An article last summer in The New York Times¹ suggested that estate planning professionals would be hard at work advising clients as a result of “estate tax repeal.” Of course, we know repeal did not happen and probably never will, but prospective changes in unified credit amounts and tax brackets, among others, have kept and will keep everyone busy. There are also other factors at play. A troubled economy, business downturn and flat stock market provide an opportunity to transfer assets which can be expected to appreciate over time. The lifetime exemption from gift tax is increased to $1,000,000 beginning in 2002. As the cases discussed in this bulletin (with the exception of True) indicate, the IRS continues to lose when it goes to court. If, as we have heard reliably, the IRS steps up its effort to audit more gift tax returns, the need for thorough, well-reasoned appraisals to support reported values becomes even more important.

Looking ahead, we expect to see considerable gift tax planning work in the pipeline, a good portion of which will involve valuations for family limited partnerships or LLCs, GRATs, senior equity freezes, voting-nonvoting recaps and sales to defective grantor trusts.

We look forward to being of assistance!

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¹ “Lawyers and Accountants Expect Windfall from Estate Tax Repeal,” David Cay Johnston, The New York Times, June 14, 2001.

Proponents of family limited partnerships with only marketable securities may like Judge Foley’s decision because:

A 40% combined discount for minority interest and lack of marketability was accepted in valuing the decedent’s
40% limited partnership interest as well as her 1992 gifts of limited partnership interests.

Unrealized capital gains on Exxon stock, the partnership’s largest holding, were considered to be a discount factor.

The legitimacy of a partnership validly formed under state law was not questioned.

COMMENT: Those who have been concerned about low discount results in the Strangi [115 T.C. 478(2000)] and Knight [115 T.C. 506(2000)] cases will be encouraged by this case where there were neither bad facts (Strangi) nor a weak appraisal (Knight).

The True case is about a family engaged in the oil and gas business who believed book value purchase price provisions in various shareholder and partnership agreements should be binding for estate and gift tax purposes and thereby established fair market value of transferred interests. Unfortunately David True’s estate and widow did not convince the Tax Court and now face many millions of dollars in estate and gift taxes and undervaluation penalties.

Judge Beghe’s opinion is very thorough (336 pages) and will be regarded as a leading case on formula price provisions in buy-sell agreements because of its thoughtful treatment and discussion of rules and cases before and after Chapter 14.

David True and his wife, Jean, sold interests in various family companies and partnerships to their children at book value in 1993 and 1994 before David’s death in June 1994. Gift tax returns reporting the transfers and David’s estate tax return took the position that shareholder and partnership agreements fixed the transfer tax value of the True entities. Book value was calculated after taking into account certain tax incentives, such as deducting costs which are normally capitalized. Thus, book value was actually “tax book value,” conceivably less than accounting book value. The IRS issued deficiency notices determining that fair market value was higher than reported book value.

The court had two issues to decide: (1) did buy-sell (shareholder and partnership) agreements fix estate and gift tax values, and (2) if not, what were the estate and gift tax values of the subject interests.

As to issue (1), the Lauder case (T.C. Memo 1992-736) was cited for its requirement that agreements satisfy “business purpose” and “nontestamentary device” tests independently. David True’s desire to maintain family control of his businesses was considered to be a bona fide business reason for the agreements. However, Judge Beghe decided that David was motivated by testamentary concerns. The judge mentioned numerous factors, including the lack of negotiation of the agreements’ terms and the failure to seek professional advice or appraisals in selecting a formula price which, among other things, might omit the value of proven oil and gas reserves. The nontestamentary device test also required proof that the tax book value pricing formula represented “adequate and full consideration” on the dates of the agreements without regard to the “depressive effect” of the agreements themselves. There was a failure to offer such proof.

A review of the valuation portion of the court’s decision indicates that experts for both sides did not do particularly well. There are many examples of valuation approaches being rejected, calculation errors noted and valuation discounts misapplied and/or substantially adjusted. Some of the court’s key conclusions and criticisms are:

The exclusive use of a public guideline approach to value True Oil, an oil and gas exploration and production business, was “inappropriate” because a hypothetical buyer would be interested in the value of its proven reserves. The court accepted the government’s “marketable minority value” and deducted a 30% discount for lack of marketability. A larger discount was denied because it took into account the depressive effect of the partnership agreement:

“As stated earlier, restrictive provisions of buy-sell agreements that are deemed to be testamentary devices should be disregarded in determining fair market value for estate and gift tax purposes.”

The court disagreed with an IRS argument that David True’s 38.47% interest in True Oil had “swing vote potential.” Assuming the hypothetical buyer to be an unrelated party, “we find it unlikely that a member of Dave True’s family would join forces with an unrelated purchaser to gain voting control over True Oil.”

Restricted stock studies were viewed as more relevant than pre-IPO studies in supporting a discount for lack of marketability. Neither were said to be useful “in determining marketability discounts applicable to controlling interests.”

