TAX COURT OPINION

Case: Estate of Eugenia F. Williams, Deceased; First Tennessee Bank, N.A., Executor
Docket Number: 12210-02
Judge: Holmes
Opinion Type: memo
Filed: 01/06/2009
Pages: 18

RECORDED SERVICE CAL. STAT. M. JUDGE T.C. Memo. 2009-5 FILES UNITED STATES TAX COURT ESTATE OF EUGENIA F. WILLIAMS, Deceased, FIRST TENNESSEE BANK, N.A., Executor, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent Docket No. 12210-02. Filed January 6, 2009. Sheldon Kay, Joseph DePew, and William Merrit for petitioner. Martha Weber, Nancy Hale, and James May, for respondent. MEMORANDUM FINDINGS OF FACT AND OPINION HOLMES, Judge: Eugenia Williams was a wealthy woman who lived a long life but had no natural heirs. She decided to leave almost her entire estate to four charities, with one important exception. She bequeathed the stock in a closely held company to - Í SERVED JAN 0 6 2006 -3- J. P. Roddy, Sr. and Dr. Williams later expanded their business by founding the Coca-Cola Bottling Company of Johnson City, Tennessee. At trial it was estimated that the David Hitt Williams Trust (the Williams Trust), which held Dr. Williams's stock interests at the time of his death, owned just under 50 percent of Johnson City Coke' s Stock. Although it was Roddy and his family who actually ran Roddy Coke and Johnson City Coke, Roddy and Dr. Williams remained friends until Dr. Williams's death in 1929. Dr. Williams.made Roddy the executor of his will and the families remained close, with the Roddy children becoming lifelong friends of Dr. Willi- ams's daughter, Eugenia. But while Roddy and his family were fruitful and multiplied, the Williamses did not: The Roddy and Williams Families J.P. Roddy Sr. D.H. Williams J.P. Roddy Jr. Ellen Kate Roddy Eugenia F. Williams J.P. Roddy III Mary Ellen (Sis) Roddy Mitchell = William Jess Mitchell Thomas Roddy 10 Children in the Fourth Generation -5- Third Generation Roddys--J.P. Roddy III, William Jess Mitchell, and Thomas Roddy--signed a Voting Trust Agreement with the Fourth Generation Roddys. This further consolidated the Third Genera- tion Roddys' control of the companies by expanding the 1971 Vo- ting Trust to capture the Fourth Generation's partial ownership of the stock. It also added one of them, Joseph Hodges McKenzie Roddy, as a trustee. 2. The Ellen Kate Roddy Trust. Ellen Kate Roddy, J.P. Jr.'s sister, had no children. When she died, the shares she inherited from her father were placed in the Ellen Kate Roddy Trust. The Third Generation Roddys had control over this trust, and it too was a member of the Voting Trust. 3. The Williams stock. When Dr. Williams died in 1929, his 386 shares of Roddy Coke stock and 10 shares of Johnson City Coke stock became the corpus of the Williams Trust. Eugenia was the trustee, as well as the beneficiary of the Williams Trust's "income and profits." The remainder of the Trust was to be divided between the National Geographic Society and J.P. Roddy, Jr. Wealthy families and successful businesses are rarely left unmarked by litigation; in 1930, Eugenia sued J.P. Roddy, Jr. to determine whether she owned her father's estate outright or sub- ject to the Williams Trust. Chandler v. Roddy, 43 S.W.2d 397 -7- power of attorney was amended to allow William Jess Mitchell to act on Eugenia's behalf if J.P. Roddy, Jr. became incapacitated. This meant that, from 1985 until her death, either J.P. Roddy, Jr. or his son-in-law had the power to control all of Eugenia's affairs, including the disposition of her 1,714 shares of Roddy Coke stock. Eugenia, it may be remembered, had been the trustee of the Williams Trust since her father's death in 1929. She needed to plan for that Trust and, in 1990, she named J.P. Roddy, Jr. and the Third Generation Roddys as trustees. This meant the Williams Trust would have a trustee, but also meant that the Roddys, in one capacity or another, would control nearly all of Roddy Coke's stock. In January 1991, the Roddys, acting as trustees of the Williams Trust, agreed with the National Geographic Society to have Roddy Coke redeem the Trust's 386 shares for $1,640,500. Even though Eugenia had an interest in the profits of the Trust and the Roddys and National Geographic held an interest only in the Trust's corpus, Eugenia was not consulted before the redemp- tion. Instead, the Roddys redeemed her shares with William Jess Mitchell acting as her attorney-in-fact. After redemption, the Voting Trust controlled more than 50 percent of the outstanding Roddy Coke stock for the first time. Left outside this flurry of dealmaking were the shares held by J.P. Roddy Jr. and Eugenia. The Roddy witnesses testified credibly that the family