Daubert Challenges and the Tax Court

Key words: Valuation; Daubert challenges
Executive Summary: In this federal income tax case, the Tax Court, in a reviewed opinion, excluded the appraisal report of the taxpayer’s appraiser on Daubert grounds and upheld the IRS’s position in the valuation of a conservation easement. The case is appealable to the U.S. Tenth Circuit Court of Appeals.
Facts: At issue was the correct value of a 2003 income tax charitable contribution deduction for a conservation easement. The relevant value positions of the litigants and that ultimately reached by the entire Tax Court are as follows:
Taxpayer’s Return Position: $3,245,000
IRS Audit/Deficiency Notice Position: $42,400
IRS Expert’s Position: $31,280
1999 Acquisition Price: $10,000 per acre
Highest and Best Use per the Taxpayer’s Expert: Condominium development
Highest and Best Use per the IRS Appraiser: Delayed single-family detached homes

Problems with the taxpayer’s appraisal report:

• Based appraisal on a draft of the conservation easement rather than on the final conservation easement
• It failed to determine the value of the easement area before and after the placement of the easement on the property, as required by Treas. Reg. Sec. 1.170A-14(h)(3)(i)
• Failure to apply realistic or objective assumptions
• Erroneous assumptions about city placement of the property and the zoning
• Failure to consider prospects for annexation into the city of Hobart and rezoning to permit the condominium project that the appraisers argued was the highest and best use of the property.
• Failure to address the argument that the proposed project would not fit on the eased property in the form drawn except by a “bald and unpersuasive assertion that the project ‘will fit, it just won’t fit as drawn’ in the site plan.”
• Failure to suggest adjustments or corrections to calculations that were obviously wrong except to assert that the original report was correct even with the factual errors.
• Failure to adequately consider the hypothetical willing buyer.

The taxpayer’s arguments against a Daubert exclusion:

• Daubert really only applies to jury trials.
• The appraisal report must be accepted since the IRS previously accepted the methodology in the appraisal report and in fact stipulated that it was a qualified appraisal.
• Tax Court Rule 143(g) mandates receipt of the appraisal report into evidence.
• The IRS complaints about the appraisal report don’t affect admissibility of the report into evidence.

The Tax Court refuted every argument of the taxpayer against a Daubert exclusion. The Tax Court cited FRE 702 and jurisprudence under it that makes Daubert exclusions applicable to jury trials. The Tax Court noted prior Tax Court jurisprudence holding that the admissibility of unreliable evidence is “an imposition on the opposing party and on the trial process.” In so doing, the Tax Court also noted:

In most cases, as in this one, there is no dispute about the qualifications of the appraisers. The problem is created by their willingness to use their resumes and their skills to advocate the position of the party who employs them without regard to objective and relevant facts, contrary to their professional obligations.

Justice is frequently as blindfolded to symbolize impartiality, but we need not blindly admit absurd expert opinions.[emphasis added]

After decades of warnings regarding the standards to be applied, we may fairly reject the burden on the parties and on the Court created by unreasonable, unreliable, and irrelevant expert testimony. In addition, the cottage industry of experts who function primarily in the market for tax benefits should be discouraged. Each case, of course, will involve exercise of the discretion of the trial judge to admit or exclude evidence. In this case, in the view of the trial judge, the expert report is so far beyond the realm of usefulness that admission is inappropriate and exclusion serves salutary purposes.[emphasis added]

We are not inclined to guess at how their valuation should be reduced by reason of their erroneous factual assumptions. Their report as a whole is too speculative and unreliable to be useful.

Although the [name purposefully omitted] experts determined that sales of comparable land nearby were occurring at approximately $12,000 an acre, their conclusion would assign a value of approximately $400,000 per acre to the subject property.

If the report and their testimony were admitted into evidence, we would decide that their opinions were not credible. The assertion that the Eased Parcel had a fair market value exceeding $3.3 million on December 29, 2003, before donation of the easement, i.e., that it would attract a hypothetical purchaser and exchange hands at that price, defies reason and common sense.[emphasis added]

The Tax Court determined that the value of the income tax charitable contribution deduction for the easement was $42,400, i.e., the deficiency notice position.

Comments: Ouch! This is a very, very important decision and highlights the risk of trial for either party, especially where there is a wide chasm between the positions of the experts. While there are certainly two sides to every story, it certainly appears that in the opinion of the entire Tax Court, the appraisers in this case were guilty of hubris by even failing to address their own factual errors and other problems with the report except to continue to assert the correctness of their positions. What are some of the takeaway lessons from Boltar?

• It is critical that the appraiser be objective and reasonable. How do you know when your appraiser is not being objective and reasonable? It requires you to be objective and reasonable as well, even when you are zealously advocating your client’s position. Co-opting your appraiser into being an advocate is the absolutely wrong approach. This is one of the reasons why I believe that a trial appraiser should not also serve as a rebuttal expert. I believe that simultaneously serving in both capacities compromises the expert in the eyes of the court. I far prefer to keep my trial expert “above the fray” and suggest hiring a separate rebuttal expert where it is determined that one is needed, even though it admittedly adds to the cost. What if your appraiser’s conclusion of value differs greatly from that of another qualified appraiser on the other side (and by this, I don’t necessarily include the work of the IRS valuation engineers, many of whom are not qualified appraisers)? It puts the onus on you to consider the possibility of having another appraiser conduct a “review” (this is a technical valuation term of art) of the subject appraisal. On balance, reviews are suggested every time that there are large differences between the conclusions of value of qualified appraisers. True, this adds expense that the client may not go for, but it’s so important in my opinion that you should go on record in writing as having suggested it so that if your appraiser is wrong, you at least can say “I told you to get a review.”
• It is imperative that your appraiser correct errors and carefully consider how the errors affect the conclusion of value. Appraisers are human too and do make mistakes from time to time. Errors can easily be made, and in appraisal reports, errors can cascade into bigger errors as they factor themselves in at each level of the analysis, throwing the conclusion of value off even further. In Boltar, the appraisers apparently didn’t consider how their errors affected their analysis, which the Tax Court termed “fatal.”
• Where an appraiser is not following a required valuation approach format, such as that for conservation easements, or the appraiser desires to use a technique that is “cutting edge” and hasn’t been vetted with the appraiser’s peers, warning bells should go off! I normally wouldn’t permit my clients to be guinea pigs unless they understood that and were nevertheless willing to do so. I strongly encourage appraisers who are “inventive” to publish articles and speak about their technique first to their peers. I really don’t care too much about whether the technique is criticized, because appraisers are notorious in criticizing each other’s work. As long as the technique is being used by other appraisers, I’m comfortable with it being employed as long as it is done correctly and consistently.

Cites: Boltar, LLC v. Comr., 136 T.C. No. 14 (April 5, 2011); Daubert v. Merrell Dow Pharm., Inc., 509 U.S. 579 (1993); Kuhmo Tire Co. v. Carmichael, 526 U.S. 137 (1999); FRE Rule 702; Tax Court Rule 143(f).

About lpaulhoodjr

I am an inactive lawyer who practiced almost 20 years as a tax and estate planning lawyer. Today, I am a speaker, author and consultant on tax and estate planning. In the recent past, I was the Director of Planned Giving for The University of Toledo Foundation. I am the co-author of six books, the sole author of another book and a frequent speaker and writer on estate planning, planned giving and business valuation.
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