The Ninth Circuit recently upheld a 2016 Tax Court case that the charitable deduction for estate taxes was limited to the post-death value of the property actually received by the charity rather than the value of such property that was included in the decedent’s gross estate. 1 Following its decision in Ahmanson Foundation v. U.S., 674 F2d 761 (9th Cir. 1981), the Ninth Circuit again concluded that the value of the estate tax charitable deduction is not necessarily tied the value of such property included in the decedent’s gross estate.
In Ahmanson, shares which were bequeathed to charity were discounted for lack of control for charitable deduction purposes but were not discounted for purposes of valuing the gross estate, and thus the value of the shares received by the charity was less than the value of the shares included in the gross estate resulting in the Ninth Circuit concluding the charitable deduction was limited to the value of the shares received by the charity rather than the value of the shares included in the gross estate. As discussed below, in Dieringer, certain post-death transactions that took place prior to transferring property to the charity resulted in the charity receiving property of a significantly lower value than what the property was valued for purposes of determining the value of the decedent’s gross estate. As in Ahmanson, the Ninth Circuit limited the estate tax charitable deduction to what was actually received by the charity. The Ninth Circuit also affirmed the Tax Court’s holding that the twenty percent (20%) accuracy related penalty under Section 6662(a) of the Internal Revenue Code (the “IRC”) was properly imposed by the Internal Revenue Service (the “IRS”).
The Dieringer family was a large family consisting of twelve children. For purposes of this case, there are four important players, Victoria Dieringer (the “Decedent”) and three of her sons, Eugene, Patrick, and Timothy. They collectively owned a closely-held company named Dieringer Properties, Inc. (“DPI”), a corporation that specialized in managing real estate in the Portland, Oregon area. The Decedent owned 425 of the 525 voting shares (80.9%) and 7,736.5 of the 9,220.5 nonvoting shares (83.9%) (collectively, the “Shares”). Eugene owned the remaining 100 voting shares, and Eugene and Patrick each owned 742 nonvoting shares. Eugene was the president, Patrick was the executive vice president and secretary, Decedent was vice president, and Timothy was the office manager. The board of directors (the “Board”) consisted of Decedent, as chairman, and Eugene, Patrick, Timothy, and an unrelated party named Thomas Keepes as directors.
The Decedent’s estate plan consisted of a pour-over will to a trust which, after distributing out personal effects and approximately $600,000 of other charitable donations, left everything to the Bob and Evelyn Dieringer Family Foundation (the “Foundation”). Eugene was appointed as the executor of the estate, the sole-trustee of the trust, and the sole trustee of the Foundation, with Patrick and Timothy also serving as advisory trustees to the Foundation.
In November of 2008, the Board discussed a plan for DPI to periodically buy back the Decedent’s Shares on terms acceptable to all parties, and the Decedent was in agreement with this plan. However, no specifics were discussed. The Decedent raised the issue again at a Board meeting in February of 2009 and expressed her interest in having DPI purchase her Shares. In anticipation of entering into a purchase agreement for the shares, DPI paid the Decedent $45,000 prior to her death. However, the Decedent unexpectedly died on April 14, 2009 prior to any specific purchase or redemption agreement being in place.
Eugene was appointed as the executor of Decedent’s estate (the “Estate”). He hired Lewis Olds & Associates (“Lewis”) to perform the appraisal of the Decedent’s Shares of DPI. Lewis determined that the value of DPI was $17,777,626 as of the Decedent’s date of death, and the Decedent’s Shares were worth $14,182,471.
In November of 2009, the Board approved the conversion of DPI from a C corporation to an S corporation for federal tax purposes in order to avail DPI and its shareholders to certain benefits available to an S corporation, and at the same time, approved the decision to buy back the Decedent’s Shares which were to be transferred from the Trust to the Foundation. The Board then entered into an agreement with the Trust to redeem all of the Trust’s Shares for $6,071,558, effective as of November 30, 2009, in return for two promissory notes. The agreement called for the stated price to be adjusted based on the fair market value of the Shares as determined by an independent appraisal. At the same time, Eugene, Patrick, and Timothy entered into subscription agreements to purchase shares of DPI in order to provide funding to DPI to redeem the Decedent’s Shares. The Tax Court found there were valid business reasons for both the S election and for the redemption agreement and subscriptions agreements, and this was not disputed or discussed by the Ninth Circuit.
Lewis was hired to perform the appraisal. At the direction and insistence of Eugene, Lewis valued the shares as a minority interest and concluded the voting shares were worth $916 per share, and the nonvoting shares were worth $870 per share, giving the Shares a total value of $7,120,055, a reduction of $7,062,416, nearly 50% from the value of the Shares seven months earlier when valued as of the Decedent’s date of death. For comparison, the net asset value of DPI as a whole were down $1,618,459 during that seven month period. Lewis included a 15% discount for lack of control and a 35% discount for lack of marketability that he had not included in his prior appraisal. At trial, Lewis testified that he did so only at the request of Eugene, and that but for Eugene’s request, Lewis would not have valued the Shares as a minority interest. As a result of the new appraisals, DPI concluded that it could not afford to redeem all of the Decedent’s Shares, and thus agreed to redeem all of the 425 voting shares and 5,600.5 nonvoting shares for total price of $5,262,462. Following the redemption, the Trust now held a short term promissory note, a long term promissory note, and 2,136 nonvoting shares of DPI, all of which were distributed to the Foundation in January of 2011.