Two of the estate’s experts valued David True’s 68.47% interest in Belle Forche (owner and operator of a network of pipelines to gather and transport crude oil) on a noncontrolling interest basis due to restrictions in the company’s shareholder agreement and the “interrelatedness of the True companies.” The court rejected both arguments, repeating again that the shareholder agreement had to be disregarded in determining fair market value and pointing out that the company moved oil primarily for unrelated companies. A 20% marketability discount was allowed.

One of the estate’s experts derived a 25% minority discount from studies of premiums offered in tenders for control of public companies. The discount was deducted in calculating the value of a noncontrolling interest in True Ranches, a partnership operating cattle ranches. The court only allowed 15%, stating that a general partner could exercise more control than a shareholder in a comparable public company.

Judge Beghe closed his opinion with the following statement on the issue of undervaluation penalties:

“In the cases at hand, the True family was well aware of the issues in controversy and the dollars at stake. They took aggressive positions on the estate and gift tax returns to test the effectiveness of the buy-sell agreements to fix transfer tax values. They did not rely, in good faith, on professional appraisals or obtain professional advice on the effects of the decisions in the prior gift tax cases. Accordingly, we hold that the reasonable cause exception to accuracy-related penalties does not apply to the cases at hand.”

COMMENT: This was not a “split the difference” decision. A review of the numbers shows that Judge Beghe was much closer to IRS values than taxpayer’s expert values so the case appears to be a loss for the True family and its valuation advisors.

The Tax Court had assigned a premium to the decedent’s minority voting stock in J.R. Simplot Co. over his nonvoting stock after considering who a likely buyer might be, how long he might wait for a return on his investment and what he might do to get control of the company. Pointing out that a hypothetical willing buyer and willing seller are not “specific individuals or entities,” the Ninth Circuit reversed a decision based on “speculation” and “imaginary scenarios:”

“In violation of the law the Tax Court constructed particular possible purchasers.”

“Speculation [about what might happen after the valuation date] is easy but not a proper way to value the transfer at the time of the decedent’s death.”

Accordingly, a share of the decedent’s voting stock was deemed to be worth no more than a nonvoting share.

COMMENTS: Although not mentioned, the concept of “swing vote premium” (potential for the owner of a minority position to vote with another family shareholder to get control) took a hit in this decision. Application of a strict hypothetical buyer-seller standard prevents the IRS from using its swing vote argument to deny a minority discount.

The Ninth Circuit did not question the Tax Court’s approval of a 35% discount for lack of marketability.

In our view the Simplot case is best remembered for the Tax Court’s inability to deal reasonably with a skewed ratio of voting to nonvoting stock (1 to 1,848). The excessive premium assigned to the voting stock would have made the company worth more than its entire sale/merger value.

The Tax Court used a control value as a starting point to value the decedent’s 49.02% interest in his hair care company (JPMS) and then deducted various discounts, including a 35% combined discount for minority interest and lack of marketability. The court said 35% was within the range of discounts supported by experts’ testimony which it believed to be 30% to 45%. However, the Ninth Circuit thought the range appeared to be much higher (46.2% to 61.5%) so the decision was vacated and remanded with instructions that the Tax Court provide a more detailed explanation of its valuation conclusions.

The Ninth Circuit relied on the Leonard Pipeline case [142.F.3d 1133 (9th Cir. 1998)] for the standard it imposed on the Tax Court:

“It is the obligation of the Tax Court to spell out its reasoning and do more than enumerate the factors and leap to a figure intermediate between petitioner’s and the Commissioner’s.”

The Tax Court was also found to have erred in denying the estate’s motion to shift the burden of proof to the IRS. Values presented at trial by the IRS were substantially lower than its original assessment, making the assessment “arbitrary and excessive” and thus allowing the burden to shift.

COMMENTS: The above language from Leonard Pipeline is a good reminder for clients to demand thorough, well-reasoned appraisals which do not “leap to a figure.”

Under Texas law the estate of a deceased partner is treated as an assignee entitled to its pro rata share of the partnership’s liquidation value. Believing this right of an assignee to be relatively fixed and certain, the U.S. District Court for the Northern District of Texas decided to disallow discounts for minority interest, lack of marketability and unattractive asset mix in determining the fair market value of the decedent’s 25% interest in Taylor properties, a general partnership owning ranchland, marketable securities and oil and gas interests. The Fifth Circuit disagreed, stating that the rights of an assignee, as opposed to those of an assigning partner, are not clearly established and should be “discounted.” The case was remanded and the district court directed to “determine the applicability of the various claimed discounts and the correct percentages of those that are found to apply.” [218 F.3d 383, 86 A.F.T.R.2d 2000-5366 (5th Cir. (Tex.) July 5, 2000)].

Upon reconsideration, the district court determined discounts of 20% (minority interest), 10% (portfolio of “poorly diversified assets”) and 35% (marketability) for an effective overall discount of 53.2%.

COMMENT: The IRS argued that the fiduciary duty owed to a minority partner should be a factor limiting the size of the minority interest discount. The district court’s response is noteworthy and one of several reasons why assignee interests are worth less than partnership interests:

“the government incorrectly asserts that the remaining partners owe a fiduciary duty to plaintiffs. Partners do not owe such a duty to an assignee of a partner.”