Article: "THE JUDGMENT OF JUDGES V. THE EXPERTISE OF EXPERTS: QUI SUNT VICTORS? "
Cases:
· Schauerhamer (T.C. Memo 1997-272)
· Eisenberg(T.C. Memo 1997-483)
· Wright (T.C. Memo 1997-53)
· Barge (T.C. Memo 1997-188)
· Mitchell (T.C. Memo 1997-461)
THE JUDGMENT OF JUDGES V. THE EXPERTISE OF
EXPERTS:
QUI SUNT VICTORS?
That’s right - who wins? In our interpretation of Tax Court valuation decisions over many years, we have observed an improving trend in the judgment of judges. Among other things, business valuation concepts have been more readily accepted and understood, appraisal education and credentials have been recognized and a higher level of documentation in support of valuation conclusions has been demanded. A clear trend in the way decisions have been reached is also apparent. Historically, in many decisions it appeared that the judge would split the difference between the IRS and taxpayer appraisals. With Buffalo Tool & Die (74 T.C. 441), we were encouraged when the judge said that the best appraisal will win - we will no longer split the difference. A few (but unfortunately not many) decisions followed this philosophy.
Now we see too many instances in which the facts suggest that one side had the winning hand but the appraiser failed to support his or her conclusions and the door was left open for the judge to reach a valuation conclusion. When the taxpayer, or the IRS, goes into court with a weak appraisal, as is far too often the case, neither they nor we can complain when the judge goes his own way. When the expert testimony is weak or flawed, the judgment of judges is called for.
In Scanlan v. Commissioner (T.C. Memo 1996-331), the business appraiser appeared to use a good valuation approach but his testimony and report were weak and the taxpayer lost. In matters such as the Wright and Mitchell cases discussed herein, though, the taxpayers had two strong appraisals and the IRS had poor ones, but the judge still went his own way in finding a value. We find this trend in decisions, of which there are other examples, disturbing because judges are not giving appropriate weight to what appear to be well-supported and well-presented valuation reports.
Does this new trend mean that the quality of the appraisal no longer matters, if the judge will not rely on it anyway? We think not, because the judges have demonstrated a growing ability to dissect appraisals, even fairly good ones. We think the lesson is clear. Tax Court judges have greater knowledge of business valuation matters than ever before and a well-documented appraisal prepared by a skilled and experienced appraiser is needed more than ever before. Obtaining the best appraisal you can will not hurt your case, but using a weak one will doom you in court. A good appraisal should, of course, keep you out of court in the first place.
Caveat emptor!
RECENT VALUATION DECISIONS
Estate of Dorothy M. Schauerhamer, et al., v. Commissioner,T.C. Memo 1997-272. Filed May 28, 1997.
In December, 1990, one month after she was diagnosed with cancer, the decedent formed and funded three family limited partnerships and then transferred limited interests to her three children. Additional funding and transfers occurred in 1991 before her death in December.
Although each partnership's income was required to be deposited in separate partnership accounts, the decedent deposited the income in a personal account where it was commingled with her own funds and income from other sources. The account was used as a personal checking account from which personal and partnership expenses were paid. No records were kept to account separately for partnership and non-partnership expenses.
The decedent's record-keeping problem made it clear that her relationship to the transferred assets was virtually the same as it was before the transfers. Accordingly, she had retained a life interest in the assets under Section 2036(a)(1) and their $2.1 million value was brought back into her gross taxable estate.
COMMENT: For those who knew about this case while it was pending and expected Judge Foley to rule on the application of Section 2703 to limited partnerships, the decision is disappointing. Other partnership cases are docketed.
Irene Eisenberg v. Commissioner, T.C. Memo 1997-483. Filed October 27, 1997.
This decision supports the position of the IRS in denying a valuation discount for the corporate tax on built-in capital gains where a corporation’s liquidation or sale of its assets is speculative.
Irene Eisenberg made minority interest gifts of her stock in Avenue N Realty Corp. in 1991, 1992 and 1993. The corporation owned property in Brooklyn, New York which was leased to a third party. The property, the sole asset of the corporation, had an appraised value of $600,000 and a tax basis of $69,500.
Mrs. Eisenberg and the IRS agreed on the value of the underlying property and that a net asset value method was appropriate for valuing the gifted stock. They also stipulated a 25% minority discount. The only issue was a valuation reduction for unrealized capital gains taxes. Mrs. Eisenberg argued that a corporation cannot avoid tax on a built-in gain because of the repeal of the General Utilities doctrine and that a willing buyer of her stock would reduce the purchase price by the "full amount of the tax.".
