Similar Fact Pattern, Different Results

By Peter Hopkins, CPA, MS (Tax) – Manager and Marie Holliday, CPA, MBA – Managing Director

As published in Delaware Banker Fall 2016 Vol.12 No. 4

A pair of recent Tax Court cases should cause advisers to take note. The IRS’s targets were Sumner Redstone and the estate of his brother, Edward. Sumner is the media mogul who resigned as executive chairman of both CBS Corporation and Viacom Inc. in February 2016, at the age of 92. Although Sumner gave up his titles, National Amusements, Inc. (NAI) continues to control nearly 80% of the voting shares of both companies. NAI is a privately owned global entertainment company that was founded by Mickey Redstone, father of Sumner and Edward. Eighty percent of NAI’s stock is owned by the Sumner M. Redstone National Amusements Inc. Trust, which is controlled by Sumner. Sumner’s daughter, Shari, owns the remaining 20%.

The Redstones made news in Delaware in July 2016, when former Viacom board members sued in the Court of Chancery over their termination by NAI. They claim that Sumner lacks mental capacity and that he is being manipulated by Shari. The case was scheduled to go to trial in October as this article went to press.

Background

Mickey began building drive-in theaters in 1936. Over time, he formed several corporations, and Sumner and Edward owned varying percentages of several of them. Both sons worked in the family business. In 1959, NAI was incorporated as a holding company to consolidate the interests of Mickey, Sumner and Edward. All three Redstones contributed the stock they owned in the separate corporations for NAI stock. Based on the stock they owned, the book values of the shares they exchanged for the NAI stock were $30,328 for Mickey, $17,845 for Edward and $18,445 for Sumner. Mickey also contributed $3,000 in cash. Although, these do not equate to fair values, the reorganization resulted in Mickey having contributed about 48% of NAI’s assets and Sumner and Edward having supplied approximately 26% each. NAI issued certificates for 100 shares of Class A voting stock to each of Mickey, Sumner and Edward. The certificates were kept in NAI’s vault.

In 1968, Mickey wanted to wind down his involvement in the business and do some estate planning. He gifted 50 of his 100 shares of NAI common stock to a trust for the benefit of his four grandchildren. The following year, Mickey exchanged his remaining 50 shares for 86,780 shares of NAI preferred stock.

In the late 1960s, Edward and his wife had their son, Michael, admitted to a psychiatric hospital over the objections of the rest of the Redstone family. Mickey and Sumner believed this reflected poorly on the family name. Eventually, Edward brought his son home, but he resented the intrusion of his parents and brother into his personal affairs. He also became unhappy with his role at NAI. He felt Mickey and Sumner were ignoring his opinions. Edward raised the possibility he might leave the family business. Sumner reacted by hiring an employee to assume Edward’s responsibilities. Edward abruptly quit his job at NAI in anger.

Edward demanded his stock certificate from NAI and threatened to sell his shares to an outsider, if the company did not redeem them at a price he considered fair. Mickey countered by claiming NAI had a right of first refusal on any sale of its shares. Mickey also argued that even though 100 shares were registered in Edward’s name, a portion of those shares had been held in an oral trust for the benefit of Edward’s children since NAI’s inception. He said this was his intention in 1959, when he allowed Edward to receive one-third of NAI’s stock, even though he contributed only 26% of the company’s initial capital. After negotiations broke down, Edward filed two lawsuits in Massachusetts demanding immediate delivery of his NAI stock. Edward’s mother, Belle, convinced her son to compromise with his father.

In 1972, the parties settled allowing Edward to sell 66 2/3 shares of NAI to the company for $5 million and stipulating that the remaining 33 1/3 shares had been held in an oral trust for the benefit of Edward’s children since 1959. Edward executed two trust instruments as settlor, one for each child, to formalize the arrangement, and each trust received 16 2/3 shares of NAI stock. Sumner became the sole trustee of each trust. Shortly after the settlement agreement was signed, Sumner executed two irrevocable trust instruments, one for each of his children. He transferred 16 2/3 shares of his NAI stock to each trust. Just as the instruments governing the trusts for Edward’s children had, these instruments named Sumner as the sole trustee and stated that they formalized the oral trust that had existed since 1959. On the advice of his CPA, Sumner filed no 1972 gift tax return.

It all could have ended there and forever remained under the proverbial rug. However, in 2006, Edward’s son, Michael, and the trustees of three Redstone family trusts sued Sumner, Edward and NAI, arguing that additional stock should have been transferred to the trusts in 1972, under the 1959 oral trust. The plaintiffs’ claim was based on Mickey’s assertion in the 1972 settlement agreement that “not less than 50 %” of the shares originally issued in Edward’s name were held in the oral trust. The plaintiffs sought to be made whole under the purported oral trust, since only 1/3 of Sumner and Edward’s original shares had been transferred to the 1972 trusts.

The case went to trial, and Edward testified that he believed he was the owner of all 100 shares of NAI that had been in dispute. However, on advice of counsel, he compromised and agreed to the settlement. Edward said that he paid no gift tax in 1972, because he made no gift. He simply renounced his ownership interest in the 33 1/3 shares to receive payment for the 66 2/3 shares.

Sumner testified that he had voluntarily transferred 33 1/3 shares of NAI to the trusts for his children. He said that Mickey had made no claim about an oral trust regarding his NAI stock as he had Edward’s shares. Rather, Sumner wanted to do the same thing for his children as Edward had done and just made an outright gift.

Ultimately, the Massachusetts courts ruled that the plaintiffs had failed to prove the existence of the oral trust.

