A 2.6 Billion Dollar Tax Bill: The Estate of Davidson and CCA 2013-033

A 2.6 billion dollar tax deficiency is likely to attract a lot of attention. The late William Davidson was a successful business man, owner of privately-held Guardian Industries, the Detroit Pistons and Tampa Bay Lightning. It appears that the decedent made substantial gifts of property but did not file gift tax returns. Some of the gifts were characterized as being made by the decedent’s spouse and that is being contested. Also, IRS contends the gifts were not properly valued. For all of these reasons, IRS assessed a gift tax deficiency of $880 million.

The estate tax deficiency is $1.8 billion. It comes as no surprise that a substantial issue is valuation. Closely-held assets pose considerable difficulty in valuation and often wind-up as a battle of experts. In Davidson, however, valuation has collateral consequences because the taxpayer utilized Self-Cancelling Installment Notes (SCINs).

First, we need to understand a SCIN. In a SCIN, the buyer purchasing the asset pays a premium for the feature that cancels the note at the death of the seller. The premium is either in form of a higher interest rate or a larger principal amount in the Note. Most SCINs call for a large balloon payment of principal on the Note at the end of the term. Thus, SCINs are beneficial if the seller dies (or is expected to die) before the end of the Note term.

I mentioned the collateral consequences of valuation. The IRS expressed its litigating position, in CCA 2013-033, that it will apply the willing buyer and seller standard to SCIN transactions, a position never before expressed. If a (SCIN) Note is worth less than fair market value of the assets sold, then the assets sold have been under-valued at the sale. The argument is that the Note being undervalued is indirect proof that the assets are undervalued.

There is another issue and that is whether the Note is bona fide and re-payment is expected. In Costanza, a notable SCIN case, the buyer (son) was able to make payments out of cash flow to the seller (father) who needed and expected payments that were the source of his retirement income. It is unclear in Davidson whether the necessary payments could be or would be made, given the asset values. The cash needed for repayment does not always match the actual cash flow which is why there is a temptation to under-value assets.

Hopefully, the Court will decide what method is appropriate for determining the mortality premium. IRS suggests the Tables under §72 (Annuities), while planners see Table 90CM under Section 7520. There are others who believe the Note is an installment sale note eligible to use the Applicable Federal Rate under §1274. Some advisors have remarked that the IRS actuaries have used the AFR rates.

There are other issues, most notably the reliance upon specific tables where the likelihood of surviving one year is less than 50%. In Rev. Rul. 80-80, the test used was “so remote as to be negligible,” however, this ruling was declared obsolete. In Davidson, there are factual issues as to the decedent’s health prompted by many transfers occurring shortly before death.

IRS has the ability to assess a penalty of 20% if assets are substantially undervalued by a taxpayer. Unfortunately, there is no penalty that can be assessed against the Service if its valuations are overstated so the Service is encouraged to litigate by asserting penalties.

We expect to learn what is the appropriate table or methodology to value a SCIN if the case goes to trial and an opinion is rendered. While bad facts make bad law, the absence of timely filings and the flurry of activity nearer to death put the taxpayer in a difficult position.