Estate of Ellen D. Foster, TC Memo 2011-95
The Tax Court has held that litigation hazards did not justify a discount to the value of estate assets or a claims deduction by the estate. It also disallowed lack of marketability and lack of control discounts for estate assets. But it determined a much lower value than asserted by IRS for claims the estate had against others.
Facts. The decedent in this case was Ellen Foster. In '51, her husband, Thomas S. Foster (Mr. Foster), founded Foster & Gallagher, Inc. (F&G), a mail-order horticulture business.
In '91, Mr. Foster and F&G entered into a stock restriction agreement (SRA) which required F&G, upon the deaths of decedent and Mr. Foster, to purchase all of the F&G stock held by Mr. Foster's family group. To ensure that it had the money to do so, the SRA required F&G to maintain life insurance on the joint lives of decedent and Mr. Foster, payable after both had died. F&G accordingly purchased and maintained $50 million of paid-up life insurance. The SRA prohibited F&G from borrowing against the cash surrender value of or otherwise encumbering the policy.
In '95, Mr. Foster and several other shareholders sold the majority of their stock to F&G's employee stock ownership plan (ESOP). The company financed the purchase by borrowing $70 million on an unsecured basis from four lenders. One of the lenders, U.S. Trust, was hired as the ESOP's trustee.
Mr. Foster contributed his roughly $33 million sales proceeds to his revocable trust. He died on July 11, '96 and the revocable trust divided into three marital trusts.
In '98, F&G began experiencing financial trouble. Its revenues and earnings steadily declined, causing it to be in violation of the financial covenants of the ESOP loans. The ESOP lenders (including Northern Trust) sought to restructure the loans to gain a security interest in the company's assets.
Northern Trust, as co-trustee of the marital trusts, waived the SRA's restrictions and allowed F&G to borrow against the cash surrender value of the life insurance and later assigned itself the life insurance as collateral for the ESOP loans.
Because of the borrowing, the life insurance ceased to be self-funded and ultimately lapsed after F&G went bankrupt in 2001 and failed to pay the premiums.
Just before the bankruptcy filing, beneficiaries of the ESOP filed suit (the Keach lawsuit) in the district court alleging breaches of fiduciary duty committed by U.S. Trust and Mr. Foster (with decedent named as a defendant as executrix of Mr. Foster's estate) in connection with the ESOP transaction. They also sought restitution against decedent and Northern Trust as cotrustees of the Marital Trusts and requested the imposition of a constructive trust over the assets held by decedent as executrix of Mr. Foster's estate and co-trustee of the Marital Trusts.
To avoid potential liability to the ESOP plaintiffs for distributions from the marital trusts, Northern Trust unilaterally froze decedent's right to withdraw the principal of marital trust #3.
The ESOP beneficiaries lost in district court but appealed on Apr. 9, 2004. Decedent died on May 15, 2004 while the appeal was pending.
The executors of her estate determined that the work done by the attorney who handled her estate and represented her in the Keach lawsuit was deficient. They also determined that the decedent had viable claims against Northern trust.
An estate tax return was filed showing values of roughly $1 million for marital trust #1, $35.5 million for marital trust #2, and $14 million for marital trust #3.
The estate also listed on Schedule F a liability related to litigation against each trust in these amounts: negative $286,100 for marital trust #1, negative $10,373,046 for marital trust #2 and negative $4,017,769 for marital trust #3. In other words, these were the discounts sought for litigation hazards.
After IRS selected the return for examination, the executors informed IRS of a potential additional asset of the estate, consisting of the claims held by the estate against the attorney and Northern Trust.
The claim against the attorney was settled in 2008 for $850,000, and the claim against Northern Trust was settled in 2009 for over $17 million.
IRS determined a deficiency of almost $5 million, which it later increased to almost $15 million. At trial, the executors claimed a total marital trust discount for litigation hazards, lack of marketability and lack of control of 32.4%.
No discount for litigation hazard. The estate contended that it was entitled to discount the values of the assets of the marital trusts because the ESOP plaintiffs sought to impose a constructive trust over those assets. The estate cited cases which it argued held that litigation (or the threat of litigation) concerning an asset in the gross estate justified discounting the value of the asset for estate tax purposes.
The Court found that those cases were distinguishable. They involved litigation that could have affected the rights of a purchaser of the asset that was the subject of the litigation. A willing buyer would have refused to pay full fair market value because the buyer's rights in the asset could have subsequently been impaired. A willing buyer would not have insisted on a discount on the assets of the marital trusts because the Keach lawsuit could not have affected a buyer's rights.
No claim deduction. Alternatively, the estate argued that the Keach lawsuit constituted a deductible claim against the estate. The Court disallowed the claim deduction.
Under the then effective regs under Code Sec. 2053, which allows a deduction for claims against the estate that allowable by the laws of the jurisdiction under which the estate is administered, an item could be entered on the return for deduction though its exact amount was not then known, provided it was ascertainable with reasonable certainty, and would be paid. The Court found that the estate failed to establish the value of the marital trust discount with reasonable certainty, as required by the applicable reg.
No lack of marketability and control discounts. The estate contended that it was entitled to lack of marketability and lack of control discounts on the assets of the marital trusts on account of the freeze placed on marital trust #3 by Northern Trust. The Court said that the freeze may have prevented decedent from selling any of the assets of marital trust #3, but it did not affect the value of those assets.
Value of estate's claims. IRS didn't meet its burden of showing the value of the claim against the attorney. IRS said that the claims against Northern Trust were worth $5.1 million as of the date of death. However, the Tax Court determined their value to be $930,000.
References: For valuation of property for estate tax purposes, see Federal Tax Coordinator 2d ¶P-6000; United States Tax Reporter Estate & Gift ¶20,314; TaxDesk ¶481,000; TG ¶42000. For the estate tax deduction for claims against an estate, see Federal Tax Coordinator 2d ¶R-5456; United States Tax Reporter Estate & Gift ¶20,534.07; TaxDesk ¶776,046; TG ¶41251.