Estate of Noble v. Commissioner was filed on January 6, 2005.1 In a 30 page decision, the Court gave short discussion to the reports of two experts, rather, focusing the decision on a discussion of a sale of the subject block some 14 months after the date of death (the valuation date). Two important issues are raised by Noble.
This article addresses both issues in the context of Noble and within one appraiser’s understanding of the meaning of fair market value.
The subject of the valuation was 116 shares of Glenwood State Bank (“the Bank”), representing 11.6% of its 1,000 shares outstanding at September 2, 1996 , the date of death of Helen M. Noble (“the Estate”). Glenwood State Bank was a small ($81 million in total assets), over-capitalized (17.5% equity-to-assets ratio), low-earning bank (3% to 5% return on equity for the last four years) located in rural Glenwood , Iowa . Historical growth of the balance sheet had been anemic prior to the valuation date, and prospects for future growth were similar. Management’s philosophy, implemented over many years, was to reinvest all earnings back into the Bank and to pay no shareholder dividends. There was no market for the Bank’s shares.
The Estate’s 11.6% block of the Bank’s stock was the only block of the Bank that Glenwood Bancorporation, the parent holding company (“the Company”), did not own at the valuation date. The Company had, over a period of many years, gradually consolidated its ownership of the Bank to this point. The Company’s historical philosophy had mirrored that of the Bank, and no dividends were paid historically or anticipated for the near future.
In short, the subject 11.6% interest in the Bank was not a very attractive investment, when viewed in terms of then-current expectations for growth, dividends, and overall returns for publicly traded bank shares.
Two appraisals were submitted to the Tax Court in this matter:
In addition, Glenwood State Bank had obtained an appraisal from Seim, Johnson, Sestak & Quist, LLP, an accounting firm, of the fair market value of the same shares as of December 31, 1996 (“the Seim Johnson Report”). This report concluded that the fair market value of the shares was $878,004 ($7,569 per share).
The Estate originally reported the fair market value of the shares at $903,988 ($7,793 per share based on then-current book value less a minority interest discount of 45%).
One more fact is important for this introduction. The Estate sold its 116 shares to Glenwood Bancorporation on October 24, 1997 , almost 14 months after the valuation date, for $1,100,000.2
Focusing on the expert reports of Herber and Mercer, the total difference in value between the two appraisals of the 11.6% interest was $259,000. Herber’s result was about 30% higher than Mercer’s. Relative to many valuation disputes, the differences were fairly small. Both appraisers agreed on the relative unattractiveness of the subject shares as an investment. Herber’s appraisal represented 73% of the Bank’s book value, while Mercer’s appraisal represented 56% of book value.
The major difference in valuation conclusions between the two appraisers was the difference in their concluded marketability discounts. This was an opportunity for the Court to address these differences in a meaningful way; however, that did not occur. We present information here not found in the opinion to inform the reader of the rest of the story.
After discussing two sales of minority interests of the Bank’s stock, one of which occurred some 15 months prior to the valuation date (at $1,000 per share), and the other of which occurred about two months prior to the valuation date ($1,500 per share), the Court’s decision notes:
As to the third sale, which occurred on October 24, 1997, approximately 14 months after the applicable valuation date, we disagree with petitioners that only sales of stock that predate a valuation date may be used to determine fair market value as of that valuation date. The Court of Appeals for the Eighth Circuit, the court to which an appeal of this case most likely lies, has held specifically that “In determining the value of unlisted stocks, actual sales made in reasonable amounts at arm’s length, in the normal course of business, within a reasonable time before or after the basic date, are the best criterion of market value.”3 [citations omitted, emphasis added]4
No mention is made in the Court’s decision as to what constitutes a “reasonable time” before or after a valuation date. The Court goes on to say, after further discussion of the subsequent transaction, that:
When a subsequent event such as the third sale before us is used to set the fair market value of property as of an earlier date, adjustments should be made to the sale price to account for the passage of time as well as to reflect any change in the setting from the date of valuation to the date of sale. [citing Estate of Scanlan5] These adjustments are necessary to reflect happenings between the two dates which would affect the later sale price vis-à-vis a hypothetical sale on the earlier date of valuation. These happenings include: (1) Inflation, (2) changes in the relevant industry and the expectations for that industry, (3) changes in business component results, (4) changes in technology, macroeconomics, or tax law, and (5) the occurrence or nonoccurrence of any event which a hypothetical reasonable buyer or hypothetical reasonable seller would conclude could affect the selling price of the property subject to valuation (e.g., the death of a key employee [citing Estate of Jung6].
The record before us does not establish the presence of any material change in circumstances between the date of the third sale and the applicable valuation date. [emphasis added]7
The Court noted that the 116 shares sold for a total of $1.1 million, or $9,483 per share, on October 24, 1997 . In response to the above guidance regarding “the happenings between the two dates” the Court stated: “While the record does not accurately pinpoint the appropriate rate to apply for that purpose [inflation], the Bureau of Labor Statistics has stated that the rate of inflation during each of the years 1996 and 1997 was slightly less than 3 percent.”
The five factors noted above are now considered:
Neither Mercer nor Herber provided an analysis of events in the stock market, in the market for bank stocks, or of detailed financial performance of Glenwood State Bank subsequent to the valuation date. Both appraisers were providing valuation opinions as of September 2, 1996 . Mercer mentioned the subsequent transaction in his report, and both appraisers mentioned the transactions prior to the valuation date. The Mercer Report discussed the subsequent change in dividend policy in detail.
