Dieringer v. Commissioner: Estate Tax Charitable Deduction for Bequest of Stock to Private Foundation Limited to Post-Death Redemption Proceeds - A Flawed Result?

Dieringer v. Commissioner: Estate Tax Charitable Deduction for Bequest of Stock to Private Foundation Limited to Post-Death Redemption Proceeds - A Flawed Result?

Article posted in U.S. Tax Court on 28 June 2016| 4 comments
audience: National Publication, Richard L. Fox, Esq. | last updated: 1 August 2016
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Summary

An interesting and perplexing case emerges from U. S. Tax Court and author Richard Fox provides cogent analysis.

By: Richard L. Fox, Esq.

The United States Tax Court in Estate of Dieringer v. Commissioner, 146 T.C. – No. 8 (March 30, 2016), held that the decedent’s estate was allowed an estate tax charitable deduction for stock bequeathed to a private foundation equal only to amount of the proceeds received upon the redemption of the stock a few months after her death, and not the greater estate tax value reported in her United States Estate (and Generation-Skipping Transfer) Tax Return (Form 706).

The court found that post-death events, essentially consisting of the redemption of the stock held by the decedent’s revocable trust (before the stock was ever even transferred to the private foundation), were to be taken into account in determining the value of the stock for purposes of the estate tax charitable deduction.  The redemption of the stock while it was still held by the revocable trust was apparently done in an attempt to avoid an indirect act of self-dealing from occurring under Internal Revenue Code Section (“Section”) 4941, given that the only shareholders of the corporation following the redemption were two of the decedent’s sons, both of whom were disqualified persons with respect to the private foundation and otherwise generally not permitted to engage in direct or indirect transactions with the foundation under the self-dealing rules of Section 4941.

The court did not discuss how the redemption, under the circumstances, presumably should have been found to have been an indirect act of self-dealing under Section 4941 which may have (1) forced the corporation or the family shareholders to reimburse the foundation for the excess of the stock’s fair market value over the redemption price, which was determined using discounts that did not appear to be appropriate and (2) resulted in excise tax imposed under Section 4941 perhaps in excess of the additional estate tax and negligence penalty imposed.

FACTS

The decedent, a resident of Oregon, owned a majority of the voting and non-voting stock in her family’s closely held business.  She had formed a private foundation during her lifetime, transfers to which could qualify for the estate tax charitable deduction under Section 2055(a).  Through her revocable trust, acting as a Will substitute, she specifically “bequeathed” all of the stock to the foundation.  Her estate reported the date of death estate tax value at the value determined by an appraiser who valued the stock without any lack of control (minority) or lack of marketability discounts. That value was not challenged by the IRS and seems to have been accepted by the Tax Court as representing its estate tax fair market value.

The decedent died on April 14, 2009.  On November 30, 2009, the corporation agreed to redeem all of the shares owned by the revocable trust which were specifically bequeathed to the foundation.  Although the exact date of the redemption was not stated in the decision, the redemption agreement was modified at least once.  In any case, it appears all of the trust’s non-voting stock and a majority of the outstanding voting stock was redeemed.  In an apparent attempt to avoid excise tax under Section 4941 by meeting the private foundation “estate administration exception” (discussed further below), the Circuit Court in Oregon was petitioned for the retroactive approval of the redemption which was approved by that court six days later.

The redemption price was determined by the same appraiser who did the appraisal for the estate tax inclusion value of the stock.  The appraiser testified that he was instructed to value the shares as representing a minority interest in the corporation for purposes of the redemption and the appraiser used a 35% lack of marketability and a 15% lack of control (minority) discounts, which discounts were not used for estate tax purposes.  Therefore, different valuation approaches were utilized for estate tax valuation purposes and for purposes of determining the redemption price.

The decedent’s sons subscribed at apparently the same time as the redemption for additional shares allegedly to provide the corporation with cash to pay off the note it gave the former revocable trust in payment for the redeemed shares at a price somewhat higher than the redemption price but less than the estate tax value of the stock.

The Internal Revenue Service contended that the estate tax charitable deduction for the shares given to the foundation should be determined by the post-death events (essentially the redemption price) and not based upon the estate tax value of the stock.  The Tax Court held that the amount of estate tax deduction for the shares given to the foundation was limited to the actual amount the foundation received in the redemption because the post-death events changed the nature of what the foundation received.

