Tales of Mystery and Imagination: Misadventures at the Tax Court

ongress has spent the last six years phasing in a repeal of the estate tax, or at least completing a reform that eliminates tax from more than 99% of estates.

Would this new benevolent attitude toward estates soften, perchance, the stern edifices of the IRS and the Tax Court like glasnost bringing down the last vestiges of the Iron Curtain? Upon learning of our kinder-gentler estate tax policy, will the IRS be more forgiving and pack it in, like Javier, the obsessive police officer in Les Miserables, finally letting Jean Valjean off the hook?2 Indeed, in July, 2006, the IRS announced plans of trimming 157 of the 345 estate tax attorneys (the estate tax auditors) on its staff.

But don't count on a free pass just yet. Estates still moving through the machinery of this tax system are regularly shredded in the gears. Here is a collection of encounters with the current transfer tax system that test the limits of imagination.

Fall of the House of Davenport

Is a comparison of the IRS with Javert an exaggeration? The lawman's pursuit in Les Mis was a mere 10 years. Contrast that with the 27-year chasm of time that extends from a 1980 transfer to the determination of tax liabilities in 2007 (barring further appeal to the Supreme Court) in U.S. v. Davenport.

Birnie and Elizabeth Davenport were spinster sisters who lived together, commingled their assets, had identical wills, and liked to invest in the Texas oil and gas industry where both had careers. Elizabeth was an assistant to corporate executives. Birnie was a legal secretary. One of their best ventures was in the Hondo Mining Company, of which they jointly owned over 3,000 shares.

Elizabeth died on December 2, 1979. Six months later, Birnie Davenport began transferring Hondo stock to a nephew and a niece using installment sale agreements that valued the stock at $804 per share. Another 537 shares were transferred as an outright gift to a nephew Charles Botefuhr who agreed, in writing, that he would file a gift tax return, but did not. The latter shares were redeemed by the company at $2,190 per share the following year.

After Birnie Davenport's death in 1991, a gift tax return was filed for the outright transfer to Charles. The transferred shares were valued at $804, comparable with the installment sale agreement. But after a 1992 audit, the IRS claimed both the transferred and "sold" assets were worth $2,730 per share. It assessed a tax deficiency of $1,422,154, as well as an addition to tax of $355,538.50 for failure to file a timely gift tax return.

In 1997, the Tax Court, having been petitioned to reconsider the amount of the deficiency, found the estate liable for a federal gift tax deficiency of $822,653 based on the 1980 gift and a penalty for untimely filing of the return of $205,663. A stipulation of the parties established $2,000 as the appropriate valuation per share of Hondo stock. Estate of Davenport v. Comm'r., 74 TCM. 405 (1997).

In 1999, this result was affirmed by the Tenth Circuit district court. Estate of Davenport v. C.I.R, 184 F3d 1176 (10th Cir., 1999). Meanwhile, in 1998, the IRS demanded payment of the estate.

But the case was not over.

The estate didn't pay the taxes after losing in court. This stands to reason since Birnie Davenport died in 1991 and one has to imagine that whatever assets weren't distributed by then must have been exhausted on eight years of litigation. This moment was merely the mid-point of litigation to date and signaled the opening round of efforts to collect taxes from the transferees of the estate.

In 2000, the government filed a complaint in the U.S. District Court for the North District of Oklahoma to reduce the estate's debt to an enforceable judgment against the transferees. A series of cases followed: U.S. v. Estate of Davenport, (N.D.Okla. 2001); U.S. v. Botefuhr, 309 F3d 1263 (10th Cir. 2002); and U.S. v. Estate of Davenport, (N.D.Okla. 2003).

By 2004, some 13 years after Birnie Davenport's death, and some 24 years after the 1980 transfers of stock that set all this in motion, one of the remaining splinters of the case reached the District Court of the Southern District of Texas and Judge Samuel Kent summed up the legacy of litigation succinctly:

"When Gordon E. Davenport and his cousins received large blocks of Hondo Drilling Company stock from their financially savvy aunt, they got more than they bargained for. Confusion regarding ownership of the stock, proper valuation of the shares, and one cousin's failure to comply with the terms of a family agreement regarding payment of gift taxes, have resulted in years of litigation and the prospect of staggering financial liability to the Federal Government." U.S. v. Davenport, (S.D.Tex. 2004).

And the case continued. In 2006, the Texas District Court granted Birnie Davenport's nephew's third motion for summary judgment, saying,

"The Government's attempt to prove the value of the stock by the Stipulation entered in the tax court case involving the Estate of Birnie Davenport ignores the limiting language of the Stipulation itself. It also runs afoul of the preclusive effect of Rule 408 of the Federal Rules of Evidence. The Stipulation was clearly reached to settle that litigation; it cannot be used to prove the value of the Government's claim in this suit." U.S. v. Davenport, (S.D.Tex. 2006).

