The IRS and executors have settled two cases in the United States Tax Court involving members of the Woelbing family, who own Carma Laboratories, Inc., of Franklin, Wisconsin, the maker of Carmex skin care products, and a sale of Carma stock to an irrevocable trust in 2006 that relied on a “defined value clause.” The agreed dispositions of the Tax Court cases indicate that the IRS conceded all the additional taxes and penalties it had previously asserted. But the end of this litigation still leaves questions and, perhaps, even warnings for estate planning clients and their advisors.

The cases are Estate of Donald Woelbing v. Commissioner (Tax Court Docket No. 30261-13, petition filed Dec. 26, 2013, stipulated decision entered March 25, 2016) and Estate of Marion Woelbing v. Commissioner (Tax Court Docket No. 30260-13, petition filed Dec. 26, 2013, stipulated decision entered March 28, 2016). In 2006 Mr. Woelbing sold his nonvoting Carma stock to an irrevocable grantor trust for an interest-bearing promissory note in the face amount of about $59 million. In other words, this was an installment sale to a grantor trust. After Mr. Woelbing died in 2009, the IRS challenged the 2006 sale in connection with its audit of his estate tax return and eventually asserted gift tax deficiencies with respect to both Mr. and Mrs.Woelbing and estate tax deficiencies with respect to Mr. Woelbing’s estate. The taxes and associated penalties the IRS asserted totaled about $152 million.

The 2006 Sale

In their Tax Court petition, Mr. Woelbing’s executors described the sale as follows:

In the 2006 stock sale transaction, Decedent sold all of his nonvoting stock of Carma Laboratories, Inc. to the Trust in exchange for an interest-bearing promissory note in the amount of $59,004,508.05. The purchase price was determined by an appraisal of the nonvoting stock’s fair market value by an independent appraiser….

The Installment Sale Agreement further provided that both the number of shares of stock sold and the purchase price of $59,004,508.05 were determined on February 28, 2006, but that Decedent and the Trust acknowledge that the exact number of shares of stock purchased by the Trust depends on the fair market value of each share of stock. The Installment Sale Agreement further provided that based on a recent appraisal of the stock, this results in 1,092,271.53 shares of stock being purchased but that in the event that the value of a share of stock is determined to be higher or lower than that set forth in the Appraisal, whether by the Internal Revenue Service or a court, then the $59,004,508.05 purchase price shall remain the same but the number of shares of stock purchased shall automatically adjust so that the fair market value of the stock purchased equals $59,004,508.05. [This type of provision is commonly known as a “defined value clause” or “value definition formula” or some variation.]

At the time of the 2006 stock sale transaction and subsequently, the Trust had significant financial capability to repay the promissory note for the nonvoting stock of Carma Laboratories, Inc. without using the nonvoting stock of Carma Laboratories, Inc. or its proceeds. This substantial financial capability exceeded 10% of the face value of the promissory note. [Ten percent was the amount of the “down payment” or “equity” or “security” the IRS reportedly required as a condition of ruling favorably on an installment sale to a grantor trust in Letter Ruling 9535026 in 1995.]

At the time of the 2006 stock sale transaction, the Trust owned three life insurance policies on Decedent’s and Mrs. Woelbing’s lives with an aggregate cash surrender value of $12,635,722 [over 21% of $59 million]. All of this cash value could be pledged to a financial institution as collateral for a loan which could be used to make payments on the promissory note to Mr. Woelbing. Since Carma Laboratories, Inc. was required to continue making payments during Mr. and Mrs. Woelbing’s lifetimes under the Split-Dollar Insurance Agreement, the amount of cash surrender value available for this purpose would continue to grow….

At the time of the 2006 stock sale transaction, Petitioners, Paul Woelbing and Eric Woelbing [sons of Mr. and Mrs. Woelbing], beneficiaries of the Trust, executed personal guarantees in the amount of ten percent of the purchase price of the stock.

The IRS Challenge

The IRS basically ignored the note, doubled the value of the stock on the date of the gift to $117 million, almost tripled the value of the stock as of the date of Mr. Woelbing’s death to $162 million, and added that value of $162 million to his gross estate.

The IRS viewed the note as a form of “retained interest” in the trust, valued at zero under section 2702, which Congress enacted in 1990 as part of the “estate freeze” provisions of chapter 14 of the Internal Revenue Code. As a result, the IRS treated the entire value of the transferred shares, which it asserted to be $117 million, not $59 million, as a taxable gift in 2006, which increased the gift taxes owed by both Mr. and Mrs. Woelbing because they had elected to “split” gifts on their 2008 federal gift tax returns.

In addition, because the transferor, Mr. Woelbing, held that “retained interest” until his death and the IRS did not view his transfer of the stock as a bona fide sale for adequate and full consideration, the IRS asserted that the entire value of the stock on the date of his death, July 6, 2009, which it viewed as $162,191,400, was included in his gross estate under section 2036 of the Internal Revenue Code. For good measure, the IRS asserted that the enjoyment of the stock Mr. Woelbing transferred to the trust in 2006 was subject at the time of his death to his right to alter, amend, revoke, or terminate, within the meaning of section 2038 of the Code.

