Article: "THE FIFTH CIRCUIT'S VIEW OF BUSINESS APPRAISERS"
Cases:
· Hackl (118 T.C. No.14.)
· Harper (T.C. Memo 2002-121.)
· Fontana (118 T.C. No. 16.)
· Thompson (T.C. Memo 2002-246.)
· Dunn (301 F.3d 339)
THE FIFTH CIRCUIT'S VIEW OF BUSINESS APPRAISERS
The recently decided Dunn case, discussed herein, prompted the following commentary from the Fifth Circuit:
“Fomented in significant part by myriad valuation challenges instituted by the IRS over the past decades, a full-fledged profession of business appraisers, such as the American Society of Appraisers, has emerged, generating its own methodology and lexicon in the process; which in turn have contributed to the profession's respect and mystique. Because - absent an actual purchase and sale - valuing businesses, particularly closely held corporations, is not a pure science replete with precise formulae and susceptible of mechanical calculation but depends instead largely on subjective opinions, the writings and public pronouncements (including expert testimony) of these learned practitioners necessarily contain some vagaries, ambiguities, inexactitudes, caveats, and qualifications. It is not surprising therefore that from time to time disagreements of diametric proportion arise among these practitioners. As the methodology we employ today may well be viewed by some of these professionals as unsophisticated, dogmatic, overly simplistic, or just plain wrong, we consciously assume the risk of incurring such criticism from the business appraisal community. In particular, we anticipate that some may find fault with (1) our insistence (like that of the Estate's expert) that, in the asset-based approach, the valuing of the Corporation's assets proceed on the assumption that the assets are sold; and (2) our determination that, in this case, the likelihood of liquidation or sale of essentially all assets be factored into the weighting of the results of the two valuation approaches and not be considered as an integral factor in valuing the Corporation under either of those approaches. In this regard, we observe that on the end of the methodology spectrum opposite oversimplification lies over-engineering.”1
We find ourselves in agreement with the court's valuation decision and its commentary. Common sense should always prevail. We urge you to study this case.
_________________________________________________________________________________
¹ Beatrice Ellen Jones Dunn, Deceased,
Estate of Jesse L. Dunn III, Independent Executor, Petitioner-Appellant, v. Commissioner
of Internal Revenue, Respondent-Appellee, United States Court of Appeals, Fifth Circuit,
No. 00-60614.
Hackl v. Commissioner, 118 T.C. No.14. Filed March 27, 2002.
In order to qualify for the annual gift tax exclusion, a gift must be of a present interest. For example, a gift to a trust where the beneficiary has no present right to the trust’s income does not qualify for the exclusion. What about a gift of a noncontrolling interest in a family LLC or limited partnership? Is it a present interest or a future interest? If the interest is severely restricted, e.g., inability to withdraw, freely transfer the interest, force distributions, etc., the IRS may try to disallow the exclusion.
There were significant restrictions in the Hackl LLC agreement. Furthermore, the LLC’s major assets were tree farms in Florida and Georgia with long-term growth potential but which would produce little or no income with no distributions “for a number of years.” Since gifts to the children and grandchildren conferred no “meaningful” “present economic benefit,” Judge Nims concluded that they failed to qualify for a Section 2503(b) exclusion.
COMMENT: We have heard that agreements with appropriate
right of first refusal language may avoid an IRS argument. Some professionals have
suggested a provision giving the donee a 60 day put at fair market value. Others believe Hackl
is wrong and would be reversed on appeal. They believe the gift in trust analogy is weak
and that the interests, albeit restricted, were vested and had present value.
Estate of Harper v. Commissioner, T.C. Memo 2002-121. Filed May 15, 2002
If Morton Harper’s son, Michael, had been more diligent in transferring his sick father’s assets to a newly formed family limited partnership, we would not have another Tax Court decision [see Estate of Reichardt v. Commissioner, 114 T.C. 144 (3/1/00)] ignoring the partnership and concluding that a decedent retained enjoyment of contributed assets under Code Section 2036(a).
Harper Financial Company, L.P. was formed in June 1994 but more than six months went by before it was fully funded and up and running. Mr. Harper died in February 1995, having made gifts of 60% of the limited partnership interests to his son and daughter back in July, leaving 39% of the interests in his estate. An accountant was engaged in the spring of 1995 to do “after the fact paperwork” but Judge Nims was not persuaded. A record of disproportionate distributions did not help matters.
Some of the Court’s language questioning the arrangement is harsh:
“We find the disregard here for partnership form to be… egregious.”
“…we find Michael’s reliance on post mortem accounting manipulations to be especially unavailing.”
“…the partners had little concern for establishing any precise demarcation between partnership and other funds during decedent’s life.”
The estate also argued that the transfer of Mr. Harper’s assets to the partnership was a bona fide sale for consideration, an exception under Section 2036(a). The Court’s response:
“In actuality, all decedent did was to change the form in which he held his beneficial interest in the contributed property.”
“…there has been only a recycling of value and not a transfer for consideration.”
COMMENT: Most practitioners follow up with their clients
to make sure the partnership is functioning as such. The Harper case possibly
illustrates the consequences of not doing so.
Estate of Fontana v. Commissioner, 118 T.C. No. 16. Filed March 28, 2002.
Unlike a QTIP trust where the surviving spouse has only an income interest, a trust over which there is a testamentary general power of appointment allows the surviving spouse to dispose of trust property in his or her Will. This power of disposition caused Judge Foley to distinguish earlier cases [Mellinger (112 T.C. 26) and Bonner (84 F.3d 196)] and aggregate the decedent’s individual shares (44.069%) in Fontana Ledyard Co., Inc. with those in the trust under his wife’s Will (50%) for valuation purposes. The estate was not allowed to value each block separately because a general power of appointment is “essentially equivalent to outright ownership” and therefore the decedent, “at the moment of death (i.e., the critical moment for estate tax valuation purposes), had control and power of disposition over the property.”