Which brings us to the present day. On April 9, 2007, the Fifth Circuit Court of Appeals found fault with the District Court's res judicata analysis because it had looked to the legal theories advanced, forms of relief requested, and types of rights asserted. The Fifth Circuit reversed, saying, "Our decision that the same cause of action is involved is consistent with the decisions of the Eighth and Eleventh Circuits that a transferee cannot relitigate the tax due after a prior court had already determined the estate's tax liability." U.S. v. Davenport, 06-40466 (5th Cir. 4-9-2007).

Thus, the $2,000-per-share value previously stipulated to was binding. However, this result is in conflict with the Tenth Circuit's decision against the three Davenport heirs in 2002. In that case, the Tenth Circuit also reversed the District Court's determination that there was personal jurisdiction over two of the defendant heirs and affirmed the District Court's ruling that the action was not barred by the statute of limitations.

Like the bloodied and enshrouded figure of Lady Madeline of Usher, returning, inevitably, from her tomb in Poe's supernatural tale, tax retribution for the 1980 gifts seems inescapable. Perhaps we have not seen the last of the Estate of Davenport.

The Tell-Tale Heart

Would a taxpayer's confession about stolen assets, beating like a tell-tale heart, induce a tax refund? Consider this tale of Texas-sized hutzpah for the refund of $2.8 million of estate tax and interest.

Dorothy Hester had established a trust that was to pay a qualifying income interest to her husband, Wendell. Dorothy died in 1993. In 1998, Wendell breached his fiduciary duties as trustee and commingled all of the trust assets with his personal Schwab account. He then engaged in day trading, borrowing on margin, paying himself $450,000 in cash, and losing about $2 million. No assets were distributed to the other trust beneficiaries.

At Wendell's death, all assets remained in his estate and notice was published for potential creditors to state claims. An estate tax return was filed in 2000, deficiencies were assessed and paid in 2002. Then a refund claim was filed in 2003.

The argument was essentially that the estate contained assets that were misappropriated and did not belong to the estate. Tear back the floorboards, open the records, the assets were stolen!

But Wendell had exercised dominion over the assets without "an express or implied recognition of an obligation to repay and without restriction as to their disposition."

The district court, in a methodical 4,400-word opinion, came to a simple conclusion: No. Summary judgment was granted to the government.3

A Dream Within a Dream

O God! can I not save
One from the pitiless wave?
Is all that we see or seem
But a dream within a dream?
-From, "A Dream Within a Dream," by Edgar Allen Poe (1827).

Austin and Edna Korby were married in 1948, built a modest estate, and, after attending an estate planning seminar in 1993, set up a revocable living trust and a family limited partnership. The Korbys transferred several bank accounts to the revocable living trust. They also transferred stocks, bonds, a vacant lot, etc.. worth $1.85 million to the FLP. Mr. and Mrs. Korby retained a 98% limited partnership interest. Meanwhile, the living trust transferred a bank account worth $37,000 to the FLP and retained a 2% general partnership interest.

In 1995, the Korbys transferred their 98% limited partnership interest into four parts and gave each of their four sons 24.5%. They then filed gift tax returns claiming a 43.61% marketability discount since these limited partnership shares lacked management powers. During 1995 through 1998, the FLP made distributions totaling $120,795 to the 2% general partner, i.e., the revocable trust.

Both Edna and Austin Korby died in 1998 and both estates filed estate tax returns in 1999. Edna's estate included half of the general partnership interest in the trust or 1% of the FLP. Austin's estate, having inherited Edna's shares, included the entire 2% general partnership share. Neither estate included the FLP. The IRS assessed deficiencies of $1,104,635 for Edna's estate and $1,070,482 for Austin's estate.

The tax court found that payments from the FLP to the living trust were not "management fees." The Korbys retained a right to the assets transferred to FLP due to an implied agreement with the four sons.

It was revealing to the court that there was no written management agreement and that payments were made whenever there was a request from Austin Korby as opposed to some schedule. It concluded that the reason for forming the FLP was not creditor protection but tax avoidance. The tax court reduced deficiencies to $124,135 for Edna's estate and $379,150 for Austin's estate.

Like the tax court, the 8th Circuit District Court wasn't buying the taxpayers "management fees" explanation. No record was kept of Austin Korby's management hours or efforts, nor did he declare the payments as self-employment income. And the Korbys retained less than $10,000 in the living trust, as though assured of future funding from the FLP.

