In Estate of Koons III v. Commissioner (11th Cir. 4/27/17), the Court of Appeals for the 11th Circuit affirmed a prior Tax Court decision and handed the taxpayer estate a double loss. John Koons owned 46.9% of the voting stock and 51.5% of the nonvoting stock of CIC Investment Corp. (“CIC”), which bottled and distributed Pepsi products and sold vending machine items. The stock of CIC not owned by Mr. Koons was owned by his children and trusts for their benefit. On December 15, 2004, CIC agreed to sell its business to Pepsi for $352 million in order to settle an ongoing dispute.

Mr. Koons developed a plan to place the sales proceeds into CI, LLC (“CI”), which would then serve as a family investment vehicle to be run by professional advisors. The children objected to this plan and conditioned the sale of their CIC shares on receiving an offer from CI to redeem their interests after the sale to Pepsi closed. CI made redemption offers to the children on December 21, 2004. The sale to Pepsi closed on January 10, 2005, and the sales proceeds went into CI. Mr. Koons died on March 3, 2005, at which time his revocable trust owned a 46.94% voting interest and 51.59% nonvoting interest in CI. The redemption of the children’s interests closed on April 30, 2005, following which Mr. Koons’ revocable trust owned 70.42% of the voting interest and 71.07% of the nonvoting interest in CI.

Mr. Koons’ estate borrowed $10 million from CI to pay part of the estate taxes that were due. It executed a promissory note bearing an annual interest rate of 9.5%. No payment was due on the note for 18 years and thereafter interest and principal were to be paid in 14 installments through 2031. On Mr. Koons’ estate tax return a deduction in the amount of $71 million was claimed as an administration expense, for interest that would become payable on the loan. The authority for deducting such interest is the Graegin case decided by the Tax Court in 1988. Loans of this nature are commonly referred to as “Graegin loans.”

The estate tax return also claimed a 31.7% discount in the valuation of the interest in CI due to lack of marketability. The Court of Appeals affirmed a prior holding of the Tax Court that had denied the deduction for the interest on the loan and also concluded that the marketability discount should be limited to 7.5%. The rationale for denying the interest expense was that under the Graegin case, such interest is a necessary interest expense only where the estate can show it would have been required to sell assets at a loss to pay the estate tax. In the Graegin case, the principal asset of the estate was stock of a closely held corporation and the loan was necessary in order to avoid a forced sale at a substantial discount. In the case of Mr. Koon’s estate, its principal asset was its significant interest in CI which held over $200 million of highly liquid and saleable assets. Mr. Koons’ revocable trust held over 70% voting control over CI following the redemptions of the children and could have voted to approve any distribution necessary to enable the payment of estate taxes. Therefore incurring the interest expense was not necessary for the administration of the estate or the payment of estate taxes.

On the issue of the correct valuation discount for the CI interest, the key question was whether the revocable trust held a controlling interest. The redemptions of the children had not closed at the time of Mr. Koons’ death so the trust literally did not hold a controlling interest. However, given the children’s level of unhappiness over CI, the court concluded that the redemptions would almost certainly be completed so the trust effectively held a 70% interest. By holding a controlling interest, the trust could have forced CI to distribute its assets so it would never sell its membership interest for any amount less than the value of its proportionate share of those assets. The offers made before Mr. Koons’ death to redeem the interests of the children, coupled with the children’s expressed dislike for CI, were fatal to any attempt to obtain a significant valuation discount.