percent of all taxpayers. Abolishing the estate tax appears to be an excellent “talking point” for Republicans, but no one seems to care very much about eliminating the estate tax. In fact. President Obama indicated that he favored reducing the federal exemption amount. Given the current makeup of Congress, Mr. Obama’s position appears to have scant likelihood for success. In the end, Congress appears unlikely likely to forego this source of revenue which is imposed on only a few thousand taxpayers, regardless of who next occupies the White House.
II. Corporate Goodwill
Several cases involving the taxation of goodwill in the context of the sale of a corporate enterprise were decided. To avoid a successful IRS assertion that goodwill belongs to the corporation rather than to the individual, taxpayers should understand both positive and negative factors which affect that determination, and plan accordingly. Goodwill, for federal tax purposes was defined by Justice Story as “[t]he advantage or benefit, which is acquired by an establishment . . . in consequence of the general public patronage and encouragement, which it receives from habitual customers, on account of its local position, or common celebrity, or reputation for skill or affluence.”
Courts have recognized two types of goodwill: “Business Goodwill” and “Personal (or professional) Goodwill.” Business goodwill refers to going-concern value, or goodwill attaching to the enterprise. Personal goodwill, on the other hand, takes into consideration the seller’s reputation and expertise, and may be considered separate and apart from the assets of the firm. When applied to professional businesses, such as medical practices, the term personal goodwill is often referred to as “Professional Goodwill.” One author provides an example of personal goodwill in a medical practice: “[I]f a doctor was a neurosurgeon with extensive experience, an excellent reputation for successfully treating highly complex and difficult neurological problems, and a good bedside manner, it is likely that patients would come to see the doctor not because of an established practice with a solid reputation in a particular locale, but because of the surgeon’s unique skills, abilities, and reputation.”
Several cases involving professional service corporations inform the contours of what may be properly characterized as professional goodwill. In Norwalk v. Com’r, T.C. Memo 1998-279 (1989), the Tax Court held that in the absence of a noncompetition agreement or other agreement with the corporation whereby goodwill in connection with existing clients became the property of the corporation, the goodwill constituted professional goodwill, since the clients had no meaningful value to the corporation. However, in Schilbach v. Com’r, T.C. Memo 1991-556, a different (and adverse) result was reached where the Court found that the sole shareholder of a professional corporation was unable to obtain malpractice insurance, was leaving the state, and it appeared doubtful that the physician would “set up a new practice in direct competition with [the purchaser].”” The Court in Schilbach imposed a 25 percent accuracy-related penalty under [then] IRC § 6661.
In a more recent case, Howard v. United States, No. 10-35768, decided by the Ninth Circuit Court of Appeals in 2011, the Court noted that “there is no corporate goodwill where ‘the business of a corporation is dependent upon its key employees, unless they enter into a covenant not to compete with the corporation or other agreement whereby their personal relationships with clients become property of the corporation’; Martin Ice Cream Co., 110 T.C. at 207-08 (finding that “personal relationships . . . are not corporate assets when the employee has no employment contract [or covenant not to compete] with the corporation.’; Macdonald v. Com’r, 3 T.C. 720, 727 (1944) (finding “no authority which holds that an individual’s personal ability is part of the assets of the corporation . . . where . . . the corporation does not have a right by contract or otherwise to the future services of that individual.” In determining whether goodwill has been transferred to a professional practice, we are especially mindful that “each case depends upon particular facts. And in arriving at a particular conclusion . . .we take into consideration all the circumstances . . . [of] the case and draw from them such legitimate inferences as the occasion warrants.” Grace Brothers v. Com’r, 173 F.2d 170, 176 (9th Cir. 1949).
In Howard, the Ninth Circuit found that the taxpayer’s dental practice was the property of the “Howard Corporation” and its sale did not generate professional goodwill. The purchase contract did recite that “[t]he personal goodwill of the [p]ractice . . . [was] established by Dr. Howard . . . [and] is based on the relationship between Dr. Howard and the patients.” However, in rejecting the significance of the contractual language, and in affirming an order of summary judgment in favor of the IRS, the Ninth Circuit concluded that the purchase agreement did not reflect the “realities” of the transaction, noting: “By now it is well established that “the incidence of taxation depends upon the substance, not the form of [a] transaction.” Com’r v. Hansen, 360 U.S. 446, 463 (1959). . . Self-serving language in a purchase agreement is not a substitute for a careful analysis of the realities of the transaction.”
* * *
In Bross Trucking v. Com’r, T.C. Memo 2014-17, the IRS alleged that where the sons succeeded to father’s business, which suffered a loss of goodwill from negative publicity, the assets of the company were distributed to father as ordinary income, and that father made a gift of the corporate goodwill to sons. The Tax Court held for the taxpayer, finding that there was little corporate goodwill for the corporation to have distributed. Citing to Martin Ice Cream v. Com’r, 110 T.C. 189 (1998), the Tax Court found that corporate goodwill was lacking, since (i) Mr. Bross had no employment or noncompetition agreement with Bross Trucking; (ii) clients patronized Bross Trucking by reason of the relationships “forged” by Mr. Bross; (iii) goodwill was “the expectation of continued patronage,” the regulatory problems encountered by Bross Trucking actually resulted in a loss of corporate goodwill; (iv) the sons of Mr. Bross had personally “cultivat[ed]” relationships with clients; and accordingly (v) the sons’ profiting thereby from “independently created relationships” was not the same as “receiving transferred goodwill.””
