Cautionary Tales

& Taxing a Windfall Home Run

By Robert L. Moshman, Esq.

If you come across a valuable object, say, Barry Bond's 756th home run ball, would you hold onto it, make it part of your estate, let it appreciate in value? Or would you sell it immediately?

That decision depends on whether the ball is a taxable windfall causing $200,000+ of income tax to fall due immediately...and on whether the IRS will pursue a taxpayer lacking the wherewithal to pay such tax and force the sale of the ball. Opinions vary widely. (For that discussion, see the separate article at the conclusion.)

Even the best laid plans may go awry, but here is a collection of bad tax moves that should serve as a warning, an example of what not to do. A mistimed lifetime transfer ends up costing beneficiaries significantly. A parent-to-child Medicaid transfer goes sour. And an artist's estate secured discounts at the time of death that became costly later.

Why did strategies backfire? Let's analyze what went wrong in each case.

The Janis Art Gallery

An artist's estate made use of valuation discounts for estate tax purposes but then encountered high capital gains consequences down the road.

Sidney Janis, born 1896 in Buffalo, New York, dropped out of high school to work in vaudeville and opened a shirt company in the 1920s. He designed a short-sleeved, two-pocket shirt that became popular. Wealth allowed an art collection that became a full-time passion. In 1948, the Sidney Janis Gallery opened and featured works of Mondrian, Klee, Bonnard, Legere, Pollack, Rousseau, Picasso, Matisse, Dali, Duchamp, Rothko, and Motherwell.

In 1988, Janis transferred the art gallery to a trust with his two sons as trustees. He died a year later and the two sons became owners of the trust. When Sidney Janis died, the gallery owned 464 works of art. Sotheby's appraised these, individually as of the alternate valuation date, six months after death, and the total was $25,876,630. This amount was discounted by 52% to $12,403,207 on the estate tax return.

The IRS Art Advisory Panel appraised the retail value of each work on an individual basis and concluded that the total undiscounted fair market value of the artwork was $36,636,630. The panel agreed that a blockage discount was appropriate because the sale of all of the art at one time would depress values. A 37% discount was recommended bringing the panel's adjusted value to $22,955,077. However, $14.5 million was agreed upon as the value for estate tax purposes, which was equivalent to a 60.42% discount.

In 1995, the trust was terminated and the assets were distributed to a partnership owned by the two Janis brothers. Artworks were sold in 1995, 1996, and 1997 using the IRS Art Advisory Panel's appraisals as the cost basis, i.e., the values that collectively equal $36,636,630. The IRS audited the returns and assessed deficiencies of about $760,000 for each of the Janis brothers.

The Tax Court ruled that the Janis brothers had a duty of consistency to use the $14,500,000 amount that was used to calculate estate tax values. That amount provides the cost basis, and any increase in value above those amounts constitutes capital gain. The case then split into appeals filed in the Ninth and Second Circuits. The Ninth Circuit noted that the Tax Court was not unreasonable in accepting $14.5 million as the tax basis and affirmed. The United States Court of Appeals for the Second Circuit affirmed for different reasons.

"By adopting the $36,636,630 valuation, the Janis brothers increased the cost of goods sold such that the gallery sustained net operating losses for each year from 1990 through 1995. Significantly, these losses flowed through to the brothers' individual federal income tax returns."

The Janises argued that policies motivating the application of the blockage discount in the estate context don't apply when artwork is sold. "We are at a loss to understand this argument," said the Court and noted that Sidney Janis acquired the works of art at a fraction of the cost of their value at the time of his death, so his heirs had already benefitted from a stepped-up basis to the value at the time of death. That value is "the price that property would have brought if it had been offered by a willing seller to a willing buyer on that date. United States v. Cartwright, 411 U.S. 546, 551(1973)."

The Court then quoted, Hess v. United States, 537 F2d 457, 463 (1976):

The success of an estate in getting through IRS audit a low valuation of property may turn into a Pyrrhic victory in the event of subsequent income taxation. This is a matter practitioners in the field are well aware of and it tends to minimize disputes as to the valuation of estates, where assets other than listed securities are involved, and especially with real property. It furthers the concept of self-assessment.

