Two Court Cases Provide Significant Developments

Two Court Cases Provide Significant Developments

The background of COVID-19 and the presidential election made for a bumpy road.

March 10, 2021

The year 2020 was destined to be turbulent as a presidential election year. The arrival of COVID-19 with business lockdowns, government payments, work-from-home and personal health issues has resulted in the bumpiest year in recent memory. Typically, new legislation or case law triggers a surge in estate planning and valuation activity. This year, COVID-19 reminded us of our mortality, and the stark differences in the tax programs of the presidential candidates raised uncertainty of what future legislation will bring. Permanent tax laws passed in 2017 seem less on solid ground and more on shifting sand.

The timeline for the pandemic shaped 2020 from the start.[1] On Dec. 31, 2019, the government of Wuhan, China first confirmed dozens of cases. By March 13, the United States had declared a national emergency, and by March 23, the S&P 500 had fallen more than 30% from the close of 2019 to its low of 2237. Despite the unique circumstances affecting all aspects of our lives this year, there were some significant developments contained in this year’s cases. 

Game Theory Takes a Loss

Pierson M. Grieve v. Commissioner[2] may be a case with sustained implications. Pierson M. Grieve was a successful businessman who spent an appreciable part of his career as the chairman and CEO of the publicly traded Ecolab, a Fortune 500 industrial company. After his wife’s passing in 2012, Pierson and his family updated their estate plan by setting up two limited liability companies (LLCs) to act as investment entities to aggregate and manage the family’s wealth. The basic structure of the two LLCs mirrored that found in many family limited partnerships. The ownership of the two LLCs consisted of a 0.2% controlling voting manager interest and a 99.8% nonvoting interest. In this case, the 0.2% controlling voting interest was owned by Pierson M. Grieve Management, an entity controlled by Pierson’s daughter, while the 99.8% nonvoting interest was owned by a Grieve family trust. Pierson gifted the 99.8% nonvoting interests in the two entities and reported discounted noncontrolling interest values on his gift tax return. The Internal Revenue Service audited the return and proposed revised values for the transfers, which resulted in a gift tax deficiency of approximately $4.4 million.

The IRS expert put forth a theoretical construct involving game theory (a strategic interaction to optimize decision making of independent and competing players). The theory presented to the court was that a hypothetical seller of the 99.8% nonvoting interest in the two LLCs wouldn’t part with the interest at a large discount to the net asset value (NAV). Rather, the owner of the 99.8% nonvoting interest would seek to enter into a transaction to acquire the 0.2% controlling voting interest from the current owner of that interest. Doing so would consolidate ownership to 100% and eradicate the diminution in value resulting from lack of control and marketability.

To numerically support this theoretical construct, the IRS expert assumed that the owner of the 99.8% nonvoting interest would pay the controlling 0.2% voting member a premium above its undiscounted pro rata NAV. In his valuation, the IRS expert estimated that an approximate 28% discount to the NAV was appropriate for the 99.8% nonvoting interest using a traditional discount methodology. Rather than accepting this discount, the IRS expert proposed that the owner of the 99.8% nonvoting interest would be willing to pay a portion of the dollar amount of the discount from NAV to purchase the 0.2% controlling voting interest at a premium to its pro rata value.

The IRS expert concluded that an appropriate discount for the 99.8% nonvoting interest would be approximately 1.5% for both entities based on speculation that giving up 5% of the otherwise applicable dollar discount from the NAV would be a sufficient premium to entice the owner of the 0.2% controlling voting interest to sell the interest. In a zero-sum game theory, each rational party would seek to maximize their benefit. If that were to be the case here, as the foundation of the IRS argument purports, the owner of the 0.2% controlling interest would rationally negotiate and accept a premium to pro rata value.

In considering the IRS argument, the court cited guidance from Olson v. United States:[3]

Elements 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—a thing to be condemned in business transactions as well as in judicial ascertainment of truth. 

The court accepted the taxpayer’s discounted noncontrolling interest values and rejected the IRS expert’s game theory valuation approach in its entirety, concluding that any construct involving the hypothetical purchase of the voting interest wasn’t reasonably probable. Grieve reaffirms the fair market value standard between hypothetical willing sellers and buyers of the specific interest at issue with the court’s statement that:

To determine the fair market values of the class B units we look at the willing buyer and willing seller of the class B units, and not the willing buyer and willing seller of the class A units.[4]

Loan or Gift?

