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Current Tax Valuation Topics
I.R.C. §2036 not raised in this case
In a decision issued September 25, 2003,
Peter S. Peracchio v. Commissioner, T.C. Memo 2003-280, the Tax Court allowed
a 6% minority discount and a 25% marketability discount (or 29.5% overall) on gifts
and sales of limited partnership interests in Peracchio Investors, L.P., a family
limited partnership with cash (44% of the portfolio!) and
marketable securities.
Before trial, the IRS abandoned three arguments; namely, that the partnership lacked
economic substance, that the partnership wrapper should be disregarded under I.R.C.
§2703(a)(2), and that the inability to withdraw is an “applicable restriction” under I.R.C.
§2704(b) that should be disregarded for valuation purposes. These are looking more and more
like worn out arguments.
The IRS argued for an 18.74% overall discount under general valuation rules of I.R.C. §2512.
The taxpayer’s two experts argued for overall discounts of 40% and 43%, respectively.
The Court took exception with all three expert’s starting benchmark for the marketability
discount, and unpersuasive arguments why the discount for Peracchio Investors would be
higher or lower than the benchmark.
Interestingly, the IRS did not raise I.R.C. §2036 even though the Peracchio
was filed more than a year after the Reichardt and Trotter decisions. Perhaps
it is the timing because the Thompson, Kimbell and Strangi II decisions
all came after Peracchio was filed.
I.R.C. §2503(b) allows an individual to gift up to $11,000 per year
to anyone free of gift tax. Many estate plans include annual gifting
of limited partnership or limited liability company membership interests
to children and grandchildren.
That strategy came under fire in
Hackl v. Commissioner, 118 TC No. 14.
The Seventh Circuit has affirmed the Tax Court's decision that gifts of LLC
membership interests do not qualify for the annual exclusion under §2503(b)(1)
because the gifts were not of a "present interest."
Albert J. Hackl, Sr.
and Christine M. Hackl v. Commissioner, US 7th Cir. CA Nos. 02-3093 &
02-3094 (July 11, 2003).
Although the Hackls gave away the entire bundle of rights, the restrictions on
the transfer of the membership interests "meant that they were essentially without
immediate value to the donees," according to the Appellate Court decision.
Attorneys for the Hackls had argued that the Court need not look beyond the
"plain meaning" of "future interest" in the statute. The Appellate Court noted
that "calling any tax law 'plain' is a hard row to hoe."
Sage would be happy to discuss our "valuation take" on these cases if your
client's estate plan includes annual gifting.
IRS Gains Momentum on I.R.C. §2036
Under I.R.C. §2036(a), gross estate includes any property that was transferred
during life, where decedent retained "the possession or enjoyment of, or right
to the income from, the property…"
In a series of recent cases [see
Reichardt, 114 T.C. 144 (2000),
Trotter, T.C. Memo 2001-250,
Thompson, T.C. Memo 2002-246], the Tax Court held that because the decedent
retained "enjoyment of the property" during his lifetime, that the partnership
interests were brought back into the estate, thereby defeating the goals of lifetime gifting.
IRS victories have continued. In
Estate of Albert Strangi v. Commissioner, T.C. Memo 2003-145
(May 20, 2003) and Kimbell,
91 AFTR2d 2003-585 the IRS used §2036(a) to include the value of partnership assets
in a decedent's estate.
The only issue in the Strangi remand was whether §2036(a) applied. Albert
owned 47% if Stranco, Inc. the 1% general partner of Strangi Family Limited
Partnership (SFLP). Albert contributed 98% of his wealth, including his residence,
to SFLP. Some of Albert's personal expenses were paid with SFLP assets and Albert
died two months after SFLP was formed. His son-in-law, attorney Michael Gulig, was
both Albert's attorney in fact and the manager of Stranco, which had sole authority,
as GP, to determine distributions from SFLP. On remand, the Tax Court found that
the assets Albert had contributed to both Stranco and SFLP were includable in his
estate under both §2036(a)(1) - retained economic benefit and §2036(a)(2) - retained
right to designate who could enjoy the property.
Charles T. McCord, Jr., and Mary S. McCord v. Commissioner,
120 T.C. No. 13 (May 14, 2003) shows that the FLP tussle has
turned from disregarding the entity itself (except in cases where
Sec. 2036 applies) to the size of minority and marketability discounts.
On January 12, 1996, the McCords gifted limited partnership interests "worth"
$9.9 million to their four sons, to trusts for the benefit of their four sons,
and to two charities. The sons and the trusts would receive $7.04 million in
limited partnership interests, and the two charities would receive the remainder.
The percentages transferred were determined based on a fair market value appraisal
in March 1996. The interests transferred to the charities were subject to a "call"
provision, which the partnership exercised in June, to repurchase the interests
the fair market value determined by the March appraisal.
The McCord opinion discusses discount methodology in great detail. The Court
reduced the minority and marketability discounts to 15% and 20%, respectively
(which were lower the 22% and 35% claimed by the taxpayers' expert but higher
than the 8.34% and 7% opined by Dr. Mukesh Bajaj for the IRS).
Although the aggregate value of the gifts to the sons and trusts was increased
from $7,044,933 to $9,883,832 when the Court reduced the discounts, the
adjustment clause failed and the charitable contributions were not then
calculated at $2,838,899. Instead, the Court valued those contributions at
$415,020 (by applying the Court's discounted value to the percentages
transferred to one charity, but, oddly, not the other). Note that this figure
was about $90,000 more than the charities actually received in June.
Thus, the taxpayers did not achieve their ends of avoiding an increase in gift
tax by donating the "extra" to charity. It probably didn't help that the charities
were cashed out at a much lower value under the call provision.
The Court held that it was appropriate to "net" the gift by subtracting the
gift tax (to be paid by donees), but it was not appropriate to net the gift
by the increase in estate tax that would occur if either Mr. or Mrs. McCord
should die within three years of the date of the gifts. The latter adjustment
was too "speculative" according to the Court, and there was no precedent for
doing so.
The entire Court reviewed this case, and the decision was split. Judges Foley
(the trial judge) Chiechi and Laro dissented to various parts of the opinion.
Judge Swift concurred with the majority, but would have disallowed the charitable
deduction because the transfer of an assignee interest (which, according to Judge
Swift, the taxpayers argued for to "beef up" the discounts) is a gift of a partial
interest, a deduction for which would be disallowed under Sec. 2522(c)(2). Judge
Laro objected to the charitable deduction valued at $90,000 more than what the
charities eventually received.
A Tax Court Opinion issued on May 2, 2003 illustrates that financial
assets are increasingly complex, and valuing those assets for tax
purposes is complicated. The value of a "financial derivative" is
derived (as implied by its name) from the performance of an underlying
financial asset, rate, or index. In a 259-page opinion, Judge Laro
tackles the valuation of "interest rate swaps" for income tax purposes.
Bank One Corporation v.
Commissioner, 110 T.C. No. 11 (May 2, 2003).
For the first time, the Court appointed its own experts under Rule 706
of the Federal Rules of Evidence, noting that "we have become all to
accustomed to hearing testimony elicited from experts that merely followed
the litigating position of the retaining party and lacked any true benefit
to the Court" (footnote 54).
In 1993, First National Bank of Chicago (FNBC) was the 16th largest swap
dealer in the world. FNBC valued its interest rate swaps based on a
"midmarket rate" (that is the average between the bid and ask prices)
adjusted for the creditworthiness of the counterparty and expected future
administrative costs. The IRS argued that no adjustments should be made to
the midmarket value. The Tax Court agreed that adjustment is proper, but that
FNBC's methods for making adjustments were incorrect.
Judge Laro's opinion traces the evolution of the definition of fair market
value for the past 170 years, beginning with United States v. Fourteen Packages
of Pins, 25 F. Cas. 1182 (E.D. Pa. 1832). The opinion also has an extensive
discussion of the difference between "fair market value," which is the
definition of value for gift and estate and income tax, and "fair value,"
which is used in GAAP accounting and financial reporting. The Tax Court held
that the fair value of the swaps for financial accounting purposes cannot be
used for income tax purposes because it does not clearly reflect its income
under I.R.C. §475. Instead, each swap, and other like derivatives, must be
valued "at its midmarket value as properly adjusted on a dynamic basis for
credit risk and administrative costs."
In November of 2002 the IRS issued
TAM 200245053, regarding the use
of adjustment clauses in gift assignments. In that TAM, the IRS does
not dispute the use of an independent appraisal in establishing the
final percentage transferred (an "adjustment clause"), as that serves
to implement the original, bona fide intent of the parties. However,
further adjustment based on a final determination of value by the IRS
or the Tax Court is rejected.
It is often a "chicken and egg" problem in determining value as of a
specific date, especially if the FLP includes marketable securities. This
TAM does not preclude the use of an adjustment clause based on an
independent appraisal, and that is still the most efficient way to
perform a valuation.
In
Pueblo Bancorporation v. Lindoe, No. 01SC645 (January 21, 2003)
the Colorado Supreme Court held that, as a matter of law, no minority or
marketability discounts should be applied in determining "fair value"
under the dissenting shareholder statute. In other words, the shareholder
is entitled to the proportionate share of the company, as if the entire
company had been sold.
Prior to this decision, the Colorado courts allowed
a marketability discount in some, but not all, dissenting shareholder cases.
I.R.C. §7491(a) shifted the burden of proof to the IRS for examinations began
after July 22, 1998, if the taxpayer has introduced credible evidence. The burden
of proof will shift if the taxpayer:
Probably not, unless the agreement calls for "fair market value." In Estate of
True v. Commissioner, T.C. Memo 2001-167, the taxpayer asserted that the buy/sell
agreement, which required Mr. True to sell his interests at his death for book value,
should establish value for estate tax purposes. The IRS disagreed and sent the estate
a tax bill for $105 million, including $30 million in penalties. The Tax Court held
that the buy/sell agreement did not establish value for estate tax purposes because
(1) the terms were not negotiated, (2) the family did not seek professional advice
in setting the buyout price, (3) the interests were not appraised, and (4) the book
values ignored the value of intangible assets. This case is on appeal to the Tenth
Circuit.
If a C corporation generates a taxable gain on the sale of an asset, the C corporation
must pay corporate income taxes on that gain. If the proceeds of the sale are then
distributed to the shareholders, a second level of tax will be incurred. The economic
reality is that a buyer of stock in a C corporation that holds appreciated assets would
consider this "built in gain." Since 1998, case law has supported a reduction in value
for a C corporation that has "built in gains" on an appreciated asset.
The same is not true for partnerships or limited liability companies. That is because
those entities can make an I.R.C. §754 election to step up the inside basis of an asset.
This avoids an adverse tax consequence to the partner or member when an appreciated asset
is later sold.
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