Beer, Pepsi, A Cincinnati Family And The Estate Tax

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.

The Use Of A Dynasty Trust

President Obama’s 2012 budget included a provision to limit dynasty trusts to approximately 90 years.

What is a dynasty trust? This creature exists because of estate taxes and generation-skipping taxes. Say that you and your spouse are worth $25 million. You have a daughter, and you come to me because you want to plan your estate. You think you can live on $10 million. To make this easy, say that all your wealth is in publicly-traded stocks. We call the broker and transfer $15 million in stocks to her. At the end of the year you will have a gift tax return. The gift tax exemption this year is $5 million per person, which means that you and your spouse combine for a total exemption of $10 million. You will have a gift tax, as the net gift subject to gift tax is $5,000,000 ($15,000,000 - $10,000,000).

When your daughter passes away, that $15 million will be included in her estate again and she will pay estate tax.

Ah, you say. You now understand what the estate tax is doing. What if you gift to your grandson, that way the $15 million will escape estate tax at your daughter’s death. You “skipped” a generation. Enter the generation-skipping tax, whose purpose is – you guessed it – to tax that transfer to your grandson. No skipping allowed.

Let’s tweak this a bit. Say that you gift $10 million to your daughter and $5 million to your grandson. Now you have an interesting case study. You see, the generation-skipping tax has an exemption. That exemption amount is currently $5 million per person, or $10 million for you and your spouse. You can transfer up to $10 million to your grandson, have it escape the estate tax (at the daughter’s death) and also escape the generation-skipping tax.

Let’s tweak this again. Say that your grandson receives the gift amount (at some point in the future – it doesn’t matter when). When he passes away, the $5 million is in his estate and there will be estate tax. Is there some way to skip his estate tax?

Enter the dynasty trust. You put the $5 million in a dynasty trust. Your grandson is a beneficiary and receives distributions. He does not have enough retained power to dragnet the trust into his estate upon death. The trust escapes his estate and passes on to the next tier of beneficiaries, which are presumably your great-grandchildren.

This trust is designed to never be snared by the estate or generation-skipping tax ever again. Wow!

Enter the rule against perpetuities. There is a common law principle that allows a trust to carry-on for only so long without vesting, which is about 90 years. I studied trust law at the University of Missouri Law School and, frankly, its application in practice confused me both then and now. However, there are 23 states (including Kentucky and Ohio) that have “waived” the rule against perpetuities and allow dynasty trusts. So we can employ a dynasty in Ohio, for example, and sidestep the rule against perpetuities.

Enter Obama’s proposal to limit these trusts to 90 years or so. It would do so, not by limiting the trust, but by limiting the generation-skipping exclusion. As the trust is a creature of tax policy, the effect would be the same. Do not overly worry about this happening soon, however, as Obama’s budget was voted down without dissent in the Senate. However, the proposal does provide insight into future sources of revenue that Congress may revisit.

Because of the long-lived nature of these trusts, you are (almost by default) looking at a corporate trustee. If you haven’t reviewed trustee rates recently, you may be surprised at how expensive this can be. This in turn means that you want a certain minimum amount of money to seed the trust in order to justify the fees. This tax planning is not for the middle class. You also have to be careful in how much power is reserved to the beneficiaries, as too much may result in the trust being included in a beneficiary’s estate. You have to reserve a certain minimum, of course, such as the ability to dismiss and replace a trustee that has become unproductive or overly expensive.

I see these trusts primarily as a means of asset protection against creditor claims and divorces. It may also be a means to keep family businesses under family control, such as by placing the business(es) in a family limited partnership and then placing the partnership units into the dynasty. This would also allow one to utilize gift tax discounts, further magnifying the leverage of the dynasty trust. However, I can also see that society has an interest in not bankrolling a class of nonproductive trust-fund-uberwealthies. Perhaps the President has it right on this one: maybe 90 years is enough time for this tax vehicle.