Estate of Robert E. Cartwright, Deceased, Dorothy G. Cartwright v. Commissioner of Internal Revenue

Citations: 183 F.3d 1034; 99 Cal. Daily Op. Serv. 5509; 99 Daily Journal DAR 7015; 84 A.F.T.R.2d (RIA) 5218; 1999 U.S. App. LEXIS 15220; 1999 WL 476862Docket: 97-70032

Court: Court of Appeals for the Ninth Circuit; July 12, 1999; Federal Appellate Court

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At the time of his death in 1988, Robert E. Cartwright was the majority shareholder of the law firm Cartwright, Slobodin, Bokelman, Borowsky, Wartnick, Moore, Harris, Inc. (CSB). Following his death, the firm received over five million dollars in life insurance proceeds, which were paid to his estate based on a shareholders' agreement. The tax court ruled that these proceeds were compensation for both Cartwright's shares and his potential claims to the firm's 'cases or work in process,' qualifying as 'income in respect of a decedent.' Consequently, the estate was found liable for a federal income tax deficiency of $1,105,762.

On appeal, Cartwright's estate argued that the tax court incorrectly interpreted the proceeds as redeeming more than just his stock and failed to adequately factor in advanced client costs and work in process when valuing the stock. The appellate court affirmed the tax court's findings except for the valuation of stock, which it remanded for further consideration of advanced client costs and work in process. The shareholders' agreement outlined the financial responsibilities of CSB to the deceased shareholder's estate, specifying various payments including the stock purchase price, unpaid profits, salary, expenses, and percentages of future income from certain cases, along with half of any life insurance proceeds.

In 1988, CSB amended its shareholders' agreement regarding the disposition of Robert E. Cartwright's interest in the firm upon his death. The amendment indicated that CSB had acquired two life insurance policies on Cartwright's life, totaling $5,000,000, with proceeds designated to purchase his interest in the firm. The amendment stipulated that upon Cartwright's death, the insurance proceeds would be used exclusively to buy his stock and any claims to cases or work in process from his estate and heirs. Cartwright died on June 30, 1988, owning 71.43% of CSB shares, and CSB paid the proceeds, totaling $5,062,029, to his estate, which included adjustments and interest. CSB classified $4,080,256 of this payment as non-employee compensation on a Form 1099-MISC. However, the estate did not report this amount as taxable income, contending it was solely for redeeming Cartwright's stock. The IRS disagreed, asserting that $4,080,256 was taxable compensation, resulting in a deficiency of $1,142,472 for the estate. Upon appeal, the tax court determined that the payment was for both Cartwright's stock and his claims to the firm’s work in process, valuing these items collectively at $5,000,000. The court found that the value of Cartwright's stock was $1,105,762, with the remaining $3,956,267 classified as taxable income. The tax court's decisions were reviewed similarly to district court rulings, with contract interpretations assessed de novo and stock valuation reviewed for clear error. The estate argued for a narrower interpretation of the amendment, but the court upheld the broader intent evidenced in the language of the amendment and surrounding circumstances.

CSB's distribution of insurance proceeds to Cartwright's estate is deemed a payment for both Cartwright's stock and his claims to cases or work in process, as per the explicit language of the 1988 amendment. This interpretation aligns with the understanding of Cartwright and his colleagues at the time of drafting, acknowledging that he likely had interests in ongoing cases at his death. Evidence indicates that Cartwright’s compensation was primarily derived from bonuses based on his contributions rather than salary, reinforcing his expectation of future bonuses for his work.

The tax court's ruling differentiates this case from others where payments were strictly for stock redemption, such as in Smith, Steffen, Estate of Bette, and Erickson cases, where intentions were clearly limited to stock purchase. The language of the 1988 amendment, coupled with the facts, supports the conclusion that CSB intended to buy both Cartwright's shares and his claims.

The court must now assess whether the tax court correctly apportioned the payment between the stock and claims to work in process. After evaluating conflicting expert testimonies, the court favored the IRS's expert findings based on the 1973 and 1988 agreements. The estate contends that the tax court erred in three valuation aspects: neglecting CSB's advanced client costs, overlooking work in process on contingent fee cases, and failing to classify insurance proceeds as a nonoperating asset of CSB. The estate's arguments are validated, as advanced client costs should be treated as loans and included among the firm’s assets, and work in process should also be factored into the asset valuation for its impact on stock pricing.

The tax court properly excluded life insurance proceeds from the firm's asset valuation for stock purposes, as these proceeds were offset by the obligation to pay the full benefits to Cartwright's estate. The court found that CSB's payment of life insurance benefits effectively redeemed Cartwright's stock and his claims related to the firm's ongoing cases. An amendment from 1988 and CSB's practices supported this conclusion. However, the court incorrectly calculated the allocation of proceeds between Cartwright's stock and his claims to ongoing cases, necessitating a remand for reassessment of stock value, considering advanced client costs and work in process. Judge Thomas concurred in part but dissented regarding the allocation of the $5 million paid to Cartwright's estate, arguing it should be solely attributed to his stock, as he had no legal claims to the work in process apart from his shareholder interest. The shareholders' agreement specified payments to the estate for stock value and work-related claims, with a provision for a lien on cases.

