decided: July 14, 1978.
PROVIDENT NATIONAL BANK, EXECUTOR OF THE ESTATE OF ABRAM L. SPECTOR AND TRUSTEE UNDER PARAGRAPH 12 OF THE WILL OF ABRAM L. SPECTOR, APPELLANT
UNITED STATES OF AMERICA
APPEAL FROM THE UNITED STATES DISTRICT COURT FOR THE EASTERN DISTRICT OF PENNSYLVANIA (D.C. Civil No. 76-2990)
Before Adams, Van Dusen and Rosenn, Circuit Judges.
Author: Van Dusen
Opinion OF THE COURT
This case concerns the proper federal estate tax treatment of the testamentary disposition of a decedent's controlling equity interest in a family-held closed corporation. More particularly, this appeal results from a tax refund suit which put in issue the allowance and valuation of a marital deduction from the value of a gross estate under I.R.C. § 2056. An appeal has been taken from a district court order granting the Government's motion for summary judgment and denying the taxpayer's motion for summary judgment. We believe neither motion for summary judgment should have been granted and, accordingly, we remand for further proceedings consistent with this opinion.
Abram L. Spector died testate on May 11, 1966, survived by his widow, Ruth Spector, and four children. At the time of his death, the decedent was the controlling shareholder and chief operating officer of Dial Shoe Company (Dial), a closed, family-held, Pennsylvania corporation. Dial had outstanding 2,305 shares of common voting stock and 4,610 shares of common non-voting stock denominated Class A stock. The decedent owned in his name 1,380 shares of common voting stock and 2,196 shares of Class A stock. The decedent also was the sole shareholder of 4601 Frankford Avenue Corp., which owned, Inter alia, 585 shares of Dial common voting stock and 1,170 shares of Class A stock. In total the decedent owned or controlled approximately 85% Of Dial common voting stock and 73% Of Dial Class A stock. The remaining outstanding shares of Dial were divided equally among the decedent's four children. Each child owned 85 shares of common voting stock and 311 shares of Class A stock. Stipulation of the parties filed Feb. 3, 1977 (118a).*fn1
Paragraph 4 of decedent's probated will dated June 16, 1964, appointed Ruth Spector and the Provident Tradesmens Bank and Trust Company as trustees for a marital trust referred to as Trust # 1. Subparagraph 4(a) bequeathed to Trust # 1 "All Class A Common Stock of Dial Shoe Company, Inc. in my name (to be exchanged for Preferred Stock of Dial Shoe Company, Inc. as hereinafter provided)."*fn2 The primary beneficiary with respect to distribution of income and principal of Trust # 1 was decedent's wife, Ruth Spector. Paragraph 5 of decedent's will bequeathed to his adult son, Edward M. Spector, and adult daughter, Renee Silberman, and the Provident Tradesmens Bank and Trust Company as trustees to hold in a trust referred to as Trust # 2:
"(a) All Common Stock of Dial Shoe Company, Inc., in my name.
"(b) All Class A Common Stock and Common Stock of Dial Shoe Company, Inc., owned at the time of my death by 4601 Frankford Ave. Co., to be received in the liquidation of that corporation as hereinafter provided."*fn3
Paragraph 6 of the will directed that the trustees of Trust # 2 shall manage and operate Dial and that the common stock held in Trust # 2 could not be disposed of without first offering to redeem at 105% Of par the preferred stock issued in the recapitalization.*fn4 The primary beneficiaries entitled to distribution of income and principal from Trust # 2 were Edward M. Spector and Renee Silberman. Paragraph 7 of the will directed the executor to effectuate the recapitalization of Dial, which would provide that:
". . . Five Percent (5%) Preferred Stock be created and issued in exchange for the Class A Common Stock which has been bequeathed under Paragraph 4(a) hereof to the Trustees of Trust # 1; said Preferred Stock shall have a par value equal to the book value of the Class A Common Stock exchanged therefor, . . .."*fn5
The executor paid the estate tax on the basis of a tax return adjusted after administrative audit. The Commissioner after audit valued decedent's holdings of both Dial's common voting and Class A non-voting stock for inclusion in the adjusted gross estate at $157.00 per share as of the date of death.*fn6 The Commissioner allowed as a marital deduction decedent's bequest of the block of 2,196 shares of Class A non-voting common stock to Trust # 1 for the benefit of his wife. The Commissioner valued the stock comprising such marital bequest at $157.00 per share and limited the marital deduction to that amount.*fn7