did not want to have J.P. Roddy, Jr.'s low-basis stock sold for a considerable capital gain, only to have the proceeds taxed again as part of his estate when he died. They also testified that, from their perspective, Eugenia was in a similar situation. She too was old, and she too would (cid:16)042be taxed on an enormous capital gain if she just sold her shares into the merger. But we find her position to have been diffe- rent. As the Roddys knew, she had no obvious heirs; and her will, as they also knew, left her estate to charity--except for the Roddy Coke' stock. So, if the Roddys sold her stock, all of the proceeds would end up being taxed away as capital gains or given away to charity. If the stock could somehow be kept in her name, none of its accumulated value would be taxed away as capi- tal gains, and the stock would go to the Roddys under the terms of her will. Under the Roddys' agreement with Coca-Cola Enter- prises, that stock would then be sold at a set price. The Roddys would have to pay any tax on the capital gains (reduced by the step-up in basis), and the Estate would have to pay any tax on the stock's value at the time of Eugenia's death. But at least the money would not all go to charity. The Roddys' solution to these problems was put in place in April 1993. Coca-Cola Enterprises and a subsidiary that it had -11- equal to what Coke had been willing to pay in its initial offer, but with a yearly increase of 1.5 percent in purchase price and 5.5 percent for interest. The effect was to give both J.P. Roddy, Jr. and Eugenia an income stream for the rest of their lives, Coca-Cola Enterprises the right to buy that stock when either of them died, and the Roddys who stood to inherit that stock a higher sale price when they finally received and sold the stock. On April 21, 1993, the transaction between Roddy Coke and Coca-Cola Enterprises closed. Under the merger agreement, Roddy Coke remained in existence as a corporate subsidiary of Coca-Cola Enterprises. In that capacity it began to pay management fees to its new parent for risk management, tax management, information technology, and other similar services.¹ D. Eugenia's Will and the Estate Distribution Eugenia Williams never changed her will after the merger. She died on February 26, 1998 and bequeathed all of her property except the bottling-company stock to several charities. These included bequests of $10,000 to the Old Gray Cemetery of ¹ What happened to the Johnson City stock is somewhat unthat nearly half of It seems, however, to the Roddy family's Voting Trust, and that clear from the record. the Johnson City shares were in the Williams Trust with the rest subject found its way to Coca-Cola Enterprises in a parallel deal, albeit with much lower numbers. because it was entirely subject no residuary interest, never found its way to her estate. doesn't affect the outcome of this case. the Johnson City stock, to a trust in which Eugenia had In any event, the stock It -13- After receiving the Fund, the Fourth Generation Roddys entered into a Tenants in Common Agreement. Under this Agree- ment, they paid to the Bank as executor the amount of the estate taxes attributable to the Roddy Coke stock. Each of the Roddy beneficiaries also kept an interest in the Restricted Fund equal to his allocable share of the Roddy Coke stock. Other require- ments under the Tenants in Common Agreement were that the Roddys were each responsible for paying the income taxes attributable to their portions of the Fund and that each Roddy's allocable por- tion was alienable. With these Agreements in place, the Bank distributed Eugen- ia's stock, and the Roddys sold the stock to Coca-Cola Enterpri- ses for about $33 million. None of these proceeds were returned to the Estate; the Roddys did put $20 million of the proceeds into the Restricted Fund. The Bank then filed the Estate's Form 706, valuing the 1,714 shares of Roddy Coke at $14,052,638. This meant that, whether through inheritance or via the agreements they had signed years earlier with Coca-Cola Enterpri- ses, the Roddys had received the entire value of the Roddy Coke stock. The stock was thus not considered part of the residuary proceeds of Eugenia's estate. This resulted in each of the four charities' receiving a mere $6,695,774, much less than each would have received if Eugenia had just sold her stock back in 1993 and held on to what would have been left after taxes. proceeds from the sale of Eugenia's stock be given to the -15- Charities. The original suit listed several causes of action; an amended complaint added another for constructive sale. Defendant Cause of Action Result William