Cartwright expressed concerns about ensuring his wife’s financial security upon his death and the firm's viability. Fellow shareholder Philip Borowsky indicated that Cartwright dominated the firm and contributed over 90% of its business, fearing that a 25% payout from fees to his estate could jeopardize the firm’s survival. To address these issues, the firm retained Michael Bezazian from Prudential Insurance Company, who advised valuing Cartwright’s interest and funding it via life insurance. In 1988, the shareholders amended the 1973 shareholders' agreement, establishing a $5 million valuation for Cartwright’s interest, which would be funded through life insurance proceeds. The amendment mandated that upon Cartwright's death, the proceeds would be exclusively used to purchase his stock and any claims related to his work from his estate, while also ensuring any owed salary or expenses would be paid to his estate. The amendment was contingent on the continuation of the life insurance policy; otherwise, the original agreement would apply. The intent was to fix the value of Cartwright's business interest and eliminate any independent claims from his estate regarding his work in process. Borowsky, who co-drafted the amendment, confirmed that its primary purpose was to satisfy potential claims from Cartwright's estate. The unambiguous language of the amendment and the testimony indicate that the 1988 amendment extinguished Cartwright's rights to work in process under the 1973 agreement. The case of Steffen v. Commissioner serves as a precedent, where the court ruled that payments under a stock redemption agreement were not related to salary based on accounts receivable, reinforcing the notion that such claims do not confer legal interests.

Accounts receivable pertain to services rendered by the Corporation, not the individual employees, indicating these represent obligations owed to the Corporation rather than by it to employees. In a closely held professional service corporation, the roles of employee stockholders can obscure this distinction. The case references the precedent set in Steffen, emphasizing that income must be linked to a decedent's right to receive it at the time of death per 26 U.S.C. § 691. Despite Cartwright's contributions to the firm, he had no right to the firm's work in process at his death, as any claim he had under the 1973 shareholders' agreement was nullified by the 1988 amendment. The tax court misinterpreted the amendment's language regarding Cartwright's claims, mistakenly believing residual rights were retained. The phrase in question clarified that claims to work in process were extinguished. This scenario parallels the ruling in Smith v. Commissioner, where the court determined that commissions mentioned in an agreement were effectively tied to stock alone, as the shareholder had no independent claim to them. Consequently, the life insurance proceeds received by Cartwright's estate should be viewed as compensation solely for stock. The tax court incorrectly allocated part of a $5 million payment to work in process, overlooking that the Corporation owned this asset at Cartwright's death. Thus, an appraisal of the stock was unnecessary, as its value had already been agreed upon by the parties.

Shareholders can set the value for departing shareholders in advance, provided that the determination follows a legitimate business arrangement and does not unfairly transfer assets to a decedent's family below market value. In this case, a new valuation was improperly conducted by the tax court, which mistakenly relied on an expert appraisal influenced by how compensation was handled under a 1973 agreement. This agreement segregated work in process from corporate assets, meaning payouts to departing shareholders were not equivalent to stock value. Consequently, the stock value was artificially deflated. Although the majority acknowledged the tax court's error in excluding work in process from valuation, it incorrectly endorsed a flawed methodology that relied on the outdated agreement.

The majority interpreted the phrase regarding claims to work in process as referring to a bonus expected by the decedent, Cartwright, despite this argument not being presented by either party. Testimony established that shareholders received a low fixed salary supplemented by discretionary bonuses based on undistributed profits, not tied to work in process. The historical data did not support the idea that these bonuses fell under shareholder buyout provisions. Furthermore, a 1988 amendment clarified that any owed amounts for salary or expenses would be paid to Cartwright's estate, negating the majority's allocation of life insurance payments to an anticipated bonus. The tax court's allocation of $4,080,256 to "income in respect of the decedent" was excessive and inconsistent with Cartwright's historical bonuses, which ranged from $243,500 to $400,000 in the years prior to his death, making a $4 million bonus implausible.

Neither the firm nor Cartwright's estate has claimed that additional funds are owed for an expected bonus or that the annual bonus is part of the life insurance payment. Analysis of corporate and estate tax returns indicates a bonus was already paid for the year of Cartwright's death. Consequently, it would be improper to allocate any portion of the $5 million payment to an expected annual bonus, especially not four-fifths of the insurance proceeds. The 1988 amendment clearly defines the $5 million payment as compensation solely for stock. The tax court's contrary conclusion was a legal error, resulting in a million-dollar miscalculation, warranting a reversal without remand.

Additionally, there is agreement that the tax court erred by excluding advanced client costs and work in process from corporate assets. For example, if the firm's work in process is valued at $5 million and Cartwright is responsible for 90% of it, his estate would typically receive $1,125,000 under the 1973 agreement. However, the 1988 amendment means his estate would receive $3,750,000 from the corporate assets, reflecting the value of work in process. This discrepancy in methodologies leads to vastly different outcomes, which should not be compared. 

Cartwright's salary history indicates that he received low monthly salaries, with increases leading up to his death, culminating in a total compensation of $276,000 for the tax year in question, which included both salary and bonus. Records support that compensation encompassed both elements, contradicting the majority's conclusion. While there are disagreements in interpretation, these may not be substantial and could be resolved on remand, as neither party argued for allocating life insurance proceeds to the annual bonus during the trial.