It should be clear from the above analysis of the factors mentioned by the Court, that there were material changes, virtually all positive regarding the value of 116 shares of Glenwood State Bank, between the valuation date of September 2, 1996 and the subsequent transaction on October 24, 1997.
The Court’s analysis of subsequent transactions raises several questions:
It is my understanding of the investment process that investors consider all relevant information, including that which is known and that which is reasonably foreseeable, or reasonably knowable, up to the moment that an investment is executed. After that, there are no second chances. Real-life investors know that one of only two things will happen with respect to the return performance of any particular investment:
The investment’s ultimate performance will be the (net) result of many factors, including the actual performance of the underlying entity, changes (favorable or unfavorable) in national economic conditions or specific industry conditions, the general level of the stock markets and the particular performance of a particular industry, and the other factors noted above.
The Court’s decision in Noble causes great uncertainty for both appraisers and taxpayers.
A Four-Factor Test for Bargaining Parity
The second fundamental issue in Estate of Noble relates to the nature of arm’s length transactions. This writer understands the nature of the standard of value known as fair market value to consist of:
A transaction involving these characteristics would be an “arm’s length” transaction in the context of fair market value. Fair market value transactions presume bargaining parity. Note from this definition that an actual transaction in nonpublicly traded stock would not meet the definition of arm’s length transactions in the context of fair market value if one or more of the following four conditions of bargaining parity are not met:11
It will be helpful to review the concept of arm’s length transactions in the context of these four essential elements of bargaining parity, i.e., through the four factor test outlined above. Although this test was not employed explicitly in this manner in the Mercer Report, it was employed implicitly in the discussion and analysis of the three transactions.
The Court paraphrased Polack v. Commissioner12 and Palmer v. Commissioner13 in introducing its discussion of arm’s length transactions:
While listed stocks of publicly traded companies are usually representative of the fair market value of that stock for Federal tax purposes, the fair market value of nonpublicly traded stock is “best ascertained” through arm’s-length sales near the valuation date of reasonable amounts of that stock as long as both the buyer and the seller were willing and informed and the sales did not include a compulsion to buy or to sell.14
While this guidance is flawless as far as it goes, it needs to be viewed, as just indicated, through the filter of the four factors of bargaining parity.
The Court’s decision discusses three transactions in the stock of Glenwood State Bank, the two occurring before the valuation date and the subsequent transaction some 14 months after the valuation date. The Court determined that the two prior sales were not at arm’s length:
As to the two prior sales of stock in this case, we also are unpersuaded that either of those sales was made by a knowledgeable seller who was not compelled to sell or was made at arm’s length.15
The Court actually made two additional comparisons in reaching its conclusion regarding the two prior sales. First, the decision notes that they were both smaller in size (1% or less of the shares) than the subject interest (11.6%). And second, it was noted that neither of these two transactions was made based on an appraisal.
The Court discussed the subsequent transaction at some length at this point:
Petitioners try to downplay the importance of the subsequent (third) sale of the estate’s 116 Glenwood Bank shares by characterizing it as a sale to a strategic buyer who bought the shares at greater than fair market value in order to become the sole shareholder of Glenwood Bank. Respondent argues that the third sale was negotiated at arm’s length and is most relevant to our decision. We agree with respondent. Although petitioners observe correctly that an actual purchase of stock by a strategic buyer may not necessarily represent the price that a hypothetical buyer would pay for similar shares, the third sale was not a sale of similar shares; it was a sale of the exact shares that are now before us for valuation. We believe it to be most relevant that the exact shares subject to valuation were sold near the valuation date in an arm’s length transaction and consider it to be of much less relevance that some other shares (e.g., the 10 shares and 7 shares discussed herein) were sold beforehand. The property to be valued in this case is not simply any 11.6% interest in Glenwood Bank; it is the actual 11.6-percent interest in Glenwood Bank that was owned by decedent when she died. [emphasis added]16
It would appear that the Court determined that because the same 116 shares sold 14 months after the valuation date for $9,483 per share, they were therefore worth the same $9,483 per share (less a discount for inflation) at the date of death some 14 months prior.
In reaching this conclusion, the Court did something that both appraisers warned against, in effect, assuming that the exact transaction that occurred was foreseeable.17,18 There is a world of difference in the relative risk assessment by hypothetical willing buyers and sellers between two different situations: 1) it is reasonably foreseeable that a transaction will occur at a specific price and at a specific time in the future; or 2) it is generally foreseeable that a transaction, or a variety of potential transactions, could occur at some unknown and indefinite time (or times) in the future. The Court’s analysis effectively assumed the first situation existed at the valuation date when, in fact, the second situation existed. In doing so, the Court ignored the risks of the expected investment holding period from the perspective of hypothetical buyers and sellers at the actual valuation date.
The Court also did not believe that Glenwood Bancorporation had specific motivation to purchase the shares which would cause it to pay more at the subsequent date.