ANALYSIS

Valuation is a Key in Estate Taxation. 

Valuation is a key in determining the amount of estate tax due on property included in the gross estate under Section 2031: The more an asset is worth for estate tax purposes the more tax that will be due unless the property qualifies for a deduction, such as the charitable estate tax deduction under Section 2055(a) or the marital deduction under Section 2056. 

Subject to rare exception (such as for certain real estate used in a farm or other closely-held company valued pursuant to Section 2032(A), the estate tax value of an asset is its fair market value (generally meaning the price at which the property would trade hands between a willing buyer and a willing seller as set forth in regulations under Section 2031) on the decedent’s date of death (or if elected the alternate valuation date pursuant to Section 2032).  (See, e.g., Reg. 20.2031-1(a).)

In determining an asset’s fair market value pursuant to the “willing buyer/willing seller” method, certain post-death events, such as a sale of the property near the valuation date may be determinative of its value on date of death (or alternate valuation date, if elected), may be taken into account.   A mere decline in the market value of the property post-death on account of changes in market conditions post-death are not taken into account in determination the fair market value of the valuation date. 

Limitation of Charitable and Marital Deduction Bequests by Funding with Assets Valued with a Discount. 

However, the amount allowed for the charitable or marital deduction may be limited because of the particular attributes of the specific property used to fund a marital or charitable deduction bequest.  For example, if the estate includes a majority interest in a business but only a minority interest in the business is used to fund a charitable or marital deduction bequest, the deduction will be limited to the value of the minority interest and not a proportionate part of the value of the majority interest that was included in the estate. Cf. Ahmanson Found. v. United States, 674 F.2d 761, 767 (9th Cir. 1981); Estate of Chenoweth v. Commissioner, 88 T.C. 1577 (1987), discussed in Del Duca, “Disappearing and Reappearing Value on a Two-way Street: The Reverse Chenoweth Situation,” 85 The Florida Bar Journal 34. (Sept./Oct. 2011). 

However, where an asset has been specifically bequeathed to charity or the surviving spouse (such as a work of art), the charitable deduction or marital deduction should not be reduced from the property’s estate tax value merely because it has declined in value by the time it is delivered to charity or the spouse.

Power to Divert Property from Charity. 

Reg. 20.2055-2(b)(1) provides that the charitable deduction is reduced to the extent that someone, such as a trustee, holds the power to divert property away from charity.  The Tax Court in Dieringer reduced the charitable deduction by finding that the trustee of the trust from which the gift of the stock was given to the foundation had the power to and did divert value away from charity and, therefore, the court limited the estate tax charity deduction to the redemption amount. 

Perhaps, the result may be justified by analogy to Estate of Atkinson v. Commissioner, 309 F.3d 1290 (11thCir. 2002), aff’g, 115 T.C. 26 (2000), cert.denied, 540 U.S.946 (2003), in which it was held that a trust was not a qualified charitable remainder trust under Section 664 because the annuity payments had not been made as provided in the trust.  However, Atkinson was based upon a specific regulatory requirement that the trust operate exclusively as a charitable remainder trust—and the failure to so operate meant it could not be treated as one.

Although the result in Dieringer, under the circumstances, may seem salutary, it does not seem justified.  Any trustee (or executor) with a power to sell assets specifically bequeathed to either an individual or charity could presumably sell them at less than fair market value.  But, in the normal course, the fiduciary would be liable for doing so.  The Tax Court does not discuss whether the Attorney General in Oregon had brought suit against the trustee of the Dieringer trust for diverting charitable assets to the family.  That would seem to be the preferred route to the disallowance of the charitable deduction.  Indeed, if the Tax Court is correct that the charitable deduction should be disallowed because the trustee held the power to divert property away from charity within the meaning of Reg. 20.2055-2(b)(1), then the whole deduction should have been disallowed presumably.  In fact, whenever a fiduciary could divert value from charity, the charitable deduction should be entirely disallowed.  However, it seems doubtful that the trustee had such a power.  Rather, as indicated, the trustee no doubt violated its fiduciary duty to the charity by selling the majority interest in the corporation at the value of a minority interest.

