Succession Planning and Charitable Bequests: It Pays to Sweat the Details
March 25, 2019
After Me, Who Cares?
In the context of a family-owned business, managerial succession and the transfer of ownership – not necessarily the same thing – can turn into quite an adventure when they are not well-planned.
Let’s begin with the premise that the business is owned and managed by at least one parent. As is the case with most organizations, there are persons who have a vested interest in the uninterrupted and unchanged operation of the business; there are also those who desire change, sometimes for bona fide business reasons, sometimes for purely selfish ones. Also as in the case of other organizations, there is often a strong leader in the business who holds these competing interests at bay, or who knows how to balance them or play them off of one another.
When this moderating or controlling force – i.e., the parent upon whose continued goodwill all of the competing interests depend – is no longer present, well, that’s when the adventure begins, at least where the parent has failed to provide for a transition of ownership and management in a way that effectively deals with these competing forces.
Coming Out of the Woodwork
Speaking of competing interest-holders, there may be many who will become more active or vocal following the death of a parent where the latter has failed to provide an effective “Plan B” to be implemented upon[i] their demise; these include, for example, a surviving spouse, children-in-the-business, children-not-in-the-business-but-dependent-on-it, children-not-in-the-business-and-independent-of-it,[ii] key employees of the business, business partners (such as vendors or customers), charitable organizations of which the parent or the business was a benefactor, and others. Many, if not most, of these interest-holders will take a very self-centered approach toward the resolution of those ownership and management issues that were not adequately addressed by the parent.
In some cases, the parent may have inadvertently (or not) placed one or more of these interest-holders into positions from which they can exert substantial influence over the outcome. For example, a child-in-the-business may have been placed into a key executive position in the business; another child may have been nominated or appointed to serve as a fiduciary of the parent’s estate or trust, through which the parent’s business interests (or the value they represent) are to be distributed among the parent’s beneficiaries. Sometimes, the same person will end up holding every position of authority. This individual may be ideally situated to steer events as they desire; in doing so, however, they may compromise their fiduciary duties to many of their fellow competing interest-holders, while also running afoul of the Code, as was illustrated by a recent decision.
Decedent’s Plan
Decedent’s estate (“Estate”) included a closely held C corporation (“Corp”) that managed commercial and residential real properties. At the time of Decedent’s death, Son was the president of Corp, and two of his siblings were also employed in the business. Decedent’s other children were not involved in the business.
At her death, Decedent held approximately 81-percent of Corp’s voting shares and approximately 84-percent of its nonvoting shares. The remaining voting shares were held by Son; the remaining nonvoting shares were split between Son and one of his siblings-in-the-business.
Prior to Decedent’s death, Corp’s board had preliminary discussions about purchasing Decedent’s shares as part of ongoing succession planning. In fact, the board resolved that it would “periodically purchase” Decedent’s shares based on terms acceptable to all parties. However, there were no specific redemption agreements, or other shareholder or buy-sell agreements, in place when Decedent unexpectedly died shortly thereafter.
Therefore, in accordance with Decedent’s “pour-over” will,[iii] upon her death, all of the assets owned by her at that time[iv] – including her shares of Corp stock – passed to a trust (“Trust”).
Trust provided for Decedent’s children to receive her personal effects, but no other assets from her Estate. Any assets remaining in Decedent’s Estate would pass to Foundation, a grant-making charitable organization described in Section 501(c)(3) of the Code, and classified as a private foundation.[v] These residuary assets were not intended for Decedent’s family.
Estate Administration
Son was appointed the sole executor of Estate, the sole trustee of Trust, and the sole trustee of Foundation. Son also remained the president of Corp.
To determine the value of Decedent’s Corp shares for “estate administration purposes” – including the filing of an estate tax return – Son obtained an independent appraisal of Corp, which determined that Corp’s value as of Decedent’s date of death was approximately $17.8 million, and that Decedent’s shares in Corp were worth approximately $14.2 million (a market value of approximately $1,824 per voting share and of $1,733 per nonvoting share).