Moreover, as to petitioners’ argument, we are unpersuaded by the evidence at hand that Glenwood [Bancorporation] was a strategic buyer that in the third sale paid a premium for the 116 shares. The third sale was consummated by unrelated parties (the estate and Bancorporation) and was prima facie at arm’s length. In addition, the estate declined to sell its shares at the value set forth in the appraisal and only sold those shares 5 months later at a higher price of $1.1 million. Although the estate may have enjoyed some leverage in obtaining that higher price, as suggested by Mercer by virtue of the fact that the subject shares were the only Glenwood Bank shares not owned by the buyer, this does not mean that the sale was not freely negotiated, that the sale was not at arm’s length, or that either the estate or Bancorporation was compelled to buy or to sell. 19
The Court is assuming that transactions occurring between unrelated parties provide prima facie evidence of their arms’ length natures. However, independence is only one of the four factors insuring bargaining parity and therefore, arms’ length transactions. The Court asked Mercer about the nature of this particular transaction. Mercer testified that while a transaction may appear to be at arm’s length, it should not be evidence of fair market value if there is an inequality of information regarding the potential transaction.20
Another Analysis of the Three Transactions
The Mercer Report provided background information for the two transactions prior to the valuation date as follows:
The Mercer Report also discussed the subsequent transaction at some length, and analyzed it in light of the facts and circumstances in existence at the subsequent transaction date, at least as they related to Glenwood State Bank and Glenwood Bancorporation. As noted above, the Mercer Report indicated that a significant change in policy would have materially changed the value of the subject 116 share block. Glenwood Bancorporation, after many years of not desiring to upstream dividends from Glenwood State Bank, changed its mind. The reason for this change was a decision to build a new bank in Council Bluffs , Iowa , to enter the greater Omaha metropolitan market. This decision required capital that was lying dormant in the Bank, and would require that significant dividends be paid by the Bank to the Company. Importantly, Glenwood Bancorporation did not inform the Estate’s representatives of this change in policy prior to the transaction. So the second factor of the four-factor bargaining parity test was not met. This was noted in the Mercer Report.
The Mercer Report did indicate that such a change in dividend policy could occur at Glenwood Bancorporation (i.e., was reasonably knowable); however, the analysis indicated that no rational, independent investor would assume that the change would occur in such a short time as a year or so, and that if dividends were to be paid, there would be a material, upward pressure on the value of the Bank’s minority shares.
It is important to place this subsequent change in dividend policy in perspective. The following table, provided in the Mercer Report in the discussion of the subsequent transaction, should indicate clearly that if the dividend policy had been in place at the valuation date, the valuation conclusion should have been significantly higher than either the Mercer conclusion or the conclusion of the Herber Report or that of the Court based on the subsequent transaction.
As noted above in the discussion of the nature of subsequent transactions, something material changed between the date of death and the subsequent transaction. Glenwood Bancorporation decided that it desired to receive dividends from Glenwood Bank after many years of not having the Bank pay dividends. This change in policy necessarily had a change on the value of the Bank’s shares since, other things being equal, an investment that pays dividends is worth more than one that does not pay dividends.
The Court’s analysis does not mention the remaining, critical element of a fair market value transaction – that both parties be reasonably (and equally) informed about the investment. This is a point that Mercer addressed both in his direct testimony (report) and in cross-examination.
Given that the Estate sold 116 shares for $1,100,000 on October 24, 1997 , consider the following regarding equal and reasonable information:
In fact, both the Seim Johnson and Herber Reports stated the following about the expectation of future dividends:
“Glenwood State Bank has not paid any dividends since May of 1984 and has indicated no intention to pay dividends in the near future. This decreases the value of the common stock, and, also, it adversely impacts a willing buyer’s decision to purchase the stock.” [emphasis added, Seim Johnson Report at page 7]
“As of September 2, 1996 , Glenwood State Bank had not paid a dividend in over a decade and had no plans to pay dividends in the future.” [Herber Report, page 15]
These valuation reports, prepared just shortly after the date of death (Seim Johnson) and much later (Herber), affirm the stated policy of the Bank that was provided to Mercer Capital during interviews held in 2004. They also affirm the fact that there was a significant change in policy between the date of death and the time of the third transaction some 14 months later.
The point of this discussion is that there was a material change of facts between the valuation date and the subsequent transaction and this change of facts was known to only one of the two parties to the transaction. This causes the subsequent transaction to fail the four factor bargaining parity test and disqualifies the transaction as an arm’s length transaction in the context of a determination of fair market value. In fact, had the change of policy been known, it is almost certain that the subsequent transaction would have occurred at a price substantially higher than the actual price of $9,483 per share.
The four-factor bargaining parity test is summarized for the three transactions below.
It would appear that the prior transaction involving Mr. Hopp, the former director of Glenwood State Bank, would meet the four-factor test. It occurred at a very low price (relative to book value) at a time when a knowledgeable, independent buyer had no expectations of future dividends or other avenues to liquidity within a reasonable timeframe.
It is simply unknown if the second prior transaction meets the four-factor test.
But it is clear that the subsequent transaction does not meet the test. The parties were clearly not equally informed about the change in dividend policy that Glenwood Bancorporation planned to implement immediately following the transaction.
So the question is, how can a subsequent transaction that would not pass the four-factor test for arm’s length bargaining parity at the date it occurred provide evidence of the fair market value of shares some 14 months prior to that date? In the opinion of this writer, it cannot.