Jess Mitchell Breach of duty as attorney-in-fact for settlement Eugenia F. Williams .Resolved by the J.P. Roddy, III Mary Ellen Roddy Mitchell Thomas Roddy Breach of duty as co-trustees of David Hitt Williams Trust the Chancery Court ruled for the Roddys William Jess Mitchell Constructive fraud J.P. Roddy, III Mary Ellen Roddy as Eugenia F. Williams' attorneyin-fact and as trustees Mitchell Thomas Roddy Resolved by the settlement Breach of duties as majority shareholders Civil conspiracy Fraudulent concealment and nondisclosure Conspiracy to conceal and nondisclosure Intentional interference with inheritance Conversion F. The Notice of Deficiency -17- While the state-court suit was being fought, the Commission- er began looking at the Estate's tax return, and in April 2002 he sent a notice of deficiency, determining that the Estate owed $596,086. The primary source of the alleged deficiency was an understatement of $927,999 in the value of the Roddy Coke stock. After litigation got underway, the Commissioner actually conceded this issue--the parties now agree on a value of $12 million for that stock--but the Estate began a counteroffensive by claiming a refund under section 6512(b)(1)2 of the lesser amount of the va- lue of the shares or the settlement proceeds distributed to the Charities. The Estate's claim arises from the undisputed fact that the Charities got more than the roughly $6 million each that the Estate reported on the Form 706. The Estate argues that this additional money is nothing more than a share of the sale price of Eugenia's stock to Coca-Cola Enterprises. The Commissioner argues that any extra money that the Charities got is attribut- able not to the shares, but to the settlement of the state-court litigation. He argues that any increase in the charitable deduc- tion merely matches the value--which the Estate left off its re- turn--of that litigation. 2 All section references are to the Internal Revenue Code, and the Rule reference is to the Tax Court Rules of Practice and Procedure. -19- OPINION We begin by noting how curious the Estate's argument must look to a nonlawyer: Its own return listed the stock as a tax- able asset that was to be distributed to the Roddys. Eugenia's name was (at least metaphorically--there's no indication the stock was held in street name and it wouldn't matter if it was) .on the shares. And when the Executor distributed the shares to (cid:16)042the Roddys, they sold them to Coca-Cola Enterprises--what could they possibly be selling other than shares of stock? So how can the Estate possibly argue that the settlement proceeds are somehow legally the same thing as those shares of stock? The Estate's argument might appear to be either nearly fri- volous or remarkably subtle. Its essential point is nonintui- tive--an assertion that the Roddys had effectively sold the stock before they actually received it--and that, appearances to the contrary, Eugenia did not, as a matter of law, own the stock when she died. To decide whether this argument is nothing more than fizz requires us to begin with a brief explanation of how courts ana- lyze the taxability of proceeds from settlements of litigation. This is a venerable problem--dating back at least to Lyeth v. Hoey, 305 U.S. 188, 196 (1938)--and the general rule may be sim- ply stated: If the proceeds of a settlement represent something -21- The estate could list the pearl as the asset. Then, if the law- suit against the thief leads to the pearl's return, the estate can distribute the pearl or, if the estate wins damages, can distribute those damages to its hypothetical charitable legatees. Lyeth v. Hoey teaches us to treat any settlement proceeds as if they were what they are substitutes for--in our hypothetical--the pearl. The right to damages would in some sense be the same as the pearl of great price or, at the very least, not an additional asset of the estate. Add another twist: The thief turns out to.be clever. In- stead of coming in the night to steal the pearl, he comes in the bright light of day with a cleverly designed paste pearl which he substitutes for the real one. The decedent dies. We can see no reason why the results of the last hypothetical don't again apply: The estate could list the real pearl as an asset, but would really have only a right of action against the thief for damages or return of the pearl. In the end, again, the right to damages would be treated the same as the pearl of. great price --not as an additional asset of the estate. And one last hypothetical: The hypothetical decedent's hypothetical estate doesn't realize at first that all it had was paste, so it lists the