COMMENTS: This decision has no bearing on the continuing
ability to plan for QTIP trusts in splitting closely held interests between the husband
and wife and valuing those interests on a minority interest basis.
Estate of Thompson v. Commissioner, T.C. Memo 2002-246. Filed September 26, 2002.
This is the most recent case where a decedent was found to have retained enjoyment of the property contributed to a family limited partnership within the meaning of Code Section 2036(a)(1).
Mr. Thompson contributed most of his assets (stocks, bonds and family loans receivable) to two family limited partnerships in 1993. He owned a majority of the limited partnership interests and 49% of the stock in the corporate general partner for each partnership when he died in 1995. A 40% combined discount for minority interest and lack of marketability was deducted in valuing the stock and limited partnership interests.
In concluding that assets contributed by Mr. Thompson to the partnership should be included in his gross estate under Section 2036(a)(1), Judge Jacobs placed particular emphasis on a family understanding that partnership distributions to Mr. Thompson would fund (1) traditional annual Christmas gifts of cash to family members, (2) future loans to family members and (3) any shortfall due to the excess of Mr. Thompson’s annual personal expenses over his available funds. The Judge also noted an arrangement whereby assets contributed to the partnership by the children and a son-in-law were not pooled with those of the decedent but were dealt with separately. Finally, Mr. Thompson had contributed “the vast bulk” of his assets to the partnerships, implying an agreement with his children that he would continue to rely on them for his own support.
COMMENTS: The IRS seems to be on a roll with its use of Section 2036 to attack family limited partnerships, having previously prevailed in the Schauerhamer (T.C. Memo 1997-242), Reichardt [114 T.C. 144 (2000)] and Harper (T.C. Memo 2002-121) cases.
We await the results of the Strangi remand from the Fifth Circuit [293 F. 3d 279 (5th Cir. 2002)]. The Tax Court was directed to consider whether Section 2036 applies to a fact pattern where the decedent appeared to control the partnership even though he lacked legal control. In Thompson the issue of control was dealt with as follows:
“Any control over management and distributions by Betsy and Robert is likewise of little import. Documents in the record show that the composition of the portfolio changed little prior to decedent’s death. We place little weight on averments concerning change, during decedent’s life, in the partners’ relationship to the contributed property.”
In view of these recent 2036 cases, we understand clients are being told by their advisors to seriously consider which assets should be contributed to a new partnership or LLC and, once it is formed, to behave in a manner consistent with a show of respect for the entity.
Estate of Dunn v. Commissioner, 301 F.3d 339 (5th Cir. August 1, 2002).
Beatrice Dunn died June 8, 1991 owning 62.96% of the stock of Dunn Equipment, Inc., a Texas heavy equipment rental business.
Texas law requires a two-thirds vote in order to liquidate. Thus, a buyer of Ms. Dunn’s stock could not have forced a liquidation acting alone.
The Tax Court assigned weightings of 65% to an asset-based valuation approach and 35% to an earnings-based (net cash flow) approach in determining fair market value. It only allowed a 5% reduction for built-in capital gains tax liability in its asset-based analysis because liquidation was “not imminent or even likely.” Dunn Equipment was worth considerably more under an asset-based approach (see chart below) so the IRS prevailed based on the Tax Court’s decision.
The estate did not agree with the Tax Court’s 5% reduction for potential taxes and its weightings for the two valuation approaches (having used a 50:50 ratio itself) so it appealed to the Fifth Circuit. The IRS and estate had already stipulated an earnings-based value and discounts of 15% for lack of marketability and 7.5% for lack of a super majority.
The Fifth Circuit reversed and remanded.
Under an asset-based valuation approach where the hypothetical buyer would get “operational” control (more then one-half but less than two-thirds), liquidation is assumed, regardless of what the buyer’s intentions are, so the Fifth Circuit said there would be a 34% (federal tax rate on built-in gains) reduction in the buyer’s purchase price:
“The Tax Court made a . . . significant mistake in the way it factored . . . the likelihood of a liquidation sale of assets when calculating the asset-based value of the Corporation. Under the factual totality of this case, the hypothetical assumption that the assets will be sold is a foregone conclusion - a given - for purposes of the asset-based test.”
“We hold as a matter of law that the built-in gains tax liability of this particular business’s assets must be considered as a dollar-for-dollar reduction when calculating the asset-based value of the Corporation,”
On the other hand, the likelihood of liquidation was deemed critical to the question of how much weight should be given the asset-based approach where the facts indicated that the business had “significant operational aspects.” The Tax Court had acknowledged that Dunn Equipment was a “viable operating company” and yet it gave only a 35% weighting to an earnings-based approach. The Fifth Circuit found this to be without logic and unsupportable. Accordingly, it changed the ratio to 85:15 in favor of an earnings-based approach.
COMMENT: The logic of the Fifth Circuit is immutable: if the value of the assets is to be realized, even hypothetically, the capital gains tax bite should be deducted in full.
Dunn Equipment, Inc. (62.96%)
Asset:Earnings (ratio) |
Built-in Gains Tax | Lack of Super Majority | Lack of Marketability | Valuation (rounded) | |
| Estate | 50:50 | 34% | 7.5% | 15% | $ 1.6M |
| IRS | 100:0 | No Discount | 7.5% | 15% | $ 4.4M |
| Tax Court | 65:35 | 5% | 7.5% | 15% | $ 2.7M |
| Fifth Circuit | 15:85 | 34% | 7.5% | 15% | $ 1.0M |
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