The Court considered that the sale was negotiated at arm’s length as prima facie evidence that the subsequent transaction was evidence of fair market value. However, it should be clear from the analysis above, which was presented to the Court in the Mercer Report, that there was a material change of circumstances between the date of death the date of the subsequent transaction. It should further be clear that the parties engaging in that subsequent transaction were not dealing with the same information about the value of the subject interest.
Estate of Noble raises two very important issues for business appraisers:
Should transactions (or events) occurring subsequent to a given valuation date be considered in the determination of fair market value as of that valuation date? If so, how should they be considered in the context of facts and circumstances in existence at the valuation date? How long after a given valuation date can information from a subsequent transaction be considered relevant? Opening the door to the routine analysis of subsequent transactions as providing evidence of valuation at earlier dates would seem to fly in the face of the basic intent of the fair market value standard of value.
Are transactions occurring between apparently independent parties prima facie evidence of arm’s length transactions in the context of fair market value? The four-way test of bargaining parity introduced above questions the relevance of at least certain otherwise arm’s length transactions as providing evidence of fair market value.
The questions and issues raised by Estate of Noble are important for appraisers and for taxpayers. Regarding subsequent transactions, it would seem that appraisers and the Tax Court should focus on events known or reasonably foreseeable as of the valuation date as the basic standard for fair market value determinations. Any other approach would seem to raise more questions than can be answered, and would seem to place at least one party in a valuation dispute at a distinct disadvantage.
Finally, regarding the nature of arm’s length transactions, it would seem that a more definitive understanding of the nature of “arm’s length” is needed than the mere fact that parties appear to be independent of each other. The four-way bargaining parity test above indicates that independence is only one of four factors needed to define an arm’s length transaction characterized by equal bargaining power.
1 Estate of Helen M. Noble v. Commissioner, T.C Memo. 2005-2, January 6, 2005.
2 In the final analysis, this fact was determinative of value in the Court’s decision. There was surprisingly little discussion of any of the three valuation reports before the Court in Noble.
3 The Herber Report did not mention the subsequent transaction. The Mercer report mentioned the subsequent transaction, but did not rely on it in reaching its appraisal conclusion. Herber’s conclusion, however, was identical to the value of the subsequent transaction. Mercer’s report analyzed the subsequent transaction and placed it into perspective with his valuation-date conclusion, indicating that circumstances had changed between the valuation date with respect to expected dividend policy at Glenwood Bancorporation (and therefore, with respect to Glenwood Bank). Mercer noted that while Glenwood Bancorporation knew of this change in policy, it was not communicated to the Estate’s representatives prior to the transaction.
4 Supra. Note 1, pp. 21-22.
5 Estate of Scanlan v. Commissioner, T.C. Memo. 1996-331
6 Estate of Jung v. Commissioner, 101 T.C. at 431.
7 Supra. Note 1, pp. 28-29.
8 The Court asked Mercer a direct question on the appropriateness of discounting a subsequent transaction to the valuation date “at interest.”
THE COURT: Okay. Another question for you. I asked you earlier about the possible use of the October transaction as a potential for a valuation. If one wanted to look at that and factor in an interest rate what rate would you use in order to factor that in?
THE WITNESS: Well, let me answer it just one other – one slightly different way. If you look at our valuation, my valuation, that 841,000, and I understand that Mr. Herber’s problem with talking about I and we, because we do that as firms, and you apply a 17 percent rate of return you would get to about , oh, a million. The 1.1 million, the 1.14 years implies about a 25 of 26 percent rate of return. That would not be unusual for an earlier [than anticipated] transaction.
THE COURT: But you are looking at a rate of return. I am simply saying wouldn’t you just factor, couldn’t one just factor in an interest rate, in other words, like a discount rate for time value of money?
THE WITNESS: Well, no, because the fact of the matter is an interest rate for the time value of money would not include premium for the risk of holding the stock for that period of time. So at the very least if you were going to do that to reverse back to the present you would build up a discount rate to 16, 18, 20 percent, or 26 percent, or some number, and bring that back to the present. The time value of money would not account for that risk.
THE COURT: Okay.
THE WITNESS: When you buy stock now, you have the risk going forward, and you don’t know about the transaction.
9 Clearly, the conclusions of both appraisers would have been higher had there been any reasonable expectation of such dividends in the readily foreseeable future.
10 The answer to this question is “obviously not.”
11 Mercer Z. Christopher, Valuing Enterprise and Shareholder Cash Flows – the Integrated Theory of Business Valuation ( Memphis , TN : Peabody Publishing, 2004). These issues are discussed at some length in chapter 8: “Fair Market Value vs. the Real World.”
12 Polack v. Commissioner, 366 F.3d 608, 611 (8th Cir. 2004), affg. T.C. Memo. 2002-145.
13 Palmer v. Commissioner, 62 T.C. 684, 696-698 (1974).
14 Supra. Note 1, pp. 12-13.
15 Supra. Note 1, p. 20.
16 Supra. Note 1, p. 25.
17 Counsel for the Internal Revenue Service asked Mercer a series of questions regarding the third transaction. The last question and answer was:
Q. Right. And this stock was liquidated in slightly over one year.
R. Sure. Hindsight is 20/20. I’m saying that [it] is not a reasonably foreseeable event that in 1.14 years that the stock would be sold at the price it was sold at, in my opinion.