After Decedent’s death, Son caused Corp to convert from a C corporation to an S corporation, in order to accomplish certain “long-term tax planning goals.”[vi]
Redemption?
Corp’s board also decided, presumably at Son’s “suggestion,” that it would redeem from Trust all of Decedent’s Corp shares, which were to pass to Foundation.[vii] Among the reasons put forth by the board for the decision to redeem these shares was its concern about the tax consequences of Foundation owning shares in an S corporation – presumably, the treatment of Foundation’s pro rata share of S corporation income as unrelated business income.[viii]
[Based upon what followed, however, some may conclude that a motivating factor was to divert value from Foundation to Son; others may determine that it was to preserve value in the business, which is not necessarily the same thing.[ix]]
Initially, Corp agreed to redeem all of Decedent’s shares for approximately $6.1 million. This amount was based on a much earlier appraisal, since the date-of-death appraisal had not yet been completed. As a result, the redemption agreement provided that the stated redemption price would be “reconciled and adjusted retroactively” to reflect the fair market value of the shares as of the effective date of the redemption. Corp executed two interest-bearing promissory notes payable to Trust in exchange for its shares; each note was adjustable retroactively, depending on the new appraisal value.
At the same time, Son and his in-the-business-siblings entered into separate subscription agreements to purchase additional Corp shares, in order to provide funding for Corp to meet the required payments on the promissory notes, and to establish their own, relative shareholder interests in Corp.
Redemption Appraisal
Then, at the direction of Corp – i.e., Son – yet another appraisal of Decedent’s Corp shares was undertaken, specifically for the purpose of the redemption. This time, Son instructed the appraiser to value Decedent’s shares as if they represented a minority interest in Corp.[x] The appraisal, therefore, included a 15-percent discount for lack of control and a 35-percent discount for lack of marketability.[xi] As a result, Decedent’s Corp shares were valued much lower in the redemption appraisal than in the date-of-death appraisal: $916 per voting share and $870 per nonvoting share.[xii]
Corp then determined that it could not afford to redeem all of Decedent’s shares, even at the new redemption appraisal price. The redemption agreement was amended, and Corp agreed to redeem all of Decedent’s voting shares and most, but not all, of her nonvoting shares for a total purchase price of approximately $5.3 million.
Post-Redemption
The state probate court approved the redemption agreement and indicated that the redemption transaction and the seller-financing represented by the promissory notes would not be acts of prohibited self-dealing.[xiii]
After the redemption agreement was implemented, Corp’s share ownership was as follows: (1) Trust owned 35-percent of the nonvoting shares; (2) Son owned 69-percent of the voting shares and 48-percent of the nonvoting shares; and (3) the in-the-business-siblings owned 31-percent of the voting shares and 17-percent of the nonvoting shares.
Trust subsequently distributed the promissory notes (received from Corp in exchange for Decedent’s voting shares and most of her nonvoting shares) and Decedent’s remaining nonvoting shares to Foundation.
Tax Reporting
Foundation reported the following contributions on its annual tax return, based upon the redemption appraisal:[xiv] a noncash contribution of Corp nonvoting shares with a fair market value of $1.86 million; and notes receivable with an aggregate fair market value of $5.17 million.
The Trust reported a capital loss on its annual income tax return for the sale of Decedent’s voting shares and for the sale of most of Decedent’s nonvoting shares, based on the greater date of death appraisal.[xv]
Estate filed its Federal estate tax return,[xvi] on which it claimed a charitable contribution deduction[xvii] based on the date-of-death value of Decedent’s Corp shares, and reporting no estate tax liability.[xviii]
The IRS examined Estate’s Form 706 and issued a notice of deficiency in which it asserted an estate tax deficiency in excess of $4 million, based on a lower charitable contribution deduction – specifically, the amount actually distributed from Trust to Foundation.