The executor filed a refund claim with the Commissioner and subsequently instituted a suit for refund in the United States District Court for the Eastern District of Pennsylvania on the ground that the Commissioner's assessment of the marital deduction was incorrect as a matter of law. The executor contended that the correct value for estate tax purposes of the equity interest bequeathed to the marital trust, Trust # 1, and eligible for the marital deduction was not $157.00 per share but, rather, $214.75 per share. This higher figure represented the book value of decedent's 2,196 shares of Class A common stock, which was directed in the will to be the exchange rate for the recapitalization of the 2,196 shares of Class A stock into a like number of 5% Preferred shares with a par value of $214.75.*fn8 The executor did not seek a readjustment of values of any components of the adjusted gross estate.*fn9 Consequently, the executor asserted that the higher per share valuation of the marital bequest increased the amount of the allowable marital deduction, and correspondingly decreased the value of the taxable estate entitling the taxpayer to a refund of $33,430.14.*fn10
Both the executor and the Commissioner filed motions for summary judgment. In a memorandum opinion (186a) and order (190a) dated June 24, 1977, the district court granted the Commissioner's motion for summary judgment and denied the executor's similar motion. An appeal was taken from this order and, as noted above, we reverse the grant of the Government's motion because genuine issues of material fact remain to be resolved.
I.R.C. § 2056(a) allows a marital deduction from the value of the adjusted gross estate in "an amount equal to the value of any interest in property which passes or has passed from the decedent to his surviving spouse, but only to the extent that such interest is included in determining the value of the gross estate." Qualifications in the Code and Regulations exclude the deductibility of certain interests in property which passed from decedent to surviving spouse, these being so-called terminable interests. Id. at § 2056(b). To obtain the marital deduction, an executor must establish (1) that the property interest passed from decedent to spouse, (2) the value of that property interest, (3) that the property interest is a deductible interest, and (4) the value of decedent's adjusted gross estate. Treas.Reg. § 20.2056(a)-1(b).
By statutory definition, an interest in property passes from decedent to surviving spouse if such interest is bequeathed or devised to the spouse. I.R.C. § 2056(e)(1). At the outset we note that there is agreement between the parties that the surviving spouse's beneficial interest in the marital trust, Trust # 1, consisted of a life estate with power of appointment, qualifying whatever property interests passed by devise or bequest to that trust for the marital deduction as if they had passed directly to the wife.*fn11 We need, therefore, determine precisely what interest in Dial passed by decedent's will to his widow. See Treas.Reg. § 20.2056(e)-2.
Subparagraph 4(a) of decedent's will unambiguously bequeathed to his wife all Class A common stock held in his name, subject to a direction that it be exchanged for newly created preferred stock on the conversion basis specified in paragraph 7. This was the property interest which passed to decedent's surviving spouse and classifying this interest as either "Class A common stock" or "preferred stock" is neither necessary nor helpful. Section 2056(a) comprehends convertible equity interests whether the conversion is optional or mandatory. The will speaks for itself, and under Pennsylvania law this legacy of one class of stock, subject to a direction that it be exchanged for another class, vested in the widow at the time of death. See Berger v. United States, 285 F. Supp. 92 (E.D.Pa.1968);*fn12 In re Houston's Estate, 414 Pa. 579, 591-96, 201 A.2d 592, 598-600 (1964).
The Government takes the position that as of the time of death no preferred shares were in existence as the recapitalization had yet to be effectuated and that, therefore, no interest in the preferred stock passed from the decedent within the meaning of § 2056(a). This argument obscures the central economic and legal reality that decedent bequeathed to his wife an interest in a block of Class A common shares, which were to be mandatorily exchanged for preferred shares with certain attributes created by operation of the will. So understood, the widow's equity interest in Dial was created by the will, was in existence at the time of death, and therefore passed from decedent to her.*fn13
As important as identification of the property interest which passed from decedent to his widow is valuation of that interest. The Government would value the property interest bequeathed in the will as the audited value of the Class A common stock of $157.00 per share. The taxpayer would value the property interest which passed in the will as the par value of the preferred stock received in the exchange of $214.75 per share. We reiterate that the proper measure is of neither the Class A common stock as such nor the preferred stock as such, but rather of the value of those Class A common shares subject to the testamentary directive of exchange for preferred shares.