18 Mr. Herber, the expert retained by the Internal Revenue Service, was asked directly about whether he thought the third transaction was foreseeable:
THE COURT: Do you think that as of the valuation date that subsequent sale was foreseeable by a hypothetical buyer and seller?
THE WITNESS: No.
THE COURT: Why not?
THE WITNESS: Because of the facts that are talked about in the report. They had not paid dividends. They did not want to sell the bank. There was definitely – you could not foresee that specific transaction.
THE COURT: But could you foresee the fact that there would be some transaction with a period of time?
THE WITNESS: Oh, yes, yes.
19 Supra. Note 1, pp. 25.
20 The Court’s question was raised immediately following Mercer’s “20/20 hindsight” comment quoted in Footnote 17 above.
THE COURT: That sale, though, Mr. Mercer, as far as you know that was an arm’s-length sale?
THE WITNESS: Your honor, as far as I know it was an arm’s-length sale, but let me be careful to answer a little further. An arm’s-length sale does not necessarily provide evidence of fair market value even if the transaction occurs prior to the valuation date. An arm’s-length sale with compulsion is – that’s arm’s-length, but there is compulsion [and it] would not qualify as evidence of fair market value. An arm’s-length sale with lack of knowledge would not qualify as evidence of fair market value. And I’m suggesting that this transaction was an arm’s-length sale with lack of knowledge.
THE COURT: And specifically what was the lack of knowledge? I know you have testified earlier to it, but if you would repeat it, I would appreciate it.
THE WITNESS: That the relationship between Glenwood Bank Corporation [Bancorporation], the likelihood that dividends would be paid in the future, or that I would have a chance to negotiate for this a favorable sale. The existence of Glenwood Bank Corporation, we don’t know that anyone knew that Glenwood Bank Corporation even existed because the shareholders of the bank had no reason to know anything about it. They file separately to the Federal Reserve, you know, to the federal authorities.
And the only reason we know about it is because we asked. And when we asked about the holding company, then we looked at the historical financial statements of the holding company. Now to show you the relationship between the bank and the holding company and the lack of interest of this management in paying shareholder dividends prior to the valuation date, there was over $400,000 of debt at the parent company, Glenwood Bank Corporation. It would have been an easy thing to do to upstream a dividend to pay that debt.
Rather than do that and pay the dividend to the shareholder [the 11.6% that would go to the 11.6% interest holder in the Bank], they went and bought more stock in Glenwood Bank Corporation, putting $400,000 into Glenwood Bank Corporation and paying down that debt externally. That’s a fact. That would not give me a great deal of conviction that I was likely to get dividends any time real soon.
Reprinted from Mercer Capital’s Value Matters™ 2005-02, March 4, 2005.
The Family Limited Partnership (“FLP”) has been a common estate planning technique for the nation’s wealthy. For years it allowed families to avoid some tax liability when transferring assets to heirs by first placing those assets in a FLP. And for years the U.S. Tax Court ruled in favor of these tax-minimizing vehicles. The IRS responded by fighting those who might use the FLP to avoid paying taxes on the full and undiscounted value of their estate. While the IRS’s early opposition hinged on the valuation discount applied to FLP interests, recent cases have focused on the inclusion of a FLP’s underlying assets in a taxpayer’s estate via §2036.
According to §2036: (a) General Rule.–The value of the gross estate shall include the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer (except in case of a bona fide sale for an adequate and full consideration in money or money’s worth), by trust or otherwise, under which he has retained for his life or for any period not ascertainable without reference to his death or for any period which does not in fact end before his death– (1) the possession or enjoyment of, or the right to the income from, the property … [emphasis added]. The “bona fide sale” exemption is important to our topic today. In essence, a FLP must be operated as a real business opportunity to qualify for the “bona fide sale” exception.
The IRS has raised a number of considerations in its recent challenges of FLPs. Such considerations include whether or not the taxpayer respected the FLP’s formality on both a formation and operational basis, whether or not the taxpayer contributed assets for personal use to the FLP, and whether or not the taxpayer maintained assets outside of the FLP sufficient to maintain a pre-FLP lifestyle.
The Estate of Thompson v. Commissioner (2002) illustrates the first success of the IRS.[1] The deceased created two FLPs, one for each of his children. The Tax Court, however, found that the deceased had retained benefits from the assets that he had transferred to the FLP. It rejected the family’s argument that the exchange for limited partner interests was a bona fide sale; instead, the Court deemed the transfer a “recycling of value.” Accordingly, the Tax Court stated that the asset contributions had “no legitimate business purpose” and held that the value of all the assets in the estate should be taxed at the full amount.
The next big win for the IRS came in the Appeals Court in Strangi II (2003).[2] Continuing its assault on FLPs in relation to §2036, the IRS found favor in the Appeals Court because the Tax Court found that the transferor continued to enjoy the benefits of the assets transferred and derived his economic support from the assets; thus, the Tax Court concluded that the FLP had no business purpose.
A third case that illustrates the success of the IRS is Kimbell v. US.[3] The IRS now had two strategic assault methods in its use of §2036. The first method focused on demonstrating that the FLP had no operational aspects, and the second method attempted to demonstrate that the FLP contained an “implied understanding” that the transferor would retain benefit or control of the assets. Because the deceased retained “legal right” in the FLP’s documents to control partnership assets, the Tax Court found that the FLP was in violation of §2036 and would pay taxes on the full value of the assets.