Edward’s case

When the IRS got wind of Michael suing his father and uncle, they noticed Edward had not filed a 1972 gift tax return. The Service audited Edward and, in 2013, issued a notice of deficiency to his estate for 1972 gift tax of $737,625 with a 25% late filing penalty and an additional 50% civil fraud penalty. The Service claimed that if fraud could not be proven, a 5% negligence penalty should apply. The bill from the IRS ranged from $958,912 to $1,290,844 plus interest.

The Tax Court noted that a transfer of property in the ordinary course of business is deemed to have been made for full and adequate consideration and is, therefore, not a gift. The court identified characteristics that a transfer of property must have to be considered made in the ordinary course of business. These are

(1) bona fide

(2) at arm’s length

(3) free of any donative intent.

The Tax Court concluded that the transfer was bona fide. It found no evidence that Edward was colluding with Mickey and Sumner in 1972. Rather, Edward was estranged from his father and brother. Even though the Massachusetts courts ultimately ruled there had never been an oral trust, the Tax Court found the theory espoused by Mickey to have been persuasive enough to create a genuine dispute forcing Edward to sue to recover his stock and to agree to the settlement.

The Tax Court found that the transfer was at arm’s length. The court noted Edward, Mickey and Sumner were represented by counsel in a genuine controversy. They engaged in lengthy negotiations. They reached a compromise that avoided the cost and uncertainty of litigation and the embarrassment of their family dispute being settled in public. The court was convinced that Edward had acted as one would act in settling differences with a stranger.

Edward’s actions demonstrated to the Tax Court a lack of donative intent. The court concluded that his objective was to obtain full payment for all of his 100 shares of NAI. If Edward had any donative intent, he could have accepted the oral trust theory advanced by Mickey. Instead, he rejected it and initiated litigation. The court found no evidence that Edward was motivated by the love and affection that typically inspires one to make a gift.

The IRS agreed that Edward’s transfer was bona fide, at arm’s length and free of donative intent. However, the Service claimed that since Edward’s children provided no consideration in exchange for the shares of NAI, this must be a gift. The Tax Court ruled that Edward had received full and adequate consideration and concluded the source of such consideration was irrelevant. Therefore, Edward made no gift in 1972, and a judgement was entered in favor of his estate.

Sumner’s case

In 1974, the IRS commenced a gift tax audit of Sumner’s records for 1970 through 1972, but they were not looking for a transfer of NAI shares. Instead, Sumner was audited as part of a project the IRS developed at the request of Congress to identify political donors contributing to multiple committees supporting the same candidate, skirting the $3,000 per candidate limit. The objective of the IRS project was to determine whether some contributions might be taxable gifts. At the conclusion of the audit, the Service determined that Sumner had no 1972 gift tax filing requirement.

In May 2011, the IRS commenced a second 1972 gift tax audit of Sumner’s records. Sumner complied with all document requests made by the Service. After more than a year and a half of examining Sumner’s records, the IRS issued a notice of deficiency proposing gift tax and penalties in amounts identical to those it had sought from Edward.

Before trial in the Tax Court, Sumner moved for dismissal, claiming the government was barred by laches from determining a 1972 gift tax deficiency over 40 years later. The court denied this motion, citing prior rulings that the timeliness of tax claims of the United States is governed solely by the statute of limitations, which had not yet begun, since Sumner never filed a 1972 gift tax return.

Sumner contended that the proposed deficiency should be set aside, because the IRS conducted a second examination of his 1972 records without providing him with written notice that a second examination was necessary, as required by law. The Tax Court noted that Sumner, without complaint, cooperated with the revenue agent during the recent audit. By doing so, he is deemed to have consented to a second examination of his records and cannot use the lack of an IRS notice to shield himself from taxes he owes.

Despite Sumner’s claim that his transfers of NAI stock to the trusts were done in the ordinary course of business to appease his father and facilitate the settlement of his brother’s litigation, the Tax Court was not convinced. The court pointed to Sumner’s testimony in the 2006 Massachusetts case in which he said that he had transferred the stock voluntarily and made an outright gift. The court found no evidence that Sumner received anything in exchange for the NAI shares and noted that his transfer to the trusts took place three weeks after the settlement agreement had been signed. Therefore, it had nothing to do with facilitating the settlement.

Sumner challenged the valuation of the shares transferred to the trusts, which the IRS based on the redemption price paid to Edward three weeks earlier. The Tax Court was not persuaded by Sumner’s valuation expert, who testified that the stock was worth only $735,981, and accepted the IRS’s valuation of $2.5 million.

The Tax Court found no evidence that the IRS had proven fraud and rejected the Service’s proposed fraud penalty. The court also concluded that Sumner had demonstrated reasonable cause to merit abatement of both the negligence and late filing penalties, because he relied on the advice of competent tax professionals who told him he had no 1972 gift tax filing requirement.

The Tax Court ruled in favor of the IRS regarding the tax, but Sumner proved his case on all the penalties.

Lessons learned

1. If there is any uncertainty about whether a gift tax return is required, filing one and making full disclosure starts the running of the statute of limitations and creates an end date at which a taxpayer will have certainty.

2. Identical transactions done for different reasons may not have the same consequences. Look beyond the mechanics of a transaction to determine its tax characterization.

3. If the IRS wants to reexamine a tax period it already audited, the taxpayer’s representatives should immediately clarify that the taxpayer does not consent.

4. In any controversy with the IRS, penalties should be challenged.

5. The IRS pays attention to public sources of information such as news reports and court decisions.

6. Seeking the advice of a competent tax professional can help avoid disputes with the IRS. Even if the advice turns out to be wrong, it demonstrates prudence and due care that can support a reasonable cause defense against penalties.

Peter Hopkins is a Tax Manager and Marie Holliday is the Managing Director at Cover & Rossiter. The firm is one of the oldest and most respected Delaware CPA firms. Cover & Rossiter is focused on the success and growth of its clients. The firm serves a diverse client base regionally and nationally.