What would you do?

The decedent was an extremely wealthy man, with a net worth in excess of $3 billion. You are the executor of his estate.

Prior to his death in 2009, he retained one of the top tax firms in the country to review his existing estate plan.

Under his existing plan, which included some taxable bequests, over $700 million would pass to his spouse and about $2.2 billion would pass to various charities, leaving an estate tax bill of about $88 million. The assets passing at his death would receive a step-up in basis for purposes of determining the gain realized on their subsequent sale, thereby reducing the future income tax liability of his beneficiaries. death-tax-photo

The decedent was very ill when he engaged the tax firm, but he wanted to explore the possibility of leaving more of his wealth to his children and grandchildren.

The decedent told the tax firm that he wanted to structure his estate in a tax efficient manner, but did not want to take any unnecessary risks in his estate planning. In particular, he did not want his estate to attract unnecessary IRS attention.

After presenting an overview of several wealth planning options that were potentially available to the decedent – including the use of GRATs, sales to intentionally defective grantor trusts, educational trusts, and testamentary charitable lead annuity trusts – the tax firm focused on the use of SCINs in combination with GRATs.

Within less than one month’s time, a SCIN-based estate plan was implemented: trusts were established and funded with “seed” money, for the benefit of the decedent’s children and grandchildren; and the decedent sold shares of stock in his corporation to the trusts in exchange for 5-year self-cancelling installment notes (“SCINs”), which included risk premiums for the cancellation feature, annually payable interest, and balloon principal payments. He then contributed the SCINs to 5-year GRATs. According to the tax firm, this structure ensured a “win if you live, win if you die” outcome.

Specifically, if the decedent died within 5 years, the SCINs would be cancelled, no further payments under the SCINs would be due, and the stock (which had been transferred to the trusts in exchange for the SCINs), would remain with the trusts.

If the decedent lived, upon the expiration of the 5-year term, virtually all of the principal and risk premium interest payments associated with the SCINs issued by the trusts (which had been transferred to the GRATs) would be transferred to the remainder beneficiaries of the GRATs – the trusts. Thus, the obligors and the obligees on these SCINs were to be one and the same: the trusts.

Seven weeks after the implementation of this plan, the decedent passed away, never having received any interest or principal payments in respect of the SCINs or the GRAT.

You filed estate tax and gift tax returns with the IRS and paid almost $168.5 million of federal estate tax and almost $83 million of federal gift tax.

The IRS examined these returns and challenged the estate plan. It determined that the estate owed almost $846 million of gift tax, and almost $1.887 billion of estate tax (including penalties), for a total deficiency of over $2.7 billion, plus interest.

You consulted with the estate’s professional advisers, and then filed a petition with the U.S. Tax Court in June of 2013.

In July of 2015, you and the government reached a stipulated decision in which you agreed to:

  • Deficiencies of gift tax of approximately $178 million;
  • Estate tax of approximately $153 million; and GST tax of approximately $46 million. This totaled $377 million, as opposed to the more than $2.7 billion originally sought by the IRS.

Are you relieved? Somewhat.

Are you satisfied? Not really, especially when you consider that the hundreds of millions of dollars paid to the IRS would not pass to the charities that were the intended residual beneficiaries of the decedent’s estate.

“Call My Lawyer!”

On September 24, 2015, the executors for the Estate of Davidson filed a complaint against Deloitte Tax LLP (“DT”) in NY Supreme Court, in Manhattan for recovery of approximately $500 million in additional estate and gift taxes, and related fees, penalties, and interest that the executors claim were assessed by and paid to the IRS as a result of DT’s alleged failure to: (i) disclose all material risks and information; (ii) provide reasonable and appropriate advice given the then-existing state of estate and tax planning knowledge; and (iii) design and implement a bona fide and defensible plan that could withstand the inevitable IRS scrutiny that would occur.

Over the course of 90-plus pages, the complaint provides what purports to be a detailed description of the decedent’s discussions with DT, the implementation of his estate plan, its shortcomings, the dispute with the IRS, and the resolution thereof at the Tax Court.

SCINs

The complaint touches on many of the factors that must be considered in structuring an estate-planning transaction that involves the use of a SCIN. For example, the complaint alleges that DT failed to:

  • Design and implement bona fide economic transactions, conducted at arms’ length, as opposed to purely tax driven transactions;
  • Properly structure the SCIN transactions with appropriate capitalization, interest rates, and repayment terms;
  • Use decedent’s actual anticipated life expectancy in creating the term for the SCINs, as opposed to the 5-year term from mortality tables under IRC §7520, which could not be relied on in light of decedent’s poor health;
  • Calculate the appropriate “risk premium” for the SCINs, instead of improperly relying upon the §7520 mortality tables;
  • Provide for the actual payment of at least a portion of the risk premium to the decedent during the term of the SCINs;
  • Provide appropriate amortization for the repayment of the SCINs, as opposed to, among other things, the use of a “balloon payment” due at the end of the SCINs’ 5-year term, which created the impression that there was no realistic expectation of repayment to the decedent;
  • Fund the trusts that were obligors under the SCINs with sufficient assets in order to be able to repay the holders of the SCINs upon maturity of the SCINs;
  • Create defensible and acceptable transactions, instead of creating circular, illusory arrangements by which certain obligors under the SCINs would in effect owe themselves in the event that the decedent survived their 5-year term; and
  • Separate out the various transactions in a manner that gave independent significance to each transaction, as opposed to effectuating all the various transactions within less than a month, and in some instances on the same day, making the plan subject to challenge under the “step-transaction doctrine.”

So what’s the punchline?  Check in for Part II tomorrow to find out!