Estate filed a timely petition in the Tax Court challenging the IRS’s assertion. Estate argued that it correctly used the date-of-death appraisal to determine the value of Decedent’s Corp shares for purposes of the charitable contribution deduction.
The IRS responded that post-death redemption of Decedent’s Corp shares should be considered in determining the value of the charitable contribution, because Son’s actions reduced the value of Decedent’s contribution to Foundation.
The Tax Court upheld the IRS’s reduction of Estate’s charitable contribution deduction and the resulting increase in its estate tax liability. The Tax Court found that “post-death events” – primarily Son’s decision to redeem Corp shares from Trust based upon an appraisal that applied a minority interest discount to the redemption value of such shares – reduced the value of the contribution to Foundation and, therefore, reduced the value of Estate’s charitable deduction.
Estate timely appealed the Tax Court’s decision to the Ninth Circuit.[xix]
Court of Appeals
Estate argued that the Tax Court erred by taking into account “post-death events” – that decreased the value of the property delivered to Foundation – in determining the value of the charitable deduction. Instead, Estate asserted that the charitable deduction should have been valued and determined as of Decedent’s date of death. The Court rejected Estate’s argument.
Charitable Deduction
The Court began by noting that the “estate tax is a tax on the privilege of transferring property” after one’s death. The estate tax “is on the act of the testator,” the Court explained, “not on the receipt of the property by the legatees.”
Because the estate tax is a tax on a decedent’s bequest of property, the valuation of the gross estate is typically done as of the date of death.[xx] Except in some limited circumstances, the Court added, post-death events are generally not considered in determining an estate’s gross value for purposes of the estate tax.
A related provision, the Court continued, “allows for deductions from the value of the gross estate for transfers of assets to qualified charitable entities.”[xxi] This deduction generally is allowed “for the value of property included in the decedent’s gross estate and transferred by the decedent . . . by will.”
The Court then explained that the purpose of the charitable deduction is to encourage charitable bequests, not to permit executors and beneficiaries to rewrite a will so as to achieve tax savings.
“Valuing” the Deduction
According to the Court, deductions are valued separately from the valuation of the gross estate.[xxii] Separate valuations, it noted, allow for the consideration of post-death events.
The Court then discussed the seminal case on the subject of the valuation of a charitable bequest.
The Court explained that in Ahmanson Foundation v. United States,[xxiii] the decedent’s estate plan provided for the voting shares in a corporation to be left to family members and the nonvoting shares to be left to a charitable foundation. The court there held that, when valuing the charitable deduction for the nonvoting shares, a discount should be applied to account for the fact that the shares donated to the charity had no voting power. That a discount was not applied to the value of the nonvoting shares in the gross estate did not impact the court’s holding. Significantly, the court recognized that a charitable deduction “is subject to the principle that the testator may only be allowed a deduction for estate tax purposes for what is actually received by the charity.”
In contrast, Estate argued that the charitable deduction must be valued as of the date of Decedent’s death, in keeping with the date-of-death valuation of an estate.
The Court disagreed. Valuations of the gross estate and of a charitable deduction are separate and may differ, it stated. According to the Court, while a decedent’s gross estate is fixed as of the date of their death, deductions claimed in determining the taxable estate may not be ascertainable or even accrue until the happening of events subsequent to death.[xxiv]
The Court continued, “[t]he proper administration of the charitable deduction cannot ignore such differences in the value actually received by the charity.” This rule prohibits crafting an estate plan or will, it stated, so as to game the system and guarantee a charitable deduction that is larger than the amount actually given to charity.
The decision in Ahmanson compelled the affirmation of the Tax Court’s ruling in the case considered here. Decedent structured her Estate so as not to donate her Corp shares directly to Foundation, but to Trust. She enabled Son to commit almost unchecked abuse of the Estate by nominating him to be executor of her estate, trustee of Trust, and trustee of Foundation, in addition to his roles as president, director, and majority shareholder of Corp.
