Estate of Smith v. United States
109 A.F.T.R.2d (RIA) 987, 103 Fed. Cl. 533, 2012 U.S. Claims LEXIS 73 (2012)
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Rule of Law:
In a family-controlled corporation, the lapse of an enhanced voting right that occurs upon a decedent's death is treated as a taxable transfer under Internal Revenue Code § 2704. For estate tax purposes, the stock associated with the lapsed right must be valued as if the right were nonlapsing.
Facts:
- In 1965, Rankin M. Smith, Sr. formed The Five Smiths, Inc. to operate a National Football League franchise.
- On December 31, 1986, the company converted to a Subchapter S corporation, creating Class A common stock with 11.64 votes per share and Class B common stock with 1 vote per share. Mr. Smith held a controlling interest through his Class A shares.
- The 1986 Shareholders Agreement allowed Mr. Smith to bequeath his Class A shares, with their enhanced voting rights, to his family.
- In 1991, as a condition for an investment by third parties John Imlay and Tom Watson Brown, the company's Articles of Incorporation were amended.
- The 1991 amendment stipulated that all outstanding Class A shares would automatically convert into Class B shares on a one-for-one basis upon the death of Rankin M. Smith, Sr.
- This 1991 provision could not be amended without the consent of Imlay and Brown.
- On October 26, 1997, Mr. Smith died, and pursuant to the 1991 amendment, all Class A shares automatically converted into Class B shares, eliminating their enhanced voting rights.
Procedural Posture:
- The Estate of Rankin M. Smith, Sr. filed a U.S. Estate Tax Return (Form 706) on January 26, 1999.
- The Estate filed a claim for refund with the IRS on January 25, 2002.
- On the same day, the IRS issued a Notice of Deficiency, asserting a tax deficiency of $13,644,400.00.
- The Estate paid the asserted deficiency and interest, totaling $19,290,867.00, on March 1, 2002.
- The Estate filed a second and third claim for refund, which the IRS disallowed.
- The Estate (plaintiff) filed a complaint in the United States Court of Federal Claims seeking a tax refund from the United States (defendant).
- Both parties filed cross-motions for partial summary judgment on the issue of whether IRC § 2704 applies.
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Issue:
Does Internal Revenue Code § 2704 apply to the automatic conversion of a decedent's super-voting Class A shares into single-vote Class B shares upon his death in a family-controlled corporation, requiring the shares to be valued for estate tax purposes as if the enhanced voting rights had not lapsed?
Opinions:
Majority - Judge Horn
Yes. Internal Revenue Code § 2704 applies to the automatic conversion of the shares, requiring the estate to value them as if the enhanced voting rights had not lapsed. The statute applies because the decedent and his family maintained control of the corporation both before and after his death, and the lapse of the voting rights occurred at the moment of death, not when the provision causing the lapse was adopted years earlier. The court reasoned that a 'lapse' occurs under Treasury Regulation § 25.2704-1(b) when a 'presently exercisable voting right is restricted or eliminated.' Mr. Smith possessed the full, presently exercisable enhanced voting rights of his Class A shares until the moment he died, at which point they were eliminated. The court rejected the estate's argument that the lapse occurred in 1991 when the corporate articles were amended, finding that this event merely created the condition for a future lapse. Furthermore, the court held that the statutory definition of 'control'—holding at least 50 percent of stock by vote or value—was met, and it declined to add a requirement that the family must also have the unilateral power to restore the lapsed right. Therefore, the stock must be valued at its pre-lapse value of $30 million for estate tax purposes.
Analysis:
This case provides a clear interpretation of when a 'lapse' of voting rights occurs for the purposes of IRC § 2704, solidifying that the taxable event is the actual elimination of the right, not the creation of the mechanism that will cause the future elimination. The decision reinforces the purpose of Chapter 14 of the IRC, which is to prevent taxpayers from using intra-family corporate arrangements to artificially depress the value of an estate. By narrowly construing the statutory definition of 'control' and the timing of the lapse, the court makes it more difficult for family-controlled businesses to structure transactions that shed value at death to avoid estate taxes.