In spite of a series of victories, such as those summarized above, the IRS’ §2036 argument was not victorious in Estate of Stone.[4] In its November 7, 2003 decision, the Tax Court provided much needed clarity related to confusion surrounding §2036. Relevant background information includes:
At first reading, the fact set in this case has similarities to the §2036 challenges raised in Thompson, Kimbell, and Strangi. These include death soon after formation of the FLP, distributions from the FLP used to pay the estate taxes, distributions that were not made on a pro-rata basis, retention of significant FLP interests, as well as retention of the controlling general partner interest.
As noted in the decision, “In order to resolve the parties’ dispute under §2036(a)(1), we must consider the following three factual issues presented in each of the instant cases:
As to the question regarding the transfer of property, the Court concluded “… that Mr. Stone and Ms. Stone each made a transfer of property under §2036(a).[6] As to question (2), the IRS argued that the transfer did not qualify under the bona fide sale exception, citing that the average 43% discounts claimed for tax purposes conflicted with the exception’s stipulations, which describe an exempt transfer as “a sale for adequate and full consideration only if that received in exchange is ‘an adequate and full equivalent reducible to money value.’”[7] Several facts which proved critical to the Tax Court’s approval of the transfers as bona fide sale exceptions included the following:
The Tax Court concluded that the transfers of assets by Mr. and Mrs. Stone to the FLPs were for adequate and full consideration in money or money’s worth. Furthermore, unlike in Estate of Harper, in which the Tax Court indicated that the creation of the partnerships was not motivated primarily by legitimate business concerns, the Court stated that the transfers executed by Mr. and Mrs. Stone failed to constitute unilateral recycling of value.[9]
As to question (3), because the transfers qualified under the bona fide sale exemption, the Tax Court deemed unnecessary the consideration of whether or not the decedents retained possession or enjoyment of or rights to income from the transferred property.
In spite of Thompson, Kimbell, and Strangi, among others, the FLP’s viability as an effective estate planning tool appears intact based on Estate of Stone. As stated earlier, a FLP must be operated as a real business opportunity to qualify for the “bona fide sale” exception and that seems to be the linchpin in these cases.u
Endnotes
1 Estate of Thompson – T.C. Memo. 2002-246 (September 26, 2002)
2 Estate of Strangi – T.C. Memo. 2003-145 (May 20, 2003)
3 Kimbell v. U.S. – No. 7:01-CV-0218-R, USDC ND TX., Wichita Falls Div. (January 14, 2003)
4 Estate of Stone v. Commissioner – T.C. Memo. 2003-309 (November 7, 2003)
5 Ibid.
6 Ibid.
7 Ibid.
8 Ibid.
9 Estate of Harper – T.C. Memo. 2002-121 (May 15, 2002)
Reprinted from Mercer Capital’s Value Matters™ 2003-08, December 4, 2003.
The Tax Court’s decision in Albert J. and Christine M. Hackl v. Commissioner1 has provoked a lively discussion about how to achieve discounts to net asset value and still qualify for the annual exclusion. We challenge the notion that obtaining deep discounts requires a host of restrictive provisions in the operating agreements. We also propose a broader definition of economic interest that includes the growth in value of underlying assets.
A.J. Hackl established a tree farm for the purpose of long-term growth (no pun intended). As he expected, it incurred losses in the first few years of operation. However, according to forestry consultants, Hackl managed the farm in a manner that would generate a steady income stream in the future.
Upon establishing the tree farm as an LLC, Hackl and his wife began to transfer ownership units to family members. On their tax returns, the Hackls treated these gifts as eligible for the annual exclusion. The IRS contested this classification, claiming that the transfers did not provide a present interest to the donees. To contain said interest, the gift must convey “substantial present economic benefit by reason of use, possession, or enjoyment of either the property itself or income from the property.”2
The Court ruled that the unusual restrictions in the operating agreement prevented the gifts from conferring a present interest. Specifically, the agreement granted the manager (A.J. Hackl) the authority to 1) appoint his own successor, 2) prevent withdrawal of capital contributions, 3) negotiate terms of resale of interests, and, most important, 4) prohibit any alienation or transfer of member interests. The Court focused not on the features of the interest gift, but on the underlying limitations on the interests being gifted. The Court employed a three-part test to determine whether income qualified for present interest: receipt of income, steady flow to beneficiaries, and determination of the value of that flow. Because the LLC did not make distributions in the first years of operation, the Court ruled that the donees received no enjoyment of income from the property.
Some believe that the abnormally restrictive operating agreement produced the Hackl result. If they are correct, then Hackl is an aberration that will have little effect on the construction of LLC agreements.
The reaction to Hackl presents the discount and the annual exclusion as an either/or proposition—i.e., the restrictions that produce deep discounts will deprive the recipients of the present interest required for annual exclusion. One observer concludes that estate planners must decide either to gift large interests at heavy discounts based on highly restrictive agreements or to dribble out value with annual exclusion gifts based on much less restrictive agreements.3
The other valuation issue concerns the definition of a present interest. The Court insists that, unless donees are receiving income distributions right now, their holdings contain no economic benefit today. Carried to its logical conclusion, this position says that only a portfolio of investment-grade fixed income securities has economic value at any given point in time.