Self-Dealing.  The court had a powerful weapon: imposition of the self-dealing taxes under Section 4941.

Background on self-dealing rules.

The self-dealing taxes are imposed under a two-tier regime. It provides that substantial and sometime draconian excise taxes may be imposed on the disqualified person engaging in the act of self-dealing, and in some cases on a foundation manager. These taxes are imposed on the disqualified person who participates in the act of self-dealing, not on the private foundation. Section 4941(a) imposes an initial tax of 10% of the amount involved with respect to a self-dealing transaction for each year (or part thereof) in the “taxable period.” Therefore, the 10% tax could be assessed for multiple years, and the total could be multiples of 10%.

A second-tier tax of 200% of the amount involved is imposed by Section 4941(b) upon the disqualified person if the act of self-dealing is not “corrected” during the taxable period. For this purpose, “corrected” basically means, with respect to any act of self-dealing, undoing the transaction to the extent possible, but in any case placing the private foundation in a financial position not worse than that in which it would be if the disqualified person were dealing under the highest fiduciary standards.

Direct acts of self-dealing.

Direct transactions, such as direct sales, leases, or loans between a private foundation and an estate or trust that are disqualified persons are prohibited under the self-dealing rules  Such direct transactions generally do not occur in the context of estate or trust administration, as the parties are typically aware that direct transactions between a private foundation and a disqualified person are prohibited, and they are no more likely to occur in the estate context than in the normal ongoing administration of a private foundation.

Indirect acts of self-dealing.

The self-dealing rules apply not only to direct acts of self-dealing, but also to indirect acts of self-dealing carried out by an intermediary or third-party, including one carried out through an estate or trust. Under Section 4941(d)(1)(A), “self-dealing” includes any “direct or indirect” sale, exchange, or lease of property between a private foundation and a disqualified person. While “indirect” self-dealing is not defined in Section 4941 or the regulations thereunder, it is clear that the term includes transactions between a private foundation and a disqualified person through some type of intermediary or third-party.

Private foundations are often beneficiaries of significant bequests from their founders at their deaths under a will or trust instrument, and in many cases are the residuary beneficiaries of an estate (or residuary takers under a trust such as a revocable trust). A private foundation can be created and receive its initial funding under a will or trust, or an existing foundation can receive substantial additional funding under such instruments. Where an estate plan includes a private foundation as a beneficiary, and particularly as a residuary beneficiary, a host of complicated issues can arise due to the existence of the private foundation excise tax regime under Chapter 42 of the Internal Revenue Code, presenting a potential trap for the unwary.

Transactions between an estate (or  revocable trust that become irrevocable upon the decedent’s death) and a disqualified person with respect to property in which a private foundation has an interest or expectancy, even those that may otherwise be considered routine transactions, are characterized as an indirect act of self-dealing.

It is important, therefore, that any transaction involving property interests under a will or trust having a private foundation as a beneficiary be carefully scrutinized to determine whether an indirect act of self-dealing will occur. Moreover, when an indirect act of self-dealing would otherwise result in such context, it is imperative to meet the requirements of the available “estate administration exception” (discussed further below) provided under Reg. 53.4941(d)-1(b)(3) in order to avoid the application of Section 4941. Where the requirements of this exception are met, which includes obtaining court approval, the transaction will not be considered an indirect act of self-dealing and will not, therefore, be subject to excise tax under Section 4941.

Estate administration exception.

Under the “estate administration exception” of Reg. 53.4941(d)-1(b)(3) (which is sometimes referred to as the “probate exception”), an indirect self-dealing does not include a transaction involving a private foundation's interest or expectancy in property (whether or not encumbered) held by an estate (or revocable trust, including a trust which has become irrevocable on a grantor's death), regardless of when title to the property vests under local law, if the following five-prong test is met:

(1)  The administrator or executor of an estate or trustee of a (formerly) revocable trust either: (a) possesses a power of sale with respect to the property, (b) has the power to reallocate the property to another beneficiary, or (c) is required to sell the property under the terms of any option subject to which the property was acquired by the estate (or revocable trust).

(2)  The transaction is approved by the probate court having jurisdiction over the estate (or trust) or over the private foundation. (The regulations do not specify whether the required court approval must precede the transaction, although most private letter rulings contain a representation that court approval will be obtained prior to the transaction taking place.)

(3)  The transaction occurs before the estate is considered terminated for federal income tax purposes pursuant, or in the case of a revocable trust that becomes irrevocable, the transaction occurs before it is considered subject to Section 4947.

(4)  The estate (or trust) receives an amount that equals or exceeds the fair market value of the foundation's interest or expectancy in such property at the time of the transaction, taking into account the terms of any option subject to which the property was acquired by the estate (or trust).

(5)  The transaction either: (a) results in the foundation receiving an interest or expectancy at least as liquid as the one it gave up,(b) results in the foundation receiving an asset related to the active carrying out of its exempt purposes, or (c) is required under the terms of any option which is binding on the estate (or trust).

It is imperative to note that the safe harbor protection otherwise provided under the estate administration exception will be lost if the amount paid by a disqualified person is ultimately determined to be less than fair market value, which clearly was the case in Dieringer.

Exception from Self-Dealing for Redemptions Meeting Section 4941(d)(2)(F).

Aside from the possible use of the estate administration exception under the regulations to avoid an act of self-dealing, there is also a statutory exception under Section 4941(d)(2)(F) specifically involving redemptions of securities held by a private foundation, which provides that:

“any transaction between a private foundation and a corporation which is a disqualified person (as defined in section 4946(a)), pursuant to any liquidation, merger, redemption, recapitalization, or other corporate adjustment, organization, or reorganization, shall not be an act of self-dealing if all of the securities of the same class as that held by the foundation are subject to the same terms and such terms provide for receipt by the foundation of no less than fair market value.” 

The regulations under Section 4941(d)(2)(F) provide that “all of the securities are not ‘subject to the same terms’ unless, pursuant to such transaction, the corporation makes a bona fide offer on a uniform basis to the foundation and every other person who holds such securities.”  Reg. Sec. 53.4941(d)(3)(d)(1).  Section 4941(d)(2)(F) is generally applied where the securities subject to the redemption are actually held by a private foundation, not where the securities are still held by an estate or revocable trust and not yet distributed to the foundation where the estate administration exception is generally utilized to avoid an act of self-dealing. 

The IRS has applied Section 4941(d)(2)(F) even where it is clearly anticipated that only the private foundation will accept a corporation’s redemption offer made to all shareholders.  Ltr. Rul. 200521028, 9108030, 9108036 and 9101021.   In Ltr. Rul. 200521028, the IRS ruled that the redemption of stock held by a private foundation by a disqualified person was not an act of self-dealing under the exception provided under Section 4941(d)(2)(F), notwithstanding that the foundation would be the only stockholder participating in the redemption.  (The private foundation “is the only one of the four common shareholders accepting the redemption offer; the others have declined because they would incur large taxes from capital gains.”) 

Application of the Self-Dealing in Dieringer.   

Rockefeller v. United States, 572 F. Supp. 9 (E.D.Ark.1982), aff'd, 718 F.2d 290 (8th Cir.1983), cert. denied, 466 U.S. 962 (1984), seems instructive.  The decedent’s son purchased the stock in his father’s closely-held corporation which had been bequeathed to his foundation.  Although the son had followed all of the “mechanical” requirements set forth in the estate sale exception under Reg. 53.4941(d)-1(b)(3), he and the IRS agreed he had not paid full fair market value for the stock.  In the audit of his father’s estate tax return, the IRS estate tax attorney sought to impose an estate tax on the amount by which the value of the stock bequeathed to the foundation exceeded the amount the son paid for it by contending that the charitable deduction for the stock should be accordingly reduced.  However, the appeals division of the IRS rejected that contention and conceded that the charitable deduction should be allowed in full but argued that a self-dealing tax should be imposed on the excess.  The United States District Court and the United States Court of Appeals agreed.