Judge Hamblen cites a long list of cases, most of which predate the repeal of Genereal Utilities, in denying a discount for the full amount of the tax.
COMMENT: Most attorneys and business appraisers stronglt feel that the tax on unrealized capital gains must be considered for valuation purposes. The taxpayer’s loss does not close the book on capital gains discounts. Eisenberg did not retain a business valuation expert. Curiously, there is no mention of a marketability discount in the Eisenberg opinion. An argument for the full amount of the tax is preordained to lose, as the best reasoning in support of tax related discounts does not call for discounts equal to the full amount of the tax.
Estate of W. Clyde Wright v. Commissioner, T.C. Memo 1997-53. Published January 29, 1997.
The IRS argued that a control premium should be applied in determining the estate tax value of a 23.8% interest in a bank holding company on the theory that a hypothetical single group of investors would buy decedent's block and then use it to buy up enough additional shares to get 51%. This position was rejected because it was based on "an unlikely scenario unsupported by the facts." Furthermore, it ignored a requirement in the articles of incorporation for a two-thirds shareholder vote to merge, consolidate, dissolve or sell the bank's assets.
COMMENT: The IRS position seems a waste of a court's time. A consistent loser whenever it has argued that family members join and act together, the IRS predictably lost when it speculated about what unrelated parties might do,but the taxpayer did not score a clear win. This case is a good example of the new trend in which judges have substantially disregarded what would be good quality testimony and valuation reports presented by the taxpayer’s two appraisers. In this case, the extreme position taken by the IRS appraiser may have tainted the judge's view of all of the appraisers.
Estate of Bonnie I. Barge v. Commissioner, T.C. Memo 1997-188. Filed April 23, 1997.
Judge Halpern relied on a cost of partition approach in determining, for gift tax purposes, the fair market value of a 25% undivided interest in Mississippi timberland. His approach took into account:
- The rate of return a buyer would demand (10%)
- How long a partition action would take (4 years)
- Income during the partition period ($293,000)
-Costs of a partition action spread over the partition period ($165,625)
- Value of the land in four years ($41,000,000)
Testimony supported the return income cost and time estimates used in the cost of partition calculation. Relevant data presented by experts from both sides was selected in arriving at a value of $7.4 million for a 25% interest.
COMMENT: The final number works out to be a 26% discount from net asset value, less than the 30% discount allowed in the LeFrak case (T.C. Memo 1993-526) but higher than discounts seen in previous Tax Court cases involving undivided interests.
The decision seems flawed, however, because the gifts were actually ten 2.5% undivided interests, not one 25% undivided interest. Presumably, the legal and other costs of a partition action would be the same for a 2.5% interest as for a 25% interest. If so, using Judge Halpern’s calculus, a value of $530,000 would result, representing a 48% discount.
A modest 10% rate of return was used. Would you undertake a partition action for only a 10% return? Better testimony by a skilled business appraiser could have supported a higher discount rate. A business appraiser could also include an analysis of minority and marketability discounts as supplement to a cost-of-partition analysis. We also wonder if complainants in a partition action would continue to receive income from the timberland.
Estate of Paul Mitchell v. Commissioner, T.C. MEMO 1997-461. Filed October 9, 1997.
Paul Mitchell died in April, 1989 with 49% of John Paul Mitchell Systems (JPMS) common stock. Prior to his death, JPMS grew rapidly and by the end of 1988 its sales had reached $65 million. This caught the attention of two suitors, Minnetonka Corp. and Gillette. JPMS and Gillette had agreed in December, 1987 to provide Gillette with a right of first refusal to buy JPMS at a formula price capped at $150 million. The agreement terminated in December, 1989.
The IRS value for Mitchell's stock at trial was $81 million while the estate's value was $23.1 million to $29 million based on the testimony of two well-respected appraisers.
Somewhat surprisingly, the purported $150 million Gillette offer was the court's starting point in determining the value of Mitchell's stock "at the moment immediately prior to death." The court's next concern was quantifying the impact of Mitchell's loss to JPMS "at the moment of death." After listing various "uncertainties as to the future of JPMS" and the dependence on another executive, John Paul DeJoria, to carry on, a 10% discount was deducted to reflect Mitchell's loss, leaving a value of $135 million. Finally, discounts of (1) 35% for minority interest and lack of marketability and (2) $1,500,000 to cover the possibility of a lawsuit over DeJoria's compensation, brought the value of Mitchell's 49% interest down to $41.5 million.