The Resolution

The decisions of the Tax Court, representing not the judgment of the Court but the outcome to which the executors and the IRS had stipulated, found no additional gift taxes due with respect to either Mr. or Mrs. Woelbing and no additional estate tax due with respect to Mr. Woelbing’s estate. Estate taxes were not an issue with respect to the estate of Mrs. Woelbing, who died September 29, 2013 (two days after the IRS issued its Notice of Deficiency, as her executors’ petition pointed out). For that reason, the stipulated decisions have no impact on the estate tax liability of Mrs. Woelbing’s estate, for which the statute of limitations has not run. It has been informally reported that an agreed upward valuation adjustment in the settlement was reflected in an agreed downward adjustment in the number of shares Mr. Woelbing transferred in the 2006 sale, much as the defined value clause contemplated. In that case, the value of those shares would have been included in his gross estate, would have qualified for a marital deduction, and thus presumably would increase the size of Mrs. Woelbing’s gross estate and increase the amount of estate tax owed by her estate. The settlement with the IRS probably included her executors’ agreement to make or accept those changes to her estate tax return.

But this is a surprising settlement, substantively and procedurally. It is especially surprising that the IRS would effectively agree to the defined value clause, which IRS personnel are known to really dislike. The only plausible explanation may be that the IRS attorneys thought their position on the valuation issue itself was very weak, and the executors’ attorneys thought so too, and this was the only way the IRS was able to credibly seek any concession on value.

Reflections and Lessons

In any event, as merely a settlement, the stipulated decision has no precedential value, even if we knew exactly what substantive trade-offs informed the outcome. The settlement, while very good for the parties, deprives the estate planning community of an opportunity to learn how the Tax Court might really decide difficult issues affecting the common estate planning technique of installment sales to grantor trusts, including relatively new issues like the possible reliance on life insurance policies and beneficiaries’ guarantees to provide “equity” in the trust, the application of section 2702 to the sale, and the application of sections 2036 and 2038 after the sale, and even including the seemingly familiar yet still disputed issue of the use of defined value clauses.

It is tempting to view stipulated decisions reflecting no additional tax due as a good result for the taxpayers, and that view is reasonable, especially in the absence of more information about the details of the settlement and the impact on Mrs. Woelbing’s estate. But it is important to maintain a perspective about such cases. Mr. Woelbing’s sale was in 2006, he died in 2009, Mrs. Woelbing died in 2013, the Tax Court petitions were filed at the end of 2013, an intense IRS audit had undoubtedly preceded that, and the Woelbing family is just now achieving a resolution. This could not have been easy for the Woelbing family and is not a model most people would find appealing.

How do such cases arise?

It is impossible to overlook or downplay, and difficult to explain or excuse, what appears to have been a very aggressive approach on the part of the IRS. The total amount of gift tax, estate tax, and penalties at issue for both estates was $152 million, over 250% of the appraised value of the transferred stock at the time of the transaction and even almost 94% of what the IRS asserted to be the much higher date-of-death value of the stock. While there may be some double-counting in those numbers, the all-too-familiar drumbeat of valuation, section 2702, section 2036, section 2038, and “accuracy-related” penalties suggests a degree of overreaching that itself could be subject to penalties if employed by a taxpayer. We have noted this “everything-but-the-kitchen-sink” approach in the Woelbing cases before, as in the Comment on Development Number Three in the “Top Ten” Estate Planning and Estate Tax Developments of 2014.

In the Woelbing cases, however, it is possible that this approach was partly provoked by a similarly wide-ranging estate planning approach to a commonplace transaction. Achieving the 10% rule-of-thumb “equity” target with inside financial obligations like split-dollar life insurance and beneficiaries’ guarantees rather than hard assets, reinforced by an aggressive form of defined value clause, may simply have been too many “moving parts” to sustain a low profile.

Regarding the Tax Court’s approval of what was perhaps the most ambitious defined value clause litigated to date, in Wandry v. CommissionerT.C. Memo 2012-88, we contemporaneously expressed wariness, and we continue to do so. But the Woelbing transaction seems to have used the defined value clause very expansively. The Tax Court petition states that “Decedent sold all of his nonvoting stock” but that “in the event that the value of a share of stock is determined to be higher or lower than that set forth in the Appraisal, whether by the Internal Revenue Service or a court, then … the number of shares of stock purchased shall automatically adjust.” The reference to a possible determination of a “lower” value, besides being unrealistic in the setting of a gift tax audit, is entirely meaningless in light of Mr. Woelbing’s sale of “all of his nonvoting stock” which leaves no room for the upward adjustment in the allocation of shares that such a lower value would compel. Could that have been what attracted the attention and provoked the assertiveness of the IRS?

The lesson is that levels of foreseeable risk, reward, complexity, delay, and expense need to be explained, understood, and balanced in a way that matches the client’s tolerances and minimizes the possibility of surprises. Often this balancing will forgo the use of every imaginable feature, even features that appear to be in common use, in favor of greater predictability and peace of mind and, yes, staying out of the Tax Court and out of alerts like this.

Another warning to take from the Woelbing cases is that at bottom they were fundamentally about the continuity of an operating business. Readers of this alert can go to the store and buy Carmex products (and thereby add to the value of Carmex stock). This may be part of the explanation of the IRS’s willingness to settle the cases. One would think transactions that do not involve operating businesses, perhaps involving “family limited partnerships” holding marketable securities, would be the IRS’s highest priority. It is always alarming and disappointing to see this kind of administrative preoccupation with operating businesses that Congress has repeatedly affirmed a policy of favoring. And it is an additional reason for caution when dealing with a transaction where the possible advantage of planning for an operating business is not present.