Executive Summary: In this federal estate tax case, the Ninth Circuit reversed the Tax Court’s decision substantially in favor of the IRS in a valuation case where the issue was the size of the discount for built-in capital gains and remands for recalculation.
Facts: In this case, the decedent owned a 41.128% interest in an Oregon family limited partnership that owned approximately 48,000 acres of timber land.
Valuation Positions: If you will recall, the valuation positions of the parties and how the Tax Court came out are as follows:
Position Estate IRS Tax Court
Estate Tax Return Value $12,678,117
Estate Litigation Value $12,995,000
IRS Notice of Deficiency Value $35,710,000
IRS Litigation Value $33,515,000
Tax Court Conclusion of Value $27,454,115
Value per Cash Flow Method $33,800,000 $65,760,000 $51,702,857
Tax-Fee Risk Rate 4.5% 4.52% 4.5%
Equity Risk Premium 3.6% (.5 Beta) 11.7%
Small Stock Premium 6.4% 6.4%
Partnership Specific Risk 3.5% 1.75%
Assumed Growth Rate 4% 4%
Discount for Lack of Marketability 35% 25% 25%
Discount for Lack of Control 0 12% 0
Cash Flow Method Weighting 30% 20% 75%
Asset Approach Weighting 0 60% 25%
Market Approach Weighting 30% 20% 0
Capitalization of Distributions 30% 0 0
Asset Accumulation Method 10% 0 0
Value of Land (40% Discount*) $142,974,438 $142,974,438 $142,974,438
* Discount for delays in marketing and selling the timber land
The Ninth Circuit found three areas in which the Tax Court erred in its analysis. The first ground was the Tax Court clearly erred in its assignment of a 25% probability of the decedent’s interest (which was an assignee interest that didn’t have voting rights) combining with other limited partners to form a 2/3 bloc for the purpose of liquidating the partnership’s timberland. The Ninth Circuit called down the Tax Court once again (this occurred previously in Simplot Estate v. Comr.) for its assumption that the hypothetical willing buyer would be a current limited partner. The Ninth Circuit observed:
[The Tax Court’s] conclusion is contrary to the evidence in the record. In order for liquidation to occur, we must assume that (1) a hypothetical buyer would somehow obtain admission as a limited partner from the general partners, who have repeatedly emphasized the importance that they place upon continued operation of the partnership; (2) the buyer would then turn around and seek dissolution of the partnership or removal of the general partners who just approved his admission to the partnership; and (3) the buyer would manage to convince at least two (or possibly more) other limited partners to go along, despite the fact that “no limited partner ever asked or ever discussed the sale of an interest.” Alternatively, we must assume that the existing limited partners, or their heirs or assigns, owning two-thirds of the partnership, would seek dissolution. We conclude that it was clear error to assign a 25% likelihood to these hypothetical events.
The Ninth Circuit remanded the matter to the tax Court to “recalculate the value of the estate based on the partnership’s value as a going concern.”
The Ninth Circuit also held that the Tax Court clearly erred in halving the estate’s appraiser’s proffered specific-company risk premium without explanation.
However, the Ninth Circuit affirmed the Tax Court’s disregard of tax-effecting (which, in my opinion, it should have been done) as well as the Tax Court’s selection of 25% as the discount for lack of marketability.
Comments: I pointed out in LISI EP 1829 that, in my opinion, there were two basic grounds for appeal. First, I indicated that the Tax Court’s reliance on a valuation method (cash-flow method) substantially more than either expert did was suggestive of appeal. Second, I pointed out that the Tax Court’s employment of a “unique proportionality method” in which the Tax Court assumed a 75% chance of being valued as a going concern and a 25% chance of being liquidated was problematic, especially since the Tax Court just seemed to pull those percentages out of thin air. The Ninth Circuit apparently agreed with me.
I don’t think that the Tax Court’s proportionality analysis is applicable or helpful, particularly not in this case because there was effectively no chance that the partners would have liquidated the timber holdings and generated a whopping capital gains tax. For the Tax Court to weight the likelihood of liquidation at 25% indeed was contrary to the evidence and also common sense.
What does the Ninth Circuit’s holding on the going concern issue mean? Recall that 60% of the IRS expert’s conclusion of value was weighted in the asset approach. This weighting now has effectively been tossed out, as has the 25% allocation to the asset approach that the Tax Court used. The Estate spread out the percentages in its expert’s weightings of the conclusions of value that its four valuation methods generated, although the Tax Court disregarded 70% of the conclusions of value that these methods produced. We’ll have to see how Judge Morrison of the Tax Court, who wrote the Tax Court’s opinion in this case, interprets the Ninth Circuit’s inexplicably brief and even somewhat cryptic unpublished opinion. I wonder whether the Tax Court has enough guidance to produce a responsive recalculation.
Citations: Giustina Estate v. Comr, T.C. Memo. 2011-141 (June 22, 2011), rev’d and rem’d No. 12-71747 (December 5, 2014); Simplot Estate v. Comr., 249 F. 3d 1191 (9th Cir. 2001).