It seems that same could occur in Dieringer.  The Tax Court seems to have found that the price paid in the redemption was less than the stock’s fair market value.   Therefore, despite obtaining court approval, the estate administration exception would not apply.  So a Section 4941 tax presumably should have been imposed on an indirect act of self-dealing.  Indeed, the tax might have been assessed not just on the corporation but, because it is apparent the sons essentially were indirectly purchasing the stock redeemed, also on the sons, who were also disqualified persons with respect to the foundation.  Furthermore, the foundation managers may have faced the tax that may be imposed upon them.  In fact, the finding of negligence by the court may well have served as a finding that the managers knew the redemption was an act of self-dealing. 

It should be noted that it seems that the procedure followed in the redemption may have resulted in an act of self-dealing even if the “estate administration exception” had been followed and full fair market value had been paid for the stock. As mentioned above, local court approval is required and it is far from certain that a retroactive approval of the transaction allows it to fall under the probate exception. This would mean self-dealing tax would be imposed on the full value of the stock and not just the excess of fair market value over what was paid.

Similarly, it is not clear that the redemption exception under Section 4941(d)(2)(F) was correctly used.  First, one of the requirements, as mentioned above, is that full fair market value must be paid—and quite apparently, according to the court, it was not.  Moreover, it is far from clear the basic “mechanical” requirements were followed.  For example, the exception for redemptions requires, as discussed above, that “The corporation makes a bona fide offer on a uniform basis to the foundation and every other person who holds such securities.”  Reg. 53.4941-3(d). There is nothing in the opinion that suggests that occurred or would be found to have occurred.   The fact that the corporation elected S corporation status shows that the transaction was “wired.”  Although a charitable organization (such as private foundation) may be an S shareholder, the income imputed to it is unrelated business taxable income under Section 512—presumably, unless it was known that charity’s stock would be redeemed, the S election would not have been made when it was.

Moreover, because it is likely that the purchase of stock by the decedent’s sons (disqualified persons) from the corporation essentially occurred immediately after the redemption could result in a finding that the transaction was not really a redemption but, under the step transactions doctrine, was a sale to the sons, meaning the sale would have had to fall under the probate exception and, as explained above, that may have been impossible because the court having jurisdiction over the trust did not approve the transaction ahead of time.

CONCLUSION

Be wary when a trust or an estate provides for dispositions in favor of a private foundation or another entity such as a charitable lead or remainder trust to which the self-dealing statute, Section 4941, may apply.  Although Dieringer involved a sale (or equivalent) or assets that were to pass to the foundation, consideration of potential self-dealing may arise in other contexts such as where the foundation is entitled to a dollar amount that may be funded with non-cash assets.   Even if the estate or trust is trying to rely on another exception to self-dealing, such as a redemption, it probably is wise also to use the “probate” exception and it is strongly recommended that the court having jurisdiction render its “approval” before the transaction is complete.   Making the state attorney general, as the statutory representative of charity, a party to the proceeding also is appropriate to consider.  In any case, if the foundation is paid less than full fair market value for its interest, neither the probate nor the redemption exception will provide protection against the imposition of the Section 4941 excise tax.
 

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Comments

Re: Dieringer v. Commissioner: Estate Tax Charitable ...

It looks like the petition to approve the redemption was done as a walkthrough, with Eugene's lawyer not advising the state court and the court not recognizing on its own that the state attorney general was probably a necessary party.

Re: Dieringer v. Commissioner: Estate Tax Charitable ...

Unfortunately docket info for the Multnomah County court is not available online, but it seems odd the court would approve the petition to approve the redemption retroactively on what seems to be a walkthrough. Wouldn't the state attorney general be a necessary party?

Re: Dieringer v. Commissioner: Estate Tax Charitable ...

You agree with me - the decision was flawed. The deduction should not have been reduced and it looks like self-dealing. No indication if there was a release.

Richard Fox
richard.fox@bipc.com

Re: Dieringer v. Commissioner: Estate Tax Charitable ...

The decision seems wrong. If the will or rev trust, left the foundation $10 bucks instead of stock valued at $10 would the estate only get a charitable deduction for $8 because the estate only distributed $8? Of course not. Did the opinion indicate whether the foundation signed a receipt, release and reimbursement agreement discharging the estate? Then you should get the full deduction and have income from the RRR, assuming the RRR is not voidable, which I guess it might be. Thanks for your article on this.

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