For the 2011 tax year, the Foundation reported the following contributions on its Form 990-PF, Return of Private Foundation: (1) a noncash contribution of DPI shares with a fair market value of $1,858,961; (2) a long-term note receivable with a fair market value of $2,921,312; and (3) a short-term note receivable with a fair market value of $2,250,000. The Trust reported a capital loss of $385,934 for the sale of the 425 voting shares and $4,831,439 for the sale of 5,600.5 nonvoting shares for the taxable year ending in December 31, 2009 on its Form 1041 Tax Return. The Estate filed its Form 706, United States Estate Tax Return on July 12, 2010 reporting no estate tax liability. The Estate claimed a charitable contribution deduction of $18,812,181, in part based on Lewis date of death appraisal of the Decedent’s Shares.
The IRS audited the Form 706 and issued a Notice of Deficiency of $4,124,717 along with an accuracy related penalty of $824,943. The Estate challenged the IRS conclusions and took the case to trial with the Tax Court. The Tax Court upheld the IRS conclusions. The Tax Court determined that the redemption plan was not part of the Decedent’s estate plan, and, while there were valid business reasons for the post-death transactions that took place, they resulted in a significant reduction in value to the Shares which passed to charity and therefor a reduction in the value of the Estate’s charitable deduction. In addition, the Tax Court concluded that there was no evidence that the decline in value of the Shares was due to a poor business climate at the time. The Estate appealed to the Ninth Circuit.
Pursuant to Section 2031 of the IRC, the “value of the gross estate of the decedent shall be determined by including to the extent provided for in this part, the value at the time of his death of all property, real or personal, tangible or intangible, wherever situated.” In general, Sections 2033 through 2045 of the IRC govern what property is included in the gross estate when valuing the gross estate under Section 2031. Section 2055 of the IRC provides a deduction against the estate tax for property that is included in the value of the gross estate and which is transferred to charity.
Citing Ahmanson, the Court noted that deductions are valued separately from the valuation of the gross estate and the statute (Section 2055 of the IRC) does not ordain equal valuation as between an item in the gross estate and the same item under the charitable deduction. The Estate argued to the contrary, putting forth the proposition that the charitable deduction must be valued as of the date of the Decedent’s death. The Court noted that while such valuation method had been approved in prior cases, each case is different and there is no uniform rule for all circumstance.2 The Court went on to distinguish each such case on multiple grounds.
The Estate argued that Ahmanson was limited to situations where the testamentary plan diminishes the value of the charitable property but the Court concluded this was not the case holding that “Ahmanson extends to situations where ‘the testator would be able to produce an artificially low valuation by manipulat[ion],’ which includes the present situation.” Further, the Court noted that the Decedent’s estate plan provided the framework for such manipulation by concentrating power in Eugene’s hands due to his roles as executor of the Estate and trustee of the Trust and Foundation.
In conclusion, the Court’s analysis in Ahmanson, together with the facts of the present case, compelled the Court to affirm the Tax Court’s ruling valuing the Estate’s charitable deduction based on the value of the property actually transferred to the Foundation. The Court summed up the facts as follows:
[Decedent] structured her Estate so as not to donate her DPI shares directly to a charity, or even directly to the Foundation, but to the Trust. [Decedent] enabled Eugene to commit almost unchecked abuse of the Estate by setting him up to be executor of the Estate, trustee of the Trust, and trustee of the Foundation, in addition to his roles as president, director, and majority shareholder of DPI. As the Tax Court found, Eugene improperly directed Lewis Olds to determine the redemption value of the DPI shares by applying a minority interest valuation, when he knew a majority interest applied and the Estate had claimed a charitable deduction based upon a majority interest valuation. Through his actions, Eugene manipulated the charitable deduction so that the Foundation only received a fraction of the charitable deduction claimed by the Estate.
In addition to its argument above that the charitable deduction should be determined by the value of the property used for valuing the gross estate, the Estate also argued that the reduction in value of the Shares was due to a decline in the general business climate rather than the post-death events that took place. While there was some evidence of decline due to the net asset value of DPI dropping from $17,777,626 at the date of the Decedent’s death to $16,159,167 at the date of the redemption, the Tax Court concluded that the reduction in the value of the Shares was primarily due to Eugene’s instruction to Lewis that the Shares were to be valued as minority interest for purposes of the redemption appraisal, and the Ninth Circuit found nothing clearly erroneous about this conclusion.
Further, the Ninth Circuit also affirmed the Tax Court’s finding that the accuracy related penalty under Section 6662(a) of the IRC was applicable to the Estate. In short, the Estate acted negligently in requesting the appraiser to value the Shares as a minority interest for purposes of the redemption appraisal, and the Estate did not have reasonable cause and good faith for such negligent act within the meaning of Section 1.6664-4(b)(1) of the Treasury Regulations. The Court noted that reasonable cause and good faith may be shown by reliance on the advice of a professional, but such was not the case with the Estate’s actions. The redemption appraisal was inaccurate due to Eugene’s instructions to Lewis, and thus the Estate knew of the negligent act.
The facts of this case make it clear what was going on. The Estate was attempting to take a charitable deduction for value that was actually passing to the sons, Eugene, Patrick, and Timothy (through DPI via a lower redemption price). In doing so, the Estate sought to avoid approximately $4.1 Million in taxes to the detriment of charity and the benefit of the three sons. There are a few points to take away from this case. First, at least in the Ninth Circuit, the Court has made it clear that the value of an estate tax deduction is not necessarily connected to the estate tax value of the same property for which the deduction is claimed. This is true in the charitable deduction context, and likely extends to other deductions including the marital deduction. Next, where it looks like abuse, it probably is. This case is a good example of a “bad facts” case where there was clear abuse going on. Lastly, this case highlights the importance of proper succession planning for closely held entities. With a proper succession plan in place, this case may have been avoided as many of the details of the redemption could have been previously negotiated at arm’s length thus eliminating many of the opportunities for abuse that were present in this case.