Here, the Court noted, "[t]he Janises succeeded in 'getting through the IRS audit a low valuation of their property,' perhaps an unreasonably low one, and thus have deprived themselves of the full step-up basis to which they may have otherwise been entitled."

Analysis: What went wrong here? Should the Janis brothers have opted for higher valuations to achieve a higher stepped-up basis? Not necessarily. That would have meant another $11 million of estate tax liability up front in 1989 as opposed to $6 million of future capital gains tax at 28% spread over years.

It was not the Janis brothers post-mortem strategies that failed, but the planning of the Sidney Janis trust that came up short. The trust provided a management model with the brothers in place during the lifetime of the grantor. Although this was valuable, the trust affected neither transfer tax nor capital gains tax consequences.

Considering the range of 464 assets, each with a different cost basis, some with greater potential for appreciation, some destined for museum contribu- tions, some part of the gallery business, some to be kept in the family perhaps, a more customized combination of gifts, trusts, and a family limited partnership might have been more effective at minimizing future tax consequences. Janis v. Comm'r., 469 F.3d 256 (2nd Cir. 2006).

The Wrong Gift

Mr. B, approaching the end of his life, did not want to spend time or money rewriting his will or consulting attorneys and accountants. He had a valid will that would fairly distribute all of his property to his son and the three children his late wife had from a former marriage.

But then Mr. B was overtaken by a notion that there was no time like the present to distribute assets. He wanted the reassurance that the assets would reach the right beneficiaries.

Since the family home was to be devised to the three stepchildren under his will, and Mr. B no longer lived in the home, he decided to transfer the house to them immediately and had the deed changed to their names. Then, having made that transfer, he decided to even things up by distributing about $150,000 of securities to his son. Mr. B. didn't count on passing away only 18 months later. Mr. B. didn't count on a lot of tax consequences.

The house, being highly appreciated, was a poor asset to select to make a lifetime gift. Because it was transferred during life, the children received it with Mr. B's basis instead of a stepped-up basis at death. Sale of the home by the three stepchildren resulted in over $80,000 of capital gains liability.

Nor did the lifetime transfers improve transfer tax liabilities. As gifts made within three years of death, the house as well as the securities had to be included in Mr. B's gross estate for estate tax purposes. The transfers also triggered state inheritances taxes and additional executor commissions. And because of the combination of lifetime and death transfers, tax apportionment issues arose and professional fees were incurred to sort out the particulars.

The moral of this story: Spontaneous self-help by a Testator/Grantor can backfire and deprive heirs of large percentages of an estate and prompt family tensions. Professional planning would have made a huge difference for Mr. B.

The Medicaid Trap

Mom, a widow, age 72, with a net worth of $500,000 owns a home worth $400,000. She has four children.

Five years ago Daughter and Son-in-Law lost their home and declared bankruptcy and ended up moving in with Mom. They were supposed to pay rent, but Mom would let that slide and provided all the meals and utilities and property tax.

Then, one day, Daughter and Son-in-Law informed Mom that they want to buy her house (even though they still don't have any of their own money). They tell her that by selling assets now, she'll qualify for Medicaid in the future. And they'll provide her with a life estate...she can stay in the house for life.

Son-in-Law priced the house at $300,000, had Mom provide a "gift of equity" worth $150,000, got a mortgage for the remaining $150,000 which he had Mom sign over in return for the life estate. The entire transaction was in Son-in-Law's name because Daughter still had bad credit. All the papers were signed at the lawyer's office...Mom did not a separate attorney for the transaction.

Without offering up one dime of his own money, Son-In-Law ended up with a house worth $400,000 and $150,000 cash. Meanwhile, Mom was left with a life estate. But from that day on, Mom was excluded from the household, subjected to verbal abuse, and ended up staying in her room, which was crammed with possessions that Son-In-Law threatened to throw out. The tension landed Mom in the hospital.