pearl on its return as if it were the pearl of great price. If our hypothetical decedent left the pearl not to charities but to friends, the estate might pay tax -23- The Commissioner argues that the stock was never sold till after Eugenia died, and so the settlement proceeds must instead have been proceeds of an asset--the Estate's tort action against the Roddys--that wasn't listed on the original return. If the Commissioner is correct, the settlement proceeds would still be part of the residual estate and still cp3 to the Charities, but because the litigation asset was not listed on the return, it would not have been accounted for in the original estate tax paid and the Estate would not be entitled to a refund now. The parties battle on two fronts. The first is the effect of the Roddys' Estate Distribution Agreement with the Executor on the characterization of the settlement proceeds. The Commission- er says the terms of that Agreement show that the Roddys had such unfettered control over the stock as to prove that they really owned it. The Estate argues that the Restricted Fund was, well, restricted--and so proves nothing. The second front is how to interpret the Settlement Agree- ment itself, together with the negotiations leading to it. And to characterize settlement proceeds for tax purposes: look to various factors, we must the allegations in the State court pleadings, the evidence adduced at trial, a written settlement agreement, and the intent of payer. including the Threlkeld v. Commissioner, 69 T.C. 1294, 1306 (1986), affd. 848 F.2d 81 (6th Cir. 1988). testified that the Estate Distribution Agreement was necessary -25- because: the stock into a tenants in common We needed to pay Estate taxes·on this asset that was going to come to us, and we did an agreement with the trustees whereby we would sell restricted account. shares didn't belong to us, we would return it back to the Estate, but at this time, you know, would go to us and we would treat it that way. the determination was that the shares In the event that the The Estate Distribution Agreement also contains a provision that the restrictions on the Restricted Fund--and thus the Estate Distribution Agreement itself--would terminate upon the earliest of: the release by the Executor of any claims on the shares' va- lue; the issuance of a final (nonappealable) court order regard- ing the disposition of the shares; or April 2, 2003. This indi- cates that the Estate Distribution Agreement was not an outright distribution to the Roddys, but something resembling the res in (cid:16)042an interpleader. It is as if the parties to a dispute about the ownership of a load of bananas reasonably agree between them- selves to sell the fruit before it spoils, and continue their fight over the proceeds. See also, e.g., U.C.C. sec. 2-704(2) (1998). The Commissioner argues that the Roddys held sufficient control over the Restricted Fund to make it the Roddys' property. Many factors support this argument: The Roddys had discretion-- with the Estate's permission as cosigner--to invest the proceeds -27- payment from the Restricted Fund was a direct loss only to the Fourth Generation Roddys. And the Fourth Generation Roddys did not have the same duties to Eugenia as the Third Generation Roddys. We therefore find that the Restricted Fund was created as a receptacle for the proceeds of the stock until any legal issues between the Roddys and the Estate could be resolved and the stock (cid:16)042or its proceeds could be properly distributed. We hold that its terms do not affect our characterization of the settlement pro- ceeds as either compensation for torts or other wrongs committed by the Roddys, or as restitution for a constructive sale of Eu- genia's stock before she died. B. Characterization of the Settlement in Hinds v. Mitchell We next turn to a direct analysis of the settlement proceeds from the state-court litigation. The Estate urges us to begin and end with the language of the Settlement Agreement. That Agreement is quite clear: the spethe [shares] was, as a mat- Whereas, Hinds and the Residuary Beneficiaries contend in the Litigation that cific bequest of ter of were constructively sold, and thus the [shares or their value] actually passed or should have passed to the Residuary Beneficiaries. law, adeemed and/or the said shares This was the only cause of action specifically named in the Settlement Agreement. -29- risk of punitive damages, retrieving some corporate documents, and obtaining a full release. We analyzed the problem of alloca- ting damages in that case by placing the facts in Bagley in a range bounded by Robinson v. Commissioner, 