Tax Law Update 2011-08-01 (1)Tax Law Update 2011-08-01 (1)

Internal Revenue Service rules that a will's “it is my desire” language is a mandatory bequest — In Technical Advice Memorandum 201126030, the decedent's will stated:

To the extent that I own any equity interest at my death in any of the following closely held investments, i.e. [Assets], it is my desire that such equity interests be retained and that each of them be distributed so that all such equity interests are ultimately owned in equal shares by [Children]. If any of them are deceased, it is my desire that the decedent's share of such equity interests be owned equally by such decedent's children.

At issue was whether this provision was a mandatory bequest, thereby reducing the marital deduction and increasing the taxable estate, or merely a precatory statement that doesn't legally affect the passage of the assets.

The IRS determined that the language “it is my desire” wasn't precatory, but mandatory. While some bequests in the will used the words “I give” and “I direct,” other parts of the will gave the executor discretion by using the words “I further request, but not require” and “I suggest.” The IRS cited the rule of construction requiring it to construe instruments to give effect to all provisions so that no provision is rendered meaningless. Moreover, the IRS said:

A wish directed to a beneficiary is generally regarded as precatory, unless the words clearly express the testator's intention to the contrary; but where the words are addressed to an executor, they are more often regarded as mandatory, or at least prima facie mandatory.

Accordingly, the taxable estate was increased by the amount of the bequests.

Proposed clause giving trustee discretion to pay amounts other than the annuity to charity didn't prevent trust from qualifying as a charitable remainder annuity trust — A taxpayer wanted to create a charitable remainder annuity trust (CRAT) to be funded with real property. The CRAT was going to include the following provision:

The Trustee shall have the discretion to provide for the annuity payment to Trustor by allocating a portion of the trust assets to purchase an annuity contract which will guarantee to pay to the trust a sum equal to or greater than the Trustor's computed annual annuity payout for the duration of the trust … After securing such contract, the Trustee may distribute any amount other than the amount described in Treas. Reg. Section 1.664-2(a)(1) [the annuity payment to the Trustor] to the charities named in Schedule B any time during the term of the trust.

The taxpayer asked whether such a provision would disqualify the trust as a CRAT.

In Private Letter Ruling 201126007 (released July 1, 2011), the IRS concluded that the proposed clause wouldn't prevent the trust from qualifying as a CRAT under Internal Revenue Code Section 664(d)(1). It reasoned that Treasury Regulations Section 1.664-2(a)(1) states that a CRAT must provide that the trust will pay a sum certain not less often than annually to one or more persons for each taxable year of the annuity period. Treas. Regs. Section 1.664-2(a)(4) provides that no amount other than the annuity payment may be paid to or for the use of any person other than a charitable organization. However, the governing instrument may provide that any amount other than the annuity shall be paid (or may be paid in the trustee's discretion) to a charitable organization.

Tax Court refuses to apply penalty for substantial valuation understatement because taxpayer acted in good faith — In Estate of Natale B. Giustina v. Commissioner, T.C. Memo. 2011-141 (June 22, 2011), the Tax Court had to decide the value of a 41.128 percent limited partnership (LP) interest in the estate of Natale Giustina. Giustina Land & Timber Co. LP owned 47,939 acres of timberland in the Eugene, Ore. area. It employed approximately 12 to 15 people to conduct forestry operations.

The estate tax return reported the value of the LP interest to be $12,678,117. The IRS issued a notice of deficiency and a $2,531,501 accuracy-related penalty, stating that the value of the LP was $35,710,000. At trial, the IRS contended that the value of the LP interest was $33,515,000 (a lesser amount than it had earlier determined) and the estate contended that the value was $12,995,000 (a greater amount than it had reported on its return).

The court applied the discounted cash flow (DCF) method (the present value of the cash flow from the partnership if it continued forestry operations) and the asset method (the value of the partnership's assets if they were sold). The parties agreed that the value of the timberlands, which constituted most of the partnership's assets, was $142,974,438, after applying a 40 percent discount for the delays attendant to selling the partnership's timberland.

The court determined that there was a 25 percent probability the timberland would be sold and the partnership liquidated. Therefore, the court assigned a 75 percent weight to the value under the DCF method and a 25 percent weight to the value under the asset method.

In applying the DCF method, the court applied a 25 percent discount for lack of marketability. However, in applying the asset method, the court assumed that if the timberland were sold, the partnership would also be liquidated. Therefore, it didn't apply discounts for lack of control or marketability to the LP interest under the asset method. The court held that the 25 percent weighting and the 40 percent discount to the timberland value due to the time it would take to sell, already took the appropriate discounts into account.

Ultimately, the court concluded the value of the LP interest was $27,454,115. Ordinarily, if there's an underpayment of tax, the penalty imposed under IRC Section 6662 is equal to 20 percent of the portion of the underpayment that's attributable to a substantial estate tax valuation understatement. For estate tax returns filed before Aug. 17, 2006 (as in this case), there's a substantial estate tax valuation understatement if the value on the estate tax return is 50 percent or less of the correct value. In this case, the reported value of the LP interest was less than 50 percent of the correct value. However, the court didn't impose a penalty because there was reasonable cause for the underpayment and the taxpayer acted in good faith, as permitted under IRC Section 6664(c)(1). The executor of the estate hired a lawyer to prepare the estate tax return, and the lawyer hired a professional appraiser to value the LP interest. The executor reasonably relied on the appraisal in filing the return.

Tