Freezing dad: taxing potential human capital.

Chambers, Valrie ; Armandi, Barry

CASE DESCRIPTION

The primary purpose of this case is to encourage students to derive a plausible, well-supported answer to a novel tax situation (in which virtually no direction currently exists) using critical thinking skills. This case is important because practitioners inevitably face situations without finite, predetermined answers. The secondary purposes of this case are to utilize broad-based research skills and familiarize the student with Reg. Sec.1.6694-2(b) of the Internal Revenue Code of 1986, as amended) which states that to protect the preparer from penalties, a tax solution must have a better than 1 in 3 chance of being sustained on its own merits. The level of case difficulty is a 5/6 (graduate level), and is designed to be taught in 3 class hours with 6 hours of outside student preparation, or alternatively assigned as an out-of-class report with a 1-hour in-class discussion.

CASE SYNOPSIS

"Joan, we can be very wealthy in a few years, as long as the technology keeps advancing," said Jim Andrews to his sister. "I don't know, Jim, it sounds kind of eerie and science fiction-ish. And even if the technology is there and we make millions, how much is the government going to grab?" replied Joan. "Good point!" answered Jim. "Let's talk to our accountant."

Most business cases presented to students have a fixed answer either as the result of past investigation in a formal (e.g. legislation or litigation) or informal (academically studied and expert-recommended) environment. However, many problems in life contain novel elements for which no existing answer has been published. Thus it is critical that students be able to think independently of a known, existing answer, while simultaneously relying on similar existing research or tenets. The need for critical thought required to analyze such a situation and derive a tentative solution is as timeless as changes in business environment that precede legislation and litigation. Previous examples of where practitioners have faced novel situations include: the time period where equipment became increasingly more computerized (should the estimated useful life of hybrid equipment be that of the computer elements, or that of the other underlying asset?) and the estimated useful life of software (where tax software, for example was essentially good for a year, but other applications had longer operational lives but faced acute obsolescence before they actually stopped functioning). This case, which is based on the death and subsequent litigation on the disposal of the remains of Ted Williams, has no definitive answer, and requires tax speculation supported by general logic and broad-based research.

THE NATURAL

Robert Andrews was born in a small Midwest farm in 1922. His family, including his two sisters and a younger brother, worked hard and was close and active in school and the community. Bob's father, Arthur, loved baseball and attended as many minor league games as he could afford. He always took Bob and at an early age taught him the game. Every night they would play "catch" and Arthur would teach his eager pupil how to run the bases, slide, pitch, field, and hit from both sides of the plate. Arthur was impressed how quickly his son learned and applied his lessons.

Arthur made certain Bob was involved in as many sandlot games as possible, until Bob entered high school. Bob easily made the team and his freshman coach urged the varsity coach to take him the following year. After seeing a few games he was awe-struck by Bob's natural ability. He placed on the varsity roster the next year and for three years Bob pitched and played shortstop. The team made the playoffs all of Bob's three years, winning the State Championship the last two. Bob pitched 15 wins, with only1 loss over that span and hit thirty-five home runs. He was the Most Valuable Player the last two years and was State Athlete of the Year in his senior year.

Colleges took notice of Bob's prowess and scholarship offers came in droves. Minor league scouts had also noticed Bob, and Bob accepted a contract with the Toledo Toros for $5000, a good deal of money at that time. In his first year, Bob tore up the league, with an unusually high batting average, 45 homers, and 36 stolen bases. He pitched and won every one of his fourteen starts with an impressively low Earned Run Average (ERA) of 2.6. He was the league's Most Valuable Player and helped the Toros get to the World Series.

The following year, 1941, Bob enlisted as a pilot to fight in World War II. He was as good a pilot as he was a baseball player. He shot down twenty-two enemy planes over three years, and was internationally decorated for his service. He was honorably discharged as a major in 1946, returning to the Toros for the remainder of that year.

The following year, he batted .402 with thirty home runs and thirty stolen bases and was noticed by some major league scouts. He signed a professional contract with the Kansas City Cyclones. The Cyclones used Bob sparingly his first year. During that time he batted .330, hit twelve homers, stole 17 bases, and was 5 and 2 with an ERA of 3.1, but was then traded to the New York Colonials, who decided to use him as their full time right fielder.

Bob blossomed under the Colonial system and management. In his first year, he batted .388 with 37 home runs, 112 runs batted in (RBIs), and stole 40 bases. For the next fourteen years, Bob helped the Colonials to nine World Series Championships and twelve pennants. He had a batting average of.392, with 512 home runs, 1558 RBIs, and 587 stolen bases. He batted over .400 six times and was the League MVP eight times and the World Series MVP five times. He retired in 1966; his uniform was retired in 1967. He was elected into the Hall of Fame in 1971. In 2002, Bob passed away from a heart attack. At the memorial services, all of the old timers agreed that Bob was one of the top ten greatest ball players of all time.

THE PLAN

A few years prior to his death, Bob became fascinated with the idea of cryonics, the Genome Project, and cloning. He discussed the matter with his son, Jim, and daughter, Joan. At first they were appalled at the concept. Both were brought up to be very religious by their mother, who had passed away some ten years ago. Bob was not as religious, and therefore had no problem with the idea of being frozen with the intention of coming back some day, when medicine and technology would have eliminated most diseases. He decided to look into it further, and asked Jim and Joan to do the same.

After doing some extensive reading, Jim agreed with his father and they obtained all the necessary documentation. They decided on using Cyrotek, Inc. because of their long history and their founder, who wrote one of the first papers on the idea and subsequent procedure. Bob filled out the paperwork, set up a fund for all necessary expenses, and gave Jim and Joan power of attorney. He was convinced that in the future he would come back.

CYROTEK, INC.

In 1962 the cryonics movement started with the publication of "The Prospect of Immortality" by Robert Ettinger. After more book and articles on the subject, a number of organizations began and started to offer cryostasis services. One of these was Cyrotek and its founder Charles Wright, who believed that people could be brought back to life after rapid and intense freezing. Experiments with insects, fish, fowl, and other animals were successful.

The process of cryostasis involves an initial cool down using an anticoagulant. Then the blood is removed and replaced with a cryoprotectant, which is a solution that acts similar to antifreeze in a car. Next comes more cooling and then final immersion in liquid nitrogen at a temperature of -196 degrees celsius. The procedure must begin as quickly after the person is declared legally dead.

Approximately 200 people were frozen at Cyrotek's facility located in New Mexico. Another 77 have just their head frozen, which is called neurosuspension or "neuro". In addition to an initial cost, a fund is to be established to pay for the annual storage costs and replenishing of liquid nitrogen. This fund was estimated by Cyrotek to increase by 2% per year. Only the interest from the fund was to be used. Cyrotek estimated that the principal was $150,000 for Whole Body and $50,000 for Neuro.

THE NATURAL'S "DEATH"

Bob Andrews passed away from a heart attack on July 7, 2002 in a Texas hospital. Only his son and daughter were present. As soon as Bob was declared "clinically dead", the Cyrotek team sprang into action, wrapped Bob's body in a plastic wrap to prevent freezer burn, then packed Bob's body in dry ice, and stored it in an aluminum container. The container was transported by private jet to the Cyrotek facility and the process was completed the same day. All in all, it took seven hours from the time Bob was declared "dead" to his completed suspended animation at Cyrotek. At a wake held in Bob's honor, his friends eulogized about his character, his sense of humor, and his talent. Colleagues remarked, "if you could bottle and sell Bob's talent, you'd make a fortune."

THE REVISED PLAN

During their research on cyronics, Bob and Jim, discovered the field of genetics and cloning. Strides were made with the successful cloning of animals, and human cloning bans were lifted in Europe. Bob told Jim to look into it further, but before he could, Bob died. Jim discussed the matter with Cyrotek and it was agreed that 25 small DNA samples would be preserved. There were no additional costs for the freezing and yearly maintenance.