The district court, citing, Estate of Strangi, 417 F3d at 477, found no clear error in the tax court's determination of the implied agreement. In that case, the decedent had transferred 98% of his wealth to an FLP two months prior to his death, retained only $792, lived in a house owned by the FLP, and received $34,000 for living expenses and over $100,000 for funeral expenses, personal debts and bequests.

Implied agreements had also been upheld in, Abraham v. Comm'r, 408 F3d 26 (1st Cir., 2005), and, Thompson v. Comm'r, 382 F3d 367 (3d Cir., 2004).

Nor was there a bona fide sale. Citing, Estate of Bongard, 124 TC 95 (2005), Thompson, supra, and Kimbell v. United States, 371 F3d 257 (5th Cir., 2004), the court upheld the tax court's determination that there had been no substantial business or other non-tax purpose for the FLP. The arrangement had been set up by Austin Korby with his estate attorney without any involvement of the four sons who were to own 98% of the FLP.4

The Black Cat

For the most wild, yet most homely narrative which I am about to pen, I neither expect nor solicit belief. Mad indeed would I be to expect it, in a case where my very senses reject their own evidence. Yet, mad am I not - and very surely do I not dream. But tomorrow I die, and to-day I would unburden my soul.
-Edgar Allen Poe, preface to The Black Cat.

Though tax legislators occasionally dabble in the dark arts of retroactive application of new laws, and courts, as a routine event revise their interpretation of both facts and laws, changing the outcome as cases progress from IRS to Tax Court to District Court and so on, still, even the most seasoned observer must blink with astonishment at the Tax Court's dexterity in the Succession of McCord.

This is another case that fits the FLP profile-octogenarians set up a comprehensive family wealth preservation plan with assistance from Texas-based specialists. In 1997, the IRS assessed a deficiency of more than $4 million for gifts made in 1996. The taxpayers petitioned the Tax Court and prevailed before Judge Foley.

But two years later, the case was taken away from Judge Foley, and retroactively reassigned to a new judge, who, on the same day, filed an unusual en banc opinion that favored the government.

If that makes your jaw drop open, rest assured that the Fifth Circuit had the same reaction and reversed the Tax Court. Unlike the Foley opinion, which assessed equitable doctrines of form-over-substance and violation-of-public-policy based on stipulated facts, the revised en banc decision relied on arguments that neither side had argued or briefed.

As the Fifth Circuit put it, the Tax Court opinion utilized a "sua sponte confection of methodology for valuation." In other words, it was making up the rules as it went along.5

To Be Continued…

Holy cognitive dissonance! Is this any way to phase in an estate tax repeal/reform?6

There are additional tales to be told as this article continues in a future issue of this newsletter. Indeed, rest assured, gentle reader, that as long as the estate tax remains part of the Internal Revenue Code, it will be enforced with grim predictability.

Taxpayers and estate planners, be so advised.

TECHNICAL REFERENCES

1. "Tales of Mystery and Imagination" is the title of a collection of stories by Edgar Allen Poe published in various editions for more than a century. It is also the title of a popular 1975 musical album by the Alan Parsons Project. The estate of Poe will be included in a future issue of The Estate Analyst.

2. Faced with the choice of enforcing the law when it is conflict with moral justice, Javert drops off a note on improving police procedures…and then concludes Victor Hugo's tale by drowning himself in the river Seine.

3. Estate of Hester v. U.S., U.S. District Court, W.D. Virginia, Civil Action No. 5:06-cv-00041. (March 2, 2007).

4. Estate of Korby v. Comm'r., 471 F.3d 848 (8th Cir., 2006).

5. Succession of McCord v. Comm'r., 461 F.3d 614 (5th Cir. 2006). Judge Foley, dissenting, derided the Tax Court majority for applying the "olefaction" test. The Court of Appeals, siding with Foley, studiously observed that "'olfaction' is an obvious, collegially correct synonym for the less-elegant vernacular term, "smell test," commonly used to identify a decision made not on the basis of relevant facts and applicable law, but on the decision maker's "gut" feelings or intuition."

6. "Cognitive dissonance" is a term coined by sociologist Leon Festinger in 1956 to describe the conflicting and counterintuitive beliefs retained by members of a UFO doomsday cult after their leader's prophecy of the earth's destruction failed to take place. Here, we try to reconcile an IRS that cut its estate tax auditing staff in 2006 with an IRS that still seems to "select 100% of the Family Limited Partnership cases * * * as "abusive" per se on first look basis." (Leimberg, Estate Planning Newsletter # 600, 2003).