According to the Court, Son improperly directed the appraiser to determine the redemption value of the Corp shares by applying a minority interest valuation, when he knew they represented a majority interest, and that Estate had claimed a charitable deduction based upon a majority interest valuation.
Through his actions, Son manipulated the charitable deduction so that Foundation only received a fraction of the charitable deduction claimed by Estate. In doing so, he enhanced the value of Corp, of which he was now the principal shareholder.
Estate attempted to evade Ahmanson by arguing that its holding was limited to situations where the testamentary plan itself diminished the value of the charitable property. The Court rejected this reading, stating that Ahmanson “was not limited to abuses in the four corners of the testamentary plan”; rather, the Court responded, it extended to situations where “the testator would be able to produce an artificially low valuation by manipulation.”[xxv]
The Court found that the Tax Court had correctly considered the difference between the deduction claimed and the value of the property actually received by the charity due to Son’s manipulation of the redemption appraisal value.
The Court also found that there was nothing in the record to suggest that the Tax Court’s findings were clearly erroneous. Instead, it found that Son, in his capacity as the executor and heir to Decedent’s shares, claimed a large charitable deduction based on the value of Estate property at the time of death, only to manipulate the property’s value for personal gain, deliver assets to Foundation worth substantially less than the amount claimed as a deduction, and received a windfall in the process.
In light of the foregoing, the Court sustained the estate tax deficiency.
Plan B
It is a foregone conclusion – the parent/owner/CEO of the family-owned business is either going to die on the job or retire from the job.
When that happens, they are going to leave their family with what is likely a very valuable, but illiquid, asset: the business. The business will likely represent the lion’s share of the parent’s gross estate. It is also possible that several members of the family earn their livelihoods in the business, while other members may depend upon it in some fashion for part of their support.
The removal of the parent may unleash many of the competing interests identified earlier, which in turn may result in these interest-holders’ losing sight of the one thing they have in common: the preservation of the business on which they all depend, of its ability to generate cash flow, and of the value it represents.
The first great challenge to this unifying principle will be the Federal and State estate taxes that are imposed upon the disposition of, and that are payable by, the parent’s estate.[xxvi]
The next challenge will be the faithful execution of the parent’s estate plan without compromising the business.
Both may be satisfactorily addressed if they are planned for while the parent is alive and well, if the competing interest-holders are brought into the discussion, if qualified advisers are consulted, and if guardrails are installed; for example, in the form of shareholders/partnership agreements, life insurance on the parent – which, in the case described above, could have been used by Corp to fund the very foreseeable buy-out of Foundation without compromising Corp’s business or forcing Son into an aggressive valuation posture – employment or incentive compensation agreements for key employees, and the appointment of fiduciaries to the parent’s estate or trust who understand the parent’s wishes and who are familiar with the various interest-holders.[xxvii]
Of course, if the parent truly does not care what happens to the business after their death – and we’ve all experienced such individuals – then the tax adviser’s job becomes one of damage control.
[i] In the minds of many parents, “in the event of.”
[ii] Yes, I’m making up words – the hyphen is a wonderful tool, similar to the compound word, which simply omits the hyphen, but can you imagine reading “childrennotinthebusiness”? You’d think I was writing in German. Donaudampfschiffahrtsgesellschaftskapitän, for example, means “Danube steamship company captain.” First French, now German. It’s all Greek to me.
[iii] In general, a will that does not provide for any disposition of a decedent’s assets beyond directing them to a trust created by the decedent during their lifetime; this trust provides for the detailed disposition of the assets poured over from by will; it also provides for the disposition of any assets that may have been transferred by the decedent to the trust during their lifetime. Of course, any assets that may have been owned by the decedent jointly with another with rights of survivorship would have passed to the surviving co-owner, beyond the reach of the will or trust. Similarly, assets for which the decedent contractually named a successor to their interests therein (e.g., a retirement plan account) may pass outside the will or trust.
[iv] Basically, her probate assets.