102 T.C. 116 (1994), affd. in part and revd. in part 70 F.3d 34 (5th Cir. 1995), and McKay v. Commissioner, 102 T.C. 465 (1994), vacated without pub- lished opinion 84 F.3d 433 (5th Cir. 1996). We began by acknow- ledging that the allocation of a settlement by the parties is "generally binding for tax purposes to the extent that the agree- ment is entered into by the parties in an adversarial context at arm's length and in good faith." Bagley, 105 T.C. at 407-. In Robinson, however, the allocation didn't control because it "was uncontested, non-adversarial, and entirely tax-motivated, and did not accurately reflect the underlying claims." Id. at 407. By contrast, in McKay the settlement had been made by "hostile par- ties who were in an adversarial position with respect to the al- locations to be made in the settlement." Id. In Bagley, we reasoned the facts were not like those in McKay, where the taxpayer lacked the "freedom to structure the settlement on his own," whereas in Bagley the parties had been "jointly participating in the drafting of the agreement." Id. at 408. This led us to conclude that the settlement documents were not controlling. Yet Bagley was also unlike Robinson, because -31- least a factor in the settlement. David Black, who had represen- ted the American Printing House For the Blind and then the admi- nistratrix ad litem, testified that "the most straightforward" cause of action for the administratrix to prevail on would have been the constructive-sale theory. This was due at least in part to the lack of a nee'd for any "proof of intent" or "establishment of bad acts." Black also testified, however, that litigation (cid:16)042would have been ready to proceed on any of the causes of action listed in the complaint. Even as the Commissioner's witness, Black testified on direct examination that the plaintiffs in the Hinds case were prepared to go forward on all counts which they believed viable after discovery. This would, of course, have included the constructive-sale theory. Taking that testimony into account, we find that settling the constructive-sale theory was the dominant, but not exclusive, motivation of the Roddys. This finding is also supported by the evidence that, at an early point in the administration of the Estate, both the Executor and the Charities had concerns about the propriety of the 1993 transactions and their potential to give rise to both constructive-sale and breach-of-fiduciary-duty causes of action. Indeed, the Bank was worried enough to seek legal advice on both these issues and supported the appointment of an administratix ad litem to pursue both. -33- The most important weakness of the various tort theories was that the Roddys had a plausible argument that the 1993 transac- tions were fundamentally fair to Eugenia in that the Right of First Refusal payments and the other payments she received constituted an acceptable alternative to paying a 1.arge capital- gains tax and seeing what was left of the proceeds go to the Charities. They could point to the similar deal they negotiated with the Roddy patriarch, J.P. Roddy, Sr. Eugenia was, moreover, never formally judged incompetent. There was credible testimony that the Roddys and their lawyers strongly believed that absent a finding that Eugenia was incompe- tent, any action based on a breach-of-duty theory would have been subject to a statute-of-limitations defense. Indeed, the Es- tate's attorneys originally rejected the idea of pursuing the breach claim in part because of this. We also find on the basis of the credible evidence in the record4 that the parties thought that trial of the fiduciary-duty causes of action might lead to a judgment that the stock or pro- ceeds from its sale must be disgorged. See Freeman v. Martin, 181 S.W.2d 745, 746 (Tenn. 1944). This means that even the i We use phrases like "credible evidence" in discussing state law because our focus in allocating the settlement proceeds is not on what question), but on what law was when agreeing to the settlement. the law is (obviously a legal, not a factual, the parties and their lawyers thought the -35- remainder allocable to the tort theories (or, more precisely, the damages-other-than-monetary-equivalent-of-the-stock theories). Thus, 90 percent of the settlement proceeds should be considered to be only a return of the value of the stock to the Estate and not compensation for any profits or income to Eugenia. Petitioner having agreed to a refund of the lesser of this amount or the stipulated value of the shares, and to reflect the parties' various other concessions and stipulations, Decision will be entered under Rule 155.