Analysis: What's wrong with this picture? Everything. Without her own attorney, Mom never understood what a "gift of equity" meant or where her $150,000 went. Nor did anyone take the time to explain the impact of this transaction on her estate plan. Instead of providing benefits worth $125,000 to each of her four children, this transaction left her with $100,000 to be divided equally under her existing will even though one of her children had already seized 80% of her net worth.

Additional issues: Once a major transfer of wealth was made, Mom had no leverage left and was pushed aside, yet then lacked the wherewithal to move. And if the intent was to transfer wealth to qualify for Medicaid five years later, the use of a life estate may result in a Medicaid lien on the transferred house depending on the applicable state Medicaid laws.

Taxing a Windfall Home Run

Experts can tell you precisely about the taxation of financial windfalls of every variety. Whether you win a mundane $500 raffle or an exalted $10,000 with the Pulitzer Prize…you are supposed to report your windfall as taxable income.

Win the lottery…pay tax. Win a car…pay tax on the fair market value of the car. Receive a legal settlement, reward money, even stolen money, bribes, illegal kickbacks…all taxable income.

The exceptions: Cash rebates, gifts, inheritances, damage awards compensating for personal injury ... these are examples of value that are not part of taxable income. But what about treasure that one finds?

Matt Murphy, a 21-year-old New Yorker (a Mets fan), went to a Giants game on a stopover in San Francisco on his way to Australia. He ended up bloodied and scraped under a "30-person dogpile" (his NY Mets jersey was trashed-and was later sold on e-Bay) but he came away with the record-setting 756th home run hit by Barry Bonds.

Based on advice that he would immediately owe income tax on the ball, Murphy sold it for $752,467.20 to New York fashion designer Marc Ecko. (The ball is being donated to the Baseball Hall of Fame, but will, as a result of an online poll, bear an asterisk. Bonds, in turn, asterisked Ecko as "an idiot.")

But all of that is the warm-up for the truly interesting part of all this (assuming you are an aficionado of the artistry with which our U.S. Tax Code can stimulate complete chaos among our learned tax scholars of the blogosphere). Was the tax advice to Matt Murphy a good call? Opinions ranged wildly-ask ten tax experts and you get ten opinions.

One of the best collections is "Tax Law Final Exam Question: Barry Bond's Ball," a blog posted for The Wall Street Journal by Peter Lattman. Let's distill down the key positions that bloggers and writers across the Internet have staked out:

The Ball Is NOT Taxable Income

1. The home-run ball is essentially a gift from (pick one, Barry Bonds, The Giants, Major League Baseball) to the recipient…like getting a Bobble-Head prize for attending on Bobble-Head day.

2. Finding a home-run ball should be viewed like finding any other baseball…it is simply an object worth about $8. Any value others might ascribe to the ball is purely speculative.

3. The ball is a capital asset, not income. The objects we own are not subject to current tax on their value-their value is recognized and taxed when sold.

The Ball IS Taxable Income

1. Catching a home-run ball is analogous to finding a treasure. It is an "accession to wealth" that is taxable currently. Reg. § 1.61-14(a) provides: "Treasure trove, to the extent of its value in United States currency, constitutes gross income for the taxable year in which it is reduced to undisputed possession."

2. The ball is windfall income and is taxable at its fair market value at the time it is caught. That value then becomes the cost basis and if the ball is subsequently sold for a higher price, the increased value is a capital gain.

3. The ball is not a gift because it did not result from "disinterested generosity," the standard of Commissioner v. Duberstein, 363 U.S. 278 (1960). In that case, the presidents of two metal companies did business and one gave the other a Cadillac. The Supreme Court said it was not a gift because it was intended to compensate for lucrative information and to encourage future business.

The IRS is silent on the issue at hand but has previously addressed the circumstance of a record home run being returned to the batter, i.e., Mark McGuire. Then Chairman of the IRS Charles O. Rossotti said there would be no tax in that circumstance. "This conclusion is based on an analogy to principles of tax law that apply when someone immediately declines a prize or returns unsolicited merchandise. There would likewise be no gift tax in these circumstances."

For the moment, every reader is entitled to his or her own opinion or position because the IRS is not elaborating on its prior guidance.