Originally published on Forbes.com Apr 13, 2013
The main problem with estate planning for families is that families are involved. They have this tendency to behave like families and not families like this one:
There seems to have been some sort of discord in the background in the recent Tax Court decision in the case of the Estate of John F. Koons III. There is a rather complicated series of transactions, that were meant to facilitate a sale of the Koons family beverage business to an affiliate of PepsiCo. Ultimately there would be over 300 million of cash and a mix of other assets in an entity called CI LLC. The J.F. Koons III Revocable Trust owned 46.94% of the voting interest and 51.59% of the nonvoting interest. In order to persuade Mr. Koons four children to consent to the stock sale, there was a commitment to redeem their interest in CI LLC.
Now we come to the possible discord part:
On February 21, 2005, James B. Koons wrote a letter to his father complaining that the terms of the redemption offer “felt punitive” but thanking him for the “exit vehicle” and acknowledging that the children would “like to be gone.” He made various other complaints, observations, and suggestions. He predicted that the Board of Managers of CI LLC would attempt to justify its existence by having the company buy operating businesses when, according to him, it would be better for the owners of the company if the company invested in passive assets. He continued:
This brings me to another comment from one of my lawyers. His opinion is the structure of the Operating Agreement guarantees litigation. It is not a question of “if” only “when”. When the Board of Managers starts making decisions that benefit themselves over the Koons family (which they will), there will be litigation. You can count on it.
He emailed a copy of the letter to each of his siblings.
The senior Koons responded:
“I am going to study your letter of February 21st and if I wish to accept any of your suggestions I will let you know at an appropriate time.”
He died on March 1, 2005.
The dispute with the IRS concerned the treatment of CI LLC. There were two issues. One was valuation. Since CI LLC’s assets consisted overwhelmingly of cash, it was not much of a challenge to value the entity as a whole. There was significant difference about the discount that should be applied to the underlying interest. The estate’s expert did some fancy math and came up with a valuation discount of 31.7%. The IRS expert came up with 5% to 10%.
The other issue was a loan from CI LLC to the Estate in the amount of $10,750,000. The loan was to be repaid in installments of interest and principal beginning in 2024 and ending in 2031 with no prepayment allowed. The rate on the note was. 9.5%. This resulted in an interest deduction of $71,419,497 in computing estate tax. Loans like this are sometimes referred to as Graegin Loans and have been allowed in some cases. Not every loan is Graegin, though, as one commentator noted.
The major flaw that the Court noted in this plan was the redemption of the next generation from CI LLC. Although not executed before Mr. Koons death, it was close to a done deal and was in fact followed through. After the redemption, the Revocable Trust owned over 70% of both voting and non-voting interest. Thus the trust was in a position to require CI LLC, which was cash rich, to make distributions. Thus no discount other than a small one (7.5%) for marketability was allowed and there was no need for the loan and, therefore, no interest deduction.
The thing I wonder about is whether the planning might have worked if rather than enhancing the Trust’s ownership in CI LLC, it had been slightly diluted. If the Trust’s interest were cleanly below 50%, higher discounts should have held up. The terms of the loan negotiated strike me as over the top, but with less than 50% ownership, the Trust would not be in a position to force distributions. The deficiency was over $58,000,000 which seems like it would have given the next generation quite an incentive to hang in for a little longer.
Other than the commentary noted above, the only other person, I have seen pick up on this case was Lew Taishoff. His comment was:
Good try, guys. Interest on a loan to pay estate taxes is deductible as an administrative expense, right?
Not twenty-five years’ worth.In the first place, CI LLC was loaded with cash, and the Revocable Trust could force it to distribute, so no need to sell assets. Lending the money depletes CI LLC’s cash hoard as much as a distribution, and the Revocable Trust has almost no operating assets to protect from a forced sale to pay estate tax.
Finally, this deal keeps the estate alive for 25 years after the Late Koons became the Late Koons. Too long. But a good try, even though no deduction.
It will be interesting if there is an appeal on this case.
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