A parent’s inclination to help a child who’s struggling financially runs afoul of gift tax provisions. In Estate of Mary P. Bolles v. Comm’r,[5] the Tax Court addressed the issue of whether a mother’s advances to her children were loans or gifts. Mary Boyle was a mother of five who desired to provide assets to her children equally. She kept records of advances to each child as well as each child’s repayments. The advances were treated as loans, and she forgave the loan account of each child annually based on the then-gift tax annual exemption amount. The court interestingly indicated that “her practice would have been noncontroversial but for the substantial funds she advanced to Peter.”[6]

The advances/loans to children began after the death of Mary’s husband in 1983. By 1988, one of the children, Peter, who had taken over his father’s architecture practice, failed to make any repayments due to his financial difficulties. To assist her son, beginning in 1985, Mary periodically advanced her son a total of more than $1 million over a period of 23 years. 

By 1989, reality set in that equalization among the five children would be distorted, and Mary established a revocable trust that specifically excluded her son from any distributions from her estate on her death. She amended her trust in the mid-1990s to no longer specifically exclude her son from distributions from her estate, but provided a formula to account for the loans made to him during her lifetime plus accrued interest.

Both the IRS and estate looked to Miller v. Comm’r[7] for factors to decide whether an advance is a loan or a gift. Those factors are whether: (1) there was a promissory note or other evidence of indebtedness, (2) interest was charged, (3) there was security or collateral, (4) there was a fixed maturity date, (5) a demand for repayment was made, (6) actual repayment was made, (7) the transferee had the ability to repay, (8) records maintained by the transferor and/ or the transferee reflect the transaction as a loan, and (9) the manner in which the transaction was reported for federal tax purposes is consistent with a loan.

The court observed that “in the case of a family loan, it is a longstanding principle that an actual expectation of repayment and an intent to enforce the debt are critical to sustaining the tax characterization of the transaction as a loan.”[8] Although Mary kept a record of the advances and interest, there were no loan agreements, collateral or collection actions. By her actions in 1989 when she excluded her son from distributions from her estate, it suggests that her expectation that her son could repay the advances had changed.

The court concluded that after 1989, the advances lost the characteristics of loans for tax purposes and were gifts to her son because Mary then realized she was unlikely to be repaid. 

This case reinforces the importance of having written loan documents, security for the loan and a debtor with the ability to repay. 

Looking Forward

The year 2021 will begin a new presidential administration, bringing with it tax policy changes. It appears all the movement is in the direction of higher tax rates and lower exemptions for trust and estate clients. Taxpayers and their advisors may face a wealth tax, higher gift and estate tax rates and lower exclusion amounts, which will provide a catalyst for tax avoidance planning.

The IRS has published the inflation-adjusted estate and gift tax exclusions for 2021.[9] The basic exclusion amount for the unified credit against estate tax will increase from $11.58 million per individual in 2020 to $11.7 million in 2021 (or $23.4 million per married couple). The annual exclusion for gifts will remain at $15,000 per individual. The sunsetting of the estate exclusion amount back to $5 million adjusted for inflation remains scheduled to begin in 2026, after the next presidential election. However, President-elect Biden has proposed restoring estate and gift taxes to their 2009 level: $3.5 million per individual for the estate tax, $1 million for the gift tax and a top estate tax rate of 45%. Stay tuned for how much, if any, of the estate and gift tax proposals are enacted. 

This is article originally appeared in the January 2021 issue of Trusts & Estates magazine.

  1. Derrick Bryson Taylor, “A Timeline of the Coronavirus Pandemic,” The New York Times (April 7, 2020).
  2. Pierson M. Grieve v. Commissioner, T.C. Memo. 2020-28 (March 2, 2020).
  3. Olson v. United States, 292 U.S. 246, 257 (1934).
  4. See supra note 2, at p. 34.
  5. Estate of Mary P. Bolles v. Commissioner, T.C .Memo. 2020-71 (June 1, 2020).
  6. Ibid., at p. 3.
  7. Miller v. Commissioner, T.C. Memo. 1996-3, aff’d, 113 F.3d 1241 (9th Cir. 1997).
  8. Ibid., at p. 10.
  9. Revenue Procedure 2020-45.