[v] IRC Sec. 509(a); i.e., not publicly supported.
[vi] At that point, Son owned or controlled all of Corp’s voting shares and almost all of its non-voting shares. He was probably planning for the ultimate sale of the business and looking to avoid the two levels of tax attendant on an asset sale by a C corporation, as well as the built-in gains tax applicable to former C corporations under IRC Sec. 1374.
[vii] Other reasons proffered by the board included the following: that the shares did not provide enough liquidity for Foundation to distribute 5 percent of its funds annually as required by IRC Sec. 4942; and that “freezing” the value of Foundation’s Corp shares via their sale could prevent future decline in value given the poor economic climate. These pass the smell test.
[viii] IRC Sec. 512(e). Of course, at Decedent’s death, Corp was a C corporation, so the issue of unrelated business income was not considered. Should it have been? In any case, no mention was made of the excess business holding rule under Sec. 4943, which would have been applicable either way, and under which Foundation would have five years (maybe more) to dispose of the Corp shares – a disposition that would have required the removal of value from the business, and for which no provisions were made.
[ix] I can’t entirely blame Son. He worked in the business, was its president, and had just become its controlling shareholder. He was given the task of balancing his desire to run the business as he sees fit against his duty to a new shareholder, the charity. Then he was “forced” to remove significant value from the business – no small matter – and transfer it to a charity.
[x] The appraiser testified that he would not have done so without these instructions. Query why the appraiser agreed to follow these instructions, at least with respect to the LOC discount.
[xi] Query why a LOM discount was not claimed for purposes of the Form 706. What was the appraiser thinking? That it wouldn’t make a difference because he incorrectly believed that the valuation of the shares for purposes of the gross estate would also provide the valuation for purposes of the taxable estate; i.e., for purposes of determining the amount of the charitable deduction)? Might as well get a higher stock basis?
[xii] Compared to the $1,824 per voting share and of $1,733 per nonvoting share date of death values determined.
[xiii] See the Reg. Sec. 53.4941(d)-1(b)(3) exception to indirect self-dealing.
[xiv] Form 990-PF, Return of Private Foundation.
[xv] Form 1041 Tax Return.
[xvi] On IRS Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return.
[xvii] Schedule O to the Form 706.
[xviii] The combined effect of the unified credit, the charitable deduction, and any other administration expenses.
[xix] IRC Sec. 7482.
[xx] IRC Sec. 2031; Reg. Sec. 20.2031-1(b).
[xxi] IRC Sec. 2055(a); Reg. Sec. 20.2055-1(a).
[xxii] Ahmanson (see below), which stands for “the principle that the testator may only be allowed a deduction for estate tax purposes for what is actually received by the charity.” “The statute does not ordain equal valuation as between an item in the gross estate and the same item under the charitable deduction.”
[xxiii] 674 F.2d 761 (9th Cir. 1981). https://law.resource.org/pub/us/case/reporter/F2/674/674.F2d.761.79-3600.79-3568.html
[xxiv] The Court also pointed out that certain deductions not only permit consideration of post-death events, but require them. “For example, . . . I.R.C. § 2055(c) specifies that where death taxes are payable out of a charitable bequest, any charitable deduction is limited to the value remaining in the estate after such post-death tax payment. Still another provision of the tax code, I.R.C. § 2055(d), prohibits the amount of a charitable deduction from exceeding the value of transferred property included in a gross estate – but, by negative implication, permits such a deduction to be lower than the value of donated assets at the moment of death.”
[xxv] According to the Court, Decedent’s testamentary plan laid the groundwork for Son’s manipulation by concentrating power in his hands—in his roles as executor of the Estate and as trustee of the Trust and of the Foundation—even after Decedent knew of and assented to early discussions of the share redemption plan.
[xxvi] This may include, among other options, consideration of an installment arrangement under IRC Sec. 6166 or of a Graegin loan.
[xxvii] A tall order? Maybe.