It is well settled that the nature of the interest in property passing to the surviving spouse and the valuation of that interest are to be determined as of the time of decedent's death. Jackson v. United States, 376 U.S. 503, 508, 84 S. Ct. 869, 11 L. Ed. 2d 871 (1964); Treas.Reg. § 20.2056(b)-4. As a corollary, whenever an interest in property is bequeathed or devised subject to directions which may require subsequent disposition, the Code and Regulations contemplate that the deductible interest be valued in light of the impact of the directives on the present value of the interest as of the time of death. The correct value for tax purposes is not the value after the directives are implemented but the present value at the time of death, when the will becomes operative and the interest in property becomes subject to future directives.*fn14
For example, common stock bequeathed subject to an irrevocable option to purchase by a third party, which leaves the legatee no choice but to sell the stock at the option price stipulated in the will, is generally valued for tax purposes at the option price, not the market price of unencumbered common stock. See Delone v. Commissioner, 6 T.C. 1188, 1192-93 (1946).*fn15 A devise to a spouse of real property valued at $25,000. with a direction that the spouse subsequently pay $5,000. in cash to a relative is valued for purposes of the marital deduction at $20,000., reflecting the effect of the direction at the time of death. Treas.Reg. § 20.2056(b)-4(b), Example (1). In like manner, if income from property is devised as a life estate to a person other than the surviving spouse but the remainder is devised absolutely to the spouse, this remainder interest is deductible under § 2056 in the amount of the present value of the remainder. Such present value is determined on the basis of probabilities of various uncertain factors, such as life expectancy of the life tenant and value of the property at the life tenant's death. Treas.Reg. § 20.2056(b)-4(d). In sum, the foregoing examples from the case law and Regulations demonstrate that, where a will directs future disposition of an interest in property which qualifies for the marital deduction, such disposition is taken into account in determining the Present value of the interest in property.
As of the time of decedent's death, the will's directive that the Class A block of shares be exchanged for preferred shares would likely have altered the value of that block from what it would have been had there been no such directive. The audited value relied on by the Commissioner and upheld by the district court of $157.00 per share for all Dial common stock did not reflect the will's direction that a recapitalization be effectuated which would alter the relative values of different classes of Dial equity. The audited value, by ignoring the likely effect of the recapitalization, was not measured as of the time of decedent's death. The audit clearly assumed that each Dial common share, voting and Class A non-voting, was of equal value having a proportionate claim on Dial's earnings. The recapitalization was plainly designed to alter this equivalence of share values by creating new securities, preferred stock, with greater proportionate claims on Dial's earnings than were left the remaining common stock shares. Since the recapitalization would not alter the net worth or the going concern value of Dial, a block of Class A shares would become relatively more valuable while the remaining common shares, the voting stock and the non-exchanged Class A stock, would become correspondingly less valuable.*fn16
The Government's motion for summary judgment (121a) and supporting materials (122-51a) do not provide any measure of the value of the properly identified property interest which passed to decedent's wife. The only measure of value contained in the Government's Rule 56 submissions was the audited value of Dial common shares Prior to decedent's death. Such value did not account for the will's directive to recapitalize the block of Class A shares. In the absence of a factual basis in the Government's submissions for valuing the present value of decedent's marital bequest, summary judgment should not have been granted in its favor.
Similarly, the taxpayer's motion for summary judgment (164-65a) and its supporting interrogatories (27-29a; 113-17a) offer no accurate measure of the properly identified property interest which passed to decedent's wife. The taxpayer merely asserts that the present value of the Class A shares at the time of death was worth the par or face value of the preferred shares, $214.75 per share, for which the Class A shares were to be exchanged. This factual claim is erroneous. As explained below, in section C, the par value bears no certain relation to the actual value of the block of Class A shares subject to exchange as of the time of the decedent's death. Consequently, we believe that a genuine issue of material fact exists on the record which was before the district court and is now before us. Summary judgment having been improper for either moving party, we remand to the district court for further factual development of the present value at the time of decedent's death of the interest in property which passed to the surviving wife.