III. Adequate Disclosure on Gift Tax Returns
The three-year period of assessment for timely filed gift tax returns presumes that “adequate disclosure” has been made. In Estate of Sanders v. Com’r, T.C. Memo 2014-100, the estate argued in a motion for partial summary judgment that the statute had run on the ability of the IRS to challenge the value of the gift. The Tax Court cited Reg. §301.6501(c)-1(f)(2)(iv) for the proposition that a gift is adequately disclosed if the taxpayer provides a “detailed description of the method used to determine the fair market value of the property.” In this case, the Tax Court denied the motion for partial summary judgment, concluding that a genuine dispute existed as to whether the gift tax returns adequately disclosed the value of the gift. Although the Regulations do not explicitly require that the taxpayer engage an expert to value a gift when preparing a gift tax return, it may make sense to do so anyway. If no expert appraisal for a large gift is made at the time of the gift, it may be necessary to engage an expert later — even after the donor dies — if the IRS challenges the adequacy of initial disclosure, as it did in Estate of Sanders. It may be more difficult at a later time to accurately value the gift. Gifts of some assets, such as real estate, may be far easier to value at the time of the gift, rather than many years later. Other gifts, for example, the gift of a rare coin, might not be more difficult to value at a later time.
IV. Overpayment of Estate Tax Applied to Deferred Portion of Tax
In Estate of McNeely v. U.S., 2014 WL 2617418, USTC §60679 (D. Minn. 2012), the estate made an estimated estate tax payment of $2.494 million. The estate also sought to defer payment of estate tax under IRC §6166. The estate tax return when filed showed an actual nondeferrable estate tax liability of only $512,226. The request by the estate for a refund of $1.9179 million was denied. The District Court for Minnesota held for the government in a refund action brought by the estate, reasoning that under IRC §6402, the IRS may in its discretion credit an overpayment to an outstanding tax liability.
V. 3.8 Percent Net Investment Income Tax
In Frank Aragona Trust v. Com’r, 142 T.C. No 9 (2014), the trust conducted real estate operations through an LLC. The children of the deceased grantor were trustees. The issue was whether the 3.8 percent tax on net investment income applied to the trust, which claimed that through its activities which were “regular, substantial and continuous,” the trust qualified as a “real estate professional,” and could therefore deduct its rental real estate losses. At issue was also whether the trust materially participated in the real estate activities through the trustees. The trust prevailed. The Tax Court ruled that the trust could indeed qualify as a “real estate professional.” Even though the trust could not itself perform “personal services,” those services could be provided by the trustees. The court also rejected the IRS argument that the trustees did not materially participate in the real estate activities, finding that the trustees were in fact involved in the daily activities of the real estate business.
VI. Conservation Easements
The Second Circuit affirmed a decision of the Tax Court which held that the donation of a conservation easement consisting of the façade of a brownstone in Brooklyn’s Fort Greene Historic District had not been shown to reduce the value of the property, and that the IRS was correct in challenging the charitable deduction taken by the taxpayer under IRC §170(f)(B)(iii). Schneidelman v. Com’r, Docket No. 13-2650 (6/18/2014). [The taxpayer donated the easement and claimed a charitable deduction of $115,000, premised upon the reduction in value of the property by reason of the gift. Following audit, the IRS determined that the taxpayer had not established a fair market value for the easement. The Tax Court agreed and found that the taxpayer was not entitled to claim the deduction because it had not obtained a “qualified appraisal” showing a reduction in value of the property.]
The Court noted preliminarily that its review of factual matters determined by the Tax Court was “particularly narrow when the issue is one of value” and that the conclusion of the Tax Court must be upheld if supported by “substantial evidence.” The Court then recited the familiar precept that the fair market value of property is based upon a hypothetical willing buyer–willing seller rule. The Court acknowledged that while encumbrances on real property generally reduce value, the grant of a conservation easement may, according to the regulations, increase the value. In the instant case, the appraisal the taxpayer obtained failed to take into account the particular facts and circumstances. The appraiser merely opined as to an IRS “accepted range” of percentages, which was inadequate.
The IRS, on the other hand, analyzed “the particular terms of the easement, zoning laws, and regulations” and concluded that the grant of the easement did not materially affect the value of the property. Ironically, the witness proffered by the taxpayer — the Chairman of the Fort Greene Association — testified that the Fort Greene Historic District was an “economic engine,” from which the Tax Court had properly concluded that the preservation of the façade was a benefit, rather than a detriment, to the property. The case underscores the importance of obtaining a qualified appraisal. Ironically, even if the taxpayer had been armed with a qualified appraisal, she would probably not have emerged victorious. Courts have been skeptical of deductions taken for conservation easements for good reason. It is difficult to perceive how promising not to destroy the façade of an historic building could reduce its value.