Jim felt that in the future cloning would become acceptable and technologically feasible. He thought that even if unfreezing his father would fail, that surely he could be cloned. Likewise, the comment that "if you could bottle and sell Bob's talent, you'd make a fortune" kept ringing in Jim's ears: he could sell off his father's DNA samples piece-meal to baseball fanatics, perhaps those who wanted their children to be athletically talented. He discussed the matter with his sister. Joan wanted to find out what the tax implications were. They decided to visit their accountant, Mike Stevens.

VISITING THE CPA

Jim and Joan explained their plan to Mike, who was shocked at first, but then he began to wonder, what were the tax implications of selling Bob's DNA? He told Jim and Joan that he would look into it and get back to them. Mike called in his staff and explained the situation. The staff noted that since this had not been done before, the tax laws on this point were likely unsettled. With no direct, existing precedent, the best they could do was construct a credible tax position, and hope that later, that tax position would be sustained.

In the next meeting with Jim and Joan, Mike told them that he had another client Jennifer Cohen, who ran two related for-profit corporate businesses, a sperm bank and an infertility clinic. Mike told them that Jennifer was dedicated to alleviating the emotional hardship of those who were unable, but very much wish to, conceive and bear children. Mike felt that an alliance between the two could be quite worthwhile. With their concurrence, he arranged a meeting.

At the meeting, Jennifer became very intrigued at the prospect of selling DNA samples to bidders. She felt that with cloning technology, collecting, storing, and selling DNA samples from famous people (e.g. athletes, movie stars, geniuses, etc.) for purposes of reproduction can be as profitable as her current sperm bank business, which also had samples available for conception from individuals successful in their respective fields.

After much discussion, Jim, Joan and Jennifer came to an agreement and developed two plans:

 Plan 1) the celebrity's estate handles the interment (freezing) and
 all associated costs; DNA is received as requested and then used for
 conception; a generous honorarium is paid to the heirs.

 Plan 2) the alliance could handle the interment and all associated
 costs, distributing the DNA as requested and remitting a percentage
 of the proceeds' net of costs to the estate.

In either case, profitability depended on the willingness of the celebrities and their heirs to undergo cryogenics as their "last resting place," and their willingness in turn depended in part on the tax consequences to the celebrities, their estates, and heirs. Jim, Joan, and Jennifer believed that this was a way for celebrities to "live on" and contribute successful DNA to the generations of the future. However, they asked Mike to analyze this venture from an accounting (and particularly tax) standpoint. Mike called his staff together and gave them the following assignment, after explaining this new venture:

Under either plan:

1. What is the value to the estate of a celebrity's DNA?

2. Is the value of the remains of a celebrity sufficient enough to prompt estate tax?

3. Are the costs of cryogenics deductible by the estate? Currently (or must the costs be depreciated, depleted, or amortized)?

4. What is the estimated useful life of a celebrity's remains?

5. Would this plan, if profitable, produce portfolio income, ordinary income, capital gains, or other income (type - e.g. passive) for the estate? For the heirs? For our client?

Under Plan 1:

1. What is the heirs' basis in the celebrity's DNA?

2. Is the heirs' basis in the celebrity's DNA deductible against any proceeds received from DNA sales?

3. Are the costs of cryogenics deductible by the heirs? Currently (or must the costs be depreciated, depleted, or amortized)?

Under Plan 2:

1. Assuming the celebrity is interred in your facilities for further reproductive opportunities, have you purchased an asset?

2. If so, what kind of asset is it (how do you classify it)? If not, against what do you charge expenses (e.g. cost to transport the body in, etc.)

3. What is your basis in the celebrity's DNA?

4. Is your basis in the celebrity's DNA deductible against any proceeds received from DNA sales?

5. Are the costs of cryogenics deductible? Currently (or must the costs be depreciated, depleted, or amortized)?

Valrie Chambers, Texas A & M University-Corpus Christi Barry Armandi, SUNY-Old Westbury