Two sources of uncertainty preclude determination on the existing record of the present value as of the time of death of the block of Class A shares directed to be exchanged for the preferred shares with par values of $214.75. First, there may have been some doubt as to whether decedent's widow would realize the full value of the exchange contemplated in the will. The prospect of a challenge by some minority shareholders would likely have affected the market value as of the time of death of the block of shares bequeathed to the surviving spouse. Second, and more fundamental, even if decedent's wife would not be liable to relinquish part of the value of the preferred shares bequeathed in the will, the actual present value of those shares at the time of decedent's death was not necessarily their par or face value. These two sources of uncertainty must be considered in further proceedings.
The uncertainty as to the extent of realization of the mandated exchange is twofold would any minority shareholders be legally entitled to restitution or rescission of the exchange and, if so, what effect would the likely relief have on the value of the preferred stock received by the widow? The district court reasoned that disgruntled minority shareholders could maintain a cause of action under Pennsylvania law to recover the loss in value of their holdings as a result of the recapitalization. But neither the district court nor the parties have identified which minority shareholders would be disgruntled. The recapitalization was part and parcel of the will's disposition of decedent's entire controlling share of Dial. The two adult children who were minority shareholders prior to decedent's death became majority shareholders with voting control of Dial. While the per share value of their holdings decreased by operation of the will, the aggregate value of their holdings increased. Consequently, the adult children suffered no loss in decedent's disposition of his equity interest.
The minor children, by contrast, received no additional shares from decedent's will and, consequently, suffered a loss of value in per share and aggregate value terms. But the extent of this loss was considerably less than the increase in the aggregate and per share values of the block of Class A shares bequeathed decedent's widow. Consequently, even if the par value of the preferred shares might be reduced by judicial action at the behest of the minor children, the reduction would not be to $157.00 per share. Valuation of the marital deduction must take into account the likelihood and extent of such judicially mandated recapitalization.*fn17
The second and more significant uncertainty as to the present value of the block of Class A shares inhered even if the recapitalization were effectuated without challenge. This uncertainty concerned the actual or market value of the preferred shares for which the Class A block of shares was to be exchanged on a one-to-one basis. The preferred shares carried a face or par value of $214.75 and bore an annual dividend pay-out rate of 5%. The par or face value corresponded to the book value of the Class A common shares as directed in the will. The par or face value did not correspond to a purchase price but, instead, was an arbitrary figure assigned by the decedent for purposes of calculating dividends. This arbitrary book value did not Ipso facto become the market value of the preferred shares. The 5% Annual dividend was calculated against the par value of $214.75. The actual or market value of the shares depended on the risk of default on the dividends, the arrearage provisions, and the relationship of the 5% Dividend rate to other market interest rates available to investors in comparably risky securities. For if the investment market offers interest rates greater than 5% At comparable risk, the preferred shares would not be worth their face value.*fn18 Thus, there was no necessary economic equivalence between the face value of the preferred shares and the market value of those same shares.*fn19
The record before us does not resolve the aforementioned uncertainties as to the value of the block of Class A shares subject to exchange for the 5% Preferred shares. On remand, consideration of the relevant factors influencing the present value of decedent's marital bequest can be given by the district court on the basis of a fuller factual record.*fn20
Having elaborated an acceptable valuation measure of decedent's equity interest in Dial and of decedent's marital bequest, we turn to the question whether that bequest was non-deductible by operation of the terminable interest provision of the Code. Section 2056(b)(1) renders non-deductible certain terminable interests which, although passed to the surviving spouse, may by some event or contingency ultimately pass to any other person for less than full consideration and would ultimately not be included in the surviving spouse's gross estate.*fn21 The district court ruled that insofar as the executor insisted that the property interest which passed to decedent's wife was the preferred stock, that stock was "acquired" for the spouse by the executor and was, therefore, non-deductible under § 2056(b)(1)(C). The court also held that the preferred stock could fail in the event that minority shareholders would sue to challenge the recapitalization and, hence, the stock was a terminable and non-deductible interest under the general rule of § 2056(b)(1).
We have already determined that the interest in property which passed to decedent's widow was not the preferred stock but the Class A block subject to the direction for exchange. So identified, this interest was not an after-acquired interest. While the will may direct the executor to take actions which would affect the interest, it vested and was in that form acquired by the spouse at the time of death and, therefore, was not non-deductible under § 2056(b)(1)(C).*fn22
We also do not believe that the property interest which passed to decedent's widow was non-deductible under §§ 2056(b)(1)(A) and (B). The first requirement of these provisions is that the surviving spouse's interest be subject to the possibility of "terminating" or "failing" on the occurrence of an event or contingency.*fn23 The second and third requirements of the conjunctive provisions (A) and (B) are that the interest in property pass from the Decedent to any person other than the surviving spouse for less than full consideration and that such other person may possess or enjoy such property after the termination of the interest passing to the surviving spouse. The district court held that the widow's interest in the preferred stock would fail if, as was possible, the minority shareholders successfully challenged the recapitalization and won restitution of any amount received in excess of $157.00 per share. The district court did not explicitly address the other two requirements of non-deductibility.
