I am reviewing a
tax case involving estate taxes, generation-skipping taxes, a Cincinnati family,
and a beer brand only recently brought back to the market. Let’s talk about it.
John F. Koons
(Koons) owned shares that his father had bought during the 1930s in Burger
Brewing Co., a Cincinnati brewer known for its Burger beer. The Cincinnati Reds
broadcaster Waite Hoyt nicknamed a deck at Crosley Field (where the Reds then
played) “Burgerville.”
During the 1960s
the company began bottling and distributing Pepsi soft drinks. In the 1970s it
left the beer business altogether. The company changed its name to Central
Investment Corp (CIC), and Koons was its largest shareholder.
In the late 1990s
Koons got into litigation with PepsiCo. By 2004 PepsiCo suggested that the
litigation could be resolved if CIC sold its soft drink business and left the
Pepsi-Cola system.
In July, 2004 Koons
revised his will to leave the residue of his estate to a Revocable Trust.
In August, 2004
Koons set-up Central Investments LLC (CI LLC) to receive all the non-PepsiCo
assets of CIC.
In December, 2004
Koons and the Koons children executed a stock purchase agreement with PepsiCo.
Koons owned 46.9% of the voting stock and 51.5% of the nonvoting stock of CIC.
The deal was sweet.
PepsiCo paid $50 million to settle the lawsuit as well as $340 million, plus a
working capital adjustment, for the shares of CIC.
There was a kicker
in here though: the children’s agreement to sell their CIC shares was contingent
on their also being redeemed from CI LLC. It appears that CI LLC was going to
be professionally managed, and the children were being given an exit.
In January, 2005 CI
LLC distributed approximately $100 million to Koons and the children.
By the end of
January two of the four Koons children decided to accept the buyout offer.
In February, 2005
Koons amended the Revocable Trust. He removed the children, leaving only the
grandchildren. He then contributed his interest in CI LLC to the Trust.
NOTE: A couple of things happened here.
First, the trust is now a generation-skipping trust, as all the beneficiaries
in the first generation have been removed. You may recall that there is a
separate generation-skipping tax. Second, Koons’ interest in CI LLC went up
when the two children agreed to the buyout. Why? Because he still owned the
same number of shares, but the total shares outstanding would decrease pursuant
to the redemption.
Koons – who would
soon own more than 50% of CI LLC - instructed the trustees to vote in favor of
changes to CI LLC’s operating agreement. This prompted child number 2 – James
B. Koons – to write a letter to his father. Son complained that the terms of
the buyout “felt punitive” but thanked him for the “exit vehicle.” He told his
dad that the children would “like to be gone.”
Sure enough, the
remaining two children accepted the buyout.
On March 3, 2005
Koons died.
The buyouts were
completed by April 30, 2005. The Trust now owned more than 70% of CI LLC.
And the Koons
estate had taxes coming up.
CI LLC agreed to
loan the Trust $10,750,000 to help pay the taxes. The note carried 9.5%
interest, with the first payment deferred until 2024. The loan terms prohibited
prepayment.
OBSERVATION: That’s odd.
The estate tax
return showed a value over $117 million for the Trust.
The estate tax
return also showed a liability for the CI LLC loan (including interest) of over
$71 million.
And there you have
the tax planning! This is known as a “Graegin” loan.
NOTE: Graegin was a 1988 case
where the Court allowed an estate to borrow and pay interest to a corporation
in which the decedent had been a significant shareholder.
Did it work for the
Koons estate?
The IRS did not
like a loan whose payments were delayed almost 20 years. The IRS also argued
that administration expenses deductible against the estate are limited to expenses
actually and necessarily incurred in the administration. The key term here is “necessary.”
Expenditures not essential to the proper
settlement of the estate, but incurred for the individual benefit of the heirs,
legatees, or devisees, may not be taken as deductions.”
The estate argued that it had less than $20 million in cash to
pay taxes totaling $26 million. It had to borrow.
You have to admit, the estate had a point.
The IRS fired back: the estate controlled the Trust. The Trust could
force CI LLC to distribute cash. CI LLC was sitting on over $300 million.
The estate argued that it did not want to deplete CI LLC’s cash.
The Court wasn’t buying this argument. It pointed out that the estate depleted
CI LLC’s cash by borrowing. What was the difference?
Oh, oh. There goes that $71 million deduction on the estate tax
return.
It gets worse. The IRS challenged the value of the Trust on the estate
tax return. The Trust owned over 70% of CI
LLC, so the real issue was how to value CI LLC.
The estate’s expert pointed out that the Trust owned 46.9% of CI LLC
at the time of death. There would be no control premium, although there would
be a marketability discount. The expert determined that CI LLC’s value for tax
purposes should be discounted almost 32%.
The IRS expert came in at 7.5%. He pointed out that – at the time of death
– it was reasonably possible that the redemptions of the four children would
occur. This put the Trust’s ownership over 50%, the normal threshold for
control.
Here is the Court:
The redemption offers were binding
contracts by the time Koons died on March 3, 2005. CI LLC had made written
offers to each of the children to redeem their interests in CI LLC by February
27, 2005. Once signed, the offer letters required the children to sell their
interests ....
Any increase in the
value of CI LLC would increase the generation-skipping tax to the Trust.
Any increase in the
value of the Trust would increase the estate tax to the estate.
The tax damage when
all was said and done? Almost $59 million.
Given the dollars involved,
the estate has almost no choice but to appeal. It does have difficult facts,
however. From a tax planner’s perspective, it would have been preferable to
keep the Trust from owning more than 50% of CI LLC. Too late for that however.