COMMENT: Since the original estate tax assessment by the IRS was based on a $105 million value for Mitchell's interest, this decision is, at least, a modest victory for the taxpayer. However, the court's use of a control value from a presumed offer made before death is an indication that more conventional minority valuation approaches by the estate's two investment bankers were not given sufficient weight. The judge recognized that the IRS expert took an extreme position.
Once again, two apparently credible and well-supported taxpayer valuations did not carry the day, when it appears they should have. The judge preferred the real world evidence of the Gillette right of first refusal, even though it was a control and not a minority value.
RECENT TECHNICAL ADVICE MEMORANDUMS (TAMs)
Technical Advice Memorandum 9719001. Published May 9, 1997.
A donor gave shares of a publicly traded stock to a trustee of three trusts for three grandchildren. Since each grandchild's trust was subdivided into three trusts, there were nine trusts for three grandchildren. How many gifts were made, one, three or nine, for blockage discount purposes?
The answer is nine. Gifts in trust are regarded as gifts to beneficiaries, not to a trustee. Each of the three sub-trusts had different terms so the Service ruled that nine separate gifts had been made. A discount for blockage would be based on each single gift and not calculated by aggregating other gifts of the same stock at the same time.
COMMENT: The IRS does not like the "separate gift" idea when
it works to its disadvantage. In TAM 9436005 (September 9, 1994) simultaneous gifts of 30%
blocks of a closely held stock were made to each of the donor's three children. A
"swing vote" argument was used by the IRS to aggregate two of the 30% blocks in
order to disallow a minority discount. Most practitioners discredit the IRS swing vote
theory.
Technical Advice Memorandum 9725032. Published June 20, 1997.
An employee transfers exercisable stock options in his company to an irrevocable trust for his spouse, children and grandchildren. After the transfer, only the trustee can exercise the options and determine when to do so. If employment terminates for any reason, the options expire. Because termination would change the disposition of the transferred options, has the employee retained a power which would make the gift incomplete under Section 25.2522-2 (b)?
The ruling says termination of employment is "an act of independent significance." Its effect on the trustee's ability to exercise the options is merely incidental. Accordingly, the transfer is a completed gift.
COMMENT: Many corporate executives have stock options which are not presently exercisable. We believe these options have a "readily ascertainable" fair market value and can be the subject of a completed gift. The IRS has not yet taken a position.
Technical Advice Memorandum 9719006. Published January 14, 1997.
The assets (real estate and marketable securities) of a mother who was terminally ill and off life support were transferred from revocable and marital trusts to an FLP and then "sold" to a son and daughter for cash and notes worth $1,777,000, a 48% reduction in value from the $2.26 million value of the original assets. Mother died two days later.
IRS determined this to be a single testamentary transaction "devoid of any real substance" and done solely to reduce estate taxes. Accordingly, it was disregarded and no discount was allowed.
The ruling cites Estate of Murphy v. Commissioner , T.C. Memo 1990-472 where a transfer eighteen days before death was similarly ignored because its purpose was to obtain a minority discount.
The IRS also had an alternative position. Section 2703(a)(2) would require the partnership agreement to be ignored in valuing either the underlying partnership assets or a partnership interest unless Section 2703(b) exceptions (e.g., bona fide business arrangement, not a device for an intra-family transfer at less than full consideration, etc.) are met, which the IRS argues were not.
COMMENT: Many professionals have looked at Section 2703’s legislative history and believe Congress did not intend to apply it in this manner.A court decision is needed to provide guidance. Most also agree that this fact pattern does not pass the "smell test".
This TAM conveniently ignores the Frank case (T.C. Memo 1995-132) where gifts of stock just prior to death, which put the decedent in a discountable minority position, were accepted as legitimate.
Technical Advice Memorandum 9723009. Published February 24, 1997.
The decedent lived only two months after creation of a partnership which was funded with cash, securities, two residences and personal property. The limited partnership interests she received in exchange were reported in the estate tax return at a value of 46% below that of the contributed assets.
According to the IRS, the partnership agreement’s prohibition of the decedent's right to withdraw and liquidate her interest was more restrictive than New York partnership law . This constituted an "applicable restriction" under Section 2704(b) and had to be disregarded in valuing the decedent’s partnership interest.
COMMENT: With the exception of adding Section 2704(b) to the mix, the ruling is like TAM 9719006 with similar fact pattern and reliance on the Murphy case and Section 2703(a)(2). Subsequent TAMs 9725002, 9730004 and 9735003 are more of the same, except IRS did not use a Murphy argument in 9735003.
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