We find it unnecessary to determine in this context the likelihood of whether Pennsylvania law would require that decedent's widow make restitution of the benefits of an improper recapitalization. It seems clear to us that even were a court to invalidate the recapitalization and order restitution of benefits to the minor children as minority shareholders, the equity interest in Dial would not thereby Pass from the decedent to the shareholders within the meaning of § 2056(b)(1)(A).
Section 2056(e) exclusively defines the means by which an interest passes from decedent to another person.*fn24 The hypothetical restitution of benefits from the preferred shareholder, Mrs. Spector, to the minority shareholders, her minor daughters, would not represent a bequest, devise, inheritance, or transfer from the decedent. While Mrs. Spector's interest could be said to "fail" if restitution were ordered, the interest would not revert to decedent's residuary estate nor would it be disposed of by reference to decedent's will. That the minor children would receive no interest in property from decedent is made clear by the fact that restitution would leave them in the same position they had been in prior to decedent's death. Decedent's minor children would have the same equity interest in Dial after restitution as they had prior to testamentary disposition of decedent's assets. Therefore, no interest in property would pass from decedent to his youngest children.
Some interests which fail or terminate after passing to the surviving spouse may pass again to a third person and hence become non-deductible. The Regulations illustrate such interests by reference to a bequest of a life interest to the spouse and remainder to others or to the residuary estate. Treas.Reg. §§ 20.2056(b)-1(g), Examples (1)-(8). In each example decedent's assets are eventually distributed by operation of the will to persons other than the spouse. In this case, by contrast, decedent's bequest vested unconditionally in his wife, and liabilities incurred by her to give restitution as a preferred shareholder were personal to her. Decedent did not bequeath any interest in Dial to his minor children in the event that the bequest to his wife were to fail. Accordingly, we conclude that decedent's bequest to his wife was not non-deductible under § 2056(b)(1).
Having concluded that the marital bequest was deductible, we consider finally two possible limitations on the amount of the bequest includible as a marital deduction. Section 2056 limits the extent of a marital deduction in two respects to the value of the gross estate. Subsection (c) limits the aggregate marital deduction to a maximum of 50% Of the adjusted gross estate. I.R.C. § 2056(c). Subsection (a) limits the amount of each component property interest included in the marital deduction to the "extent that such interest is included in determining the value of the gross estate." Id. § 2056(a). The district court reasoned that, because the estate valued its common shares at $157.00, it could not deduct those same shares at a higher value. Moreover, if the taxpayer were correct that the preferred stock was worth $214.75, that amount should be reflected in the value of the gross estate. The taxpayer counters that the district court imposed a false symmetry upon the valuation of decedent's bequest. The taxpayer argues that the total value of decedent's equity interest was included in the value of the gross estate at $157.00 per share and that the higher per share figure attributed to the marital bequests represents a different relative distribution among the legatees. Implicitly the taxpayer contends that, while Mrs. Spector received an interest worth $214.75 per share, the other legacies of Dial stock were worth an equivalent amount less than $157.00 per share. Both parties have missed the central point that as of the time of decedent's death there can be only one value for each equity interest in Dial. This value must be considered for calculating both the adjusted gross estate and the marital deduction.*fn25 At the time of death, some of decedent's common stock the block of Class A shares bequeathed to his wife was worth more than $157.00 and his remaining shareholdings were worth less than $157.00.
These adjustments did not cancel each other out. With the prospect of recapitalization, decedent's total equity holdings were worth more than they would have been had there been no recapitalization directed in his will.*fn26 Thus, it is clear that the executor's tax return as filed after audit incorrectly valued both the gross estate and the marital deduction. The amount of refund due, if any, depends on the revaluation of decedent's equity interest as of the time of his death. This revaluation must be undertaken in the district court on remand.*fn27
In summary, we will reverse the district court's grant of the Government's motion for summary judgment and will remand the case for further proceedings consistent with this opinion.