Mercer Capital has certain strong beliefs on both of these issues. With regard to the restrictions in operating agreements, we maintain that analysts have constructed a false dichotomy between discounts and annual exclusion. It is possible to obtain both within the same gift. We would even cast doubt on the idea that unusually heavy restrictions guarantee any additional discounts beyond those contained in typical, “plain vanilla” agreements. The discounts for minority interest and lack of marketability derived from these latter type of agreements are substantial in size and indisputably eligible for annual exclusion. Furthermore, these discounts can be computed with high degrees of accuracy. How does one systematically determine the discount associated with a host of oddball provisions? And why would one, aware of the unfavorable tax consequences, endeavor such a calculation? LLC members gain nothing from restrictions that, in the process of deepening discounts, remove the present interest and disqualify the transfer for annual exclusion. While unusual restrictions may be necessary for the parties, they are not necessary for calculating discounts.
In defining present interest, we believe that economic benefit entails more than immediate distributions. In the case of Hackl, the tree farm was highly likely to turn a profit in the long-term. Using the income approach, appraisers take the quantity of that future income and convert it to a present value. An income stream tomorrow counts for an economic benefit today. In short, present interest should also entail growth in value—the benefits from the appreciation of an underlying asset’s worth during the holding period. Unless this concept is real, a portfolio of non-dividend growth stocks carries no value. The valuation community should put pressure on the narrow definition of present interest through solutions that explicitly incorporate growth in value into its appraisals.
A widely advocated solution grants the equivalent of a Crummey power to owners of membership interests. This power is like a temporary put, allowing the holders to sell their interests back to the company in exchange for cash.4 A similar arrangement (really the same transaction, in reverse) would involve the transfer, to defective grantor trusts, of gifts of cash used to purchase discounted interests.5 This solution responds to the Court’s statement that “an ability on the part of a donee unilaterally to withdraw his or her capital account might weigh in favor of finding a present interest.”6
However, the Crummey power or any similar provision invites other questions. Members (or willing sellers) would not gift interests to individuals who intend to turn right around and sell them back for cash. Furthermore, individuals would hesitate to use the provision for fear that they would not receive future interest gifts.
From the valuation perspective, Crummey-like powers carry dubious merit compared to an agreement with more traditional provisions. For example, what is the price of withdrawal from the capital account? Would managers consent to fair market value, or tack on a premium or discount? The ability to obtain immediate cash requires generous liquidity assumptions. If these assumptions are realistic, then the ownership interests do not warrant a marketability discount. Therefore, the LLC is exchanging one economically reliable discount in a straightforward arrangement for a murky discount in a heavily restricted agreement.
We ponder a simpler approach. Agreements should rely on traditional approaches to achieve discounts, namely the right of first refusal (ROFR) and applicable state law.7 The ROFR, by allowing members to preempt the sale of interests to outside buyers, balances the competing concerns. Owners retain a necessary level of control without those extraneous restrictions, and members who want to exit the company may do so at fair market value.
Also, agreements should take advantage of existing state laws. This recommendation applies especially to those restrictions on the transfer of interests by members and the withholding of distributions by managers. The Service has ruled that a gift conveys no present interest when the manager can both unilaterally withhold distributions and prohibit the members from withdrawing or transferring their interests. Going beyond the established legal provisions risks disqualification for annual exclusion.
Therefore, the ROFR and state laws are sufficient to support minority and marketability discounts. LLCs need not load up their operating agreements with superfluous restrictions, lest they compromise the favorable tax treatment of such gifts. If such restrictions are necessary for other reasons, then we suggest that the attorney advise the appraiser to ignore them for tax purposes.
As for the (re)definition of present interest, we recommend a technology that, in computing discounts, explicitly considers all economic factors, including both distributions and growth in value. Our quantitative marketability discount model (QMDM) accomplishes this objective. It does not depend on averages computed from benchmark studies. Rather, the QMDM relies on characteristics endogenous to the entity being valued—such as holding period and growth in value. In particular, the QMDM forces members to think specifically about the timing and amount of distributions, fuzzy issues in the Hackl agreement.8 With the QMDM, the discounts match the economic assumptions related to distributions and payouts.
Endnotes
1 Albert J. and Christine M. Hackl v. Commissioner, 118 T.C. No.14. Filed March 27, 2002.
2 Hackl decision, p. 17.
3 Ron Aucutt in Steve Leimberg’s Estate Planning Email Newsletter, Archive Message #403.
4 Owen Fiore and Erwin Wilms, “Pass-Through Entities and Valuation Discounts,” Trusts & Estates (May 2002), pp. 8, 10, 52.
5 Andrew Katzenstein and David Schwartz, “Tax Court Limits Annual Gift Tax Exclusion for Gratuitous Transfers of LLC Interests,” Journal of Taxation (2002). Sample article online.
6 Hackl decision, p. 30.
7 See also James M. McCarten, Esq., “FLPs, The Gift Tax Annual Exclusion, and the Size of the Minority Interest Discount,” ACTEC 16th Annual Southern Regional Meeting (April 2002).
8 Hackl decision, p. 33.
Reprinted from Mercer Capital’s Value Added, Volume 14, No. 3, 2002.
On January 18, 2000, the U.S. District Court for the Western District of Texas issued an opinion in the first limited partnership case to be tried in federal court. The opinion resulted from a bench trial. Plaintiff had prayed for a refund of estate taxes they argued were wrongfully assessed and collected. This victory for the taxpayer provides us with an interesting fact pattern and judicial treatment of them.
On October 22, 1993, Elsie Church and her two children, Marshall Miller and Mary Elsie Newton, executed an agreement that resulted in the formation of the Stumberg Ranch Partners Ltd. under Texas limited partnership law. On October 24, 1993, Elsie Church died suddenly of cardiopulmonary collapse. On October 26, 1993, the Certificate of Limited Partnership was filed with the Office of the Texas Secretary of State.
On July 25, 1994, the Estate of Elsie Church filed its return, valuing her limited partnership interest at $617 thousand. The IRS served a notice of deficiency of $212 thousand, plus interest. On April 8, 1996, the Estate paid a total of $230 thousand. On June 26, 1997, the Estate filed a lawsuit seeking a refund of this payment after the IRS denied its claim earlier in the year.
The Stumberg Ranch Partners Ltd. (the “Partnership” or “Stumberg”) was formed for two purposes. First, the partners wanted to consolidate their undivided interests in a family ranch in order to centrally manage their interests and preserve the ranch as an ongoing enterprise. Mrs. Church’s two children actively managed the ranching operation. Second, Mrs. Church wanted to protect her assets against creditors in the event of a catastrophic tort claim against her. Mrs. Church and each of her children were limited partners. The general partner was designated as Stumberg Ranch L.C. and was to be owned by Marshall and Newton equally. This entity was not formed when the agreement was signed.
Capital contributions to the Partnership consisted of each limited partner’s undivided interest in the ranch and $1 million in marketable securities held by Mrs. Church in a Paine Webber account. The undisputed value of the interest in the Ranch contributed by Mrs. Church was $380 thousand, while her children’s interests were $233 thousand.
The partnership agreement allocated profits or losses from the ranch operations in proportion to the interests contributed by the partners. Ninety-nine percent of the taxable income from securities was allocated to Mrs. Church. Essentially, Stumberg was a pro rata partnership because profits, losses and income were allocated in proportion to each partner’s capital contribution.
At trial, the government advanced several arguments in support of their denial of a refund of estate taxes. Defendants argued that the partnership was not valid because the paperwork was not complete at the time of death and was formed in contemplation of Mrs. Church’s death. The court disagreed because medical facts indicate there was no contemplation of death. In addition, the court cited the fact that all the paperwork was not completed on the date of formation as an indication that no one involved had considered the potential for Mrs. Church’s death.
The government argued that the partnership was formed solely to reduce Mrs. Church’s taxable estate. The court disagreed. The court recognized that the partnership was formed for two valid reasons. First, it was formed to consolidate the family’s interest in the family ranch to provide for centralized management and to preserve the ranch as an on-going enterprise for future generations. Facts were introduced at trial indicating there had been difficulty with another owner of an undivided interest who had interfered with the ranch’s operation. In addition, the Partnership was formed to protect Mrs. Church’s assets from judgment creditors in the event of a tort claim against her.
The government suggested that the Partnership was simply a means of transferring property to family members for less than full consideration. The government contended the difference between the fair market value of the assets Mrs. Church contributed to the Partnership, $1.5 million, and the value of her Partnership interest, $617 thousand, should be taxed as a gift. The court rejected this argument, indicating that Mrs. Church received a partnership interest proportional to the contributions and partnership interests of the other partners and there was no evidence that anyone experienced a financial benefit or increase in wealth.
The government argued that the securities held in a Paine Webber account, valued at $1.4 million were not conveyed to the partnership since her name, rather than that of the Partnership, was on the account several months after formation of the Partnership. Therefore, the estate should be taxed on their $1.4 million value. The court disagreed, stating that well established law directs judicial attention to intent of the parties when determining ownership of property, not legal title.
Finally, the government argued that the valuation of the partnership interest should not consider restrictions on sale contained in the partnership agreement, which reduce their value. The court rejected this indicating that there is nothing in the legislative history of the estate tax suggesting Congress wanted to address restrictions on sale/assignment of partnership interests. Rather Congress (sec. 2703) indicated that rights and restrictions like below-market buy sell agreements and options that artificially depress the FMV of the taxable property should be disregarded because they are not inherent components of the property itself.
Rejecting all the arguments put forth by the government, the court granted the estate a full refund based on the value advanced by its expert. The government never presented an alternate valuation opinion.
This case is interesting because the taxpayer scored a complete victory. In the present case, none of the government’s arguments regarding the validity of the partnership or the appropriate taxation of the partnership interests were accepted. The facts of the case supported the conclusion that the limited partnership was a valid entity. However, readers should be cautioned that judicial acceptance of this partnership does not mean any limited partnership will be accepted for estate tax purposes. That determination is very fact specific.
In addition, it should be noted that part of the reason this opinion might be characterized as a “taxpayer victory” resulted from the absence of a “battle of the experts”. Many times, it seems that judicial opinions seem to “split the baby” when determining the value of a business interest between various expert opinions. The estate received its full prayer for relief in this case because the government offered no alternative valuation.
Reprinted from Mercer Capital’s BizVal.com – Vol. 12, No. 2, 2000.