Michael Jackson was no stranger to lawyers while he was alive, reportedly spending $20 million on his successful defense against sex abuse charges. Now, even after his death, he is still keeping lawyers busy, producing a healthy stream of income and paying lots of taxes on that income. Despite the size of the checks the IRS is receiving, however, the agency wants more. Yes, we’re talking estate taxes.

This article takes a look at how estate tax laws are affecting the Jackson estate today. It discusses how the IRS is able to collect both income taxes and estate taxes following a person’s death. The tax and valuation issues are particularly knotty where intellectual property and image rights are at play. More importantly, this article also emphasizes how the subjective nature of valuing assets can lead to messy disputes with the IRS. As we will see, these disputes can be particularly devastating to an estate with illiquid assets that are – or at least appear to be – immensely valuable. 

Income Taxes

Mr. Jackson died unexpectedly on June 25, 2009, at age 50. As frequently occurs with top entertainers, the star’s efforts during his lifetime have continued to produce a steady stream of income even after his death. As always, the IRS wants its cut. First, there are income taxes, which are distinct from estate taxes.

Just as in the case of a living individual, the income collected by an estate is subject to income tax. Mr. Jackson’s estate continues to rake in considerable income. Although Mr. Jackson himself is deceased and is therefore not required to continue filing income tax returns, his estate is still required to file. These are income tax returns, but filed by the estate because it is still collecting income. And that income is considerable.

Estate Taxes

You might think that after collecting all that income tax, the IRS would not ask for more. But the IRS and Jackson’s estate are locked in a Tax Court battle over estate taxes. See Estate of Michael Jackson v. Commissioner (017152-13 U.S. Tax Court). The IRS would like more than his estate reported on its federal estate tax return.

The IRS claims that the Jackson Estate owes a whopping $505.1 million in additional taxes and another $196.9 million in penalties. The penalties are based on the taxes due, so if the tax charge is struck down, the penalties go with it. Currently, the federal estate tax law allows $5.25 million per person to be passed tax-free. But in 2009, the year Jackson died, the exemption amount was only $3,500,000.

Timing the Valuation

Yet it can be hard to compromise polarized figures. Such valuation disputes often boil down to a battle of the experts, each side arguing for an aggressive number. In this case, the estate is sure to argue that the meteoric rise in Mr. Jackson’s fortunes after his death could not have been foreseen.

Rights to receive future payments must be valued for federal estate tax purposes. Their value is the projected future worth (or the aggregate of the future payment stream) discounted to present value. Reminding us of David Bowie bonds – asset-backed securities issued by musician David Bowie that used current and future revenue from recordings made before 1990 as collateral – the IRS asks what a third party would pay today for the right to receive those payments in the future.

Valuing the Estate

The estate tax depends on the value of the estate as of the date of death. Alternatively, the estate can elect to value the assets six months after death, something known as the alternate valuation date. Executors often determine which value is lower and report that lower figure. But apart from the choice of which of these two dates produces the lower tax, the IRS gets a share based on the value of the estate.

That brings us to valuation, the key in most estate tax disputes. Unlike income tax cases, where the amount of cash usually can’t be disputed, estate tax cases usually are about valuing something. Whether it is raw land, a mountain retreat, a conservation easement, or a rare piece of art, valuation disputes can be maddening, especially when dealing with illiquid assets.

For estate tax purposes, only net value – assets minus liabilities – is subject to tax. If the estate includes an asset worth $100 million but there is $50 million of debt, only $50 million is taxed. The presence and details of debts could be key variables for the estate, because Mr. Jackson reportedly had many high-value assets but many large debts too.

http://www.americanbar.org/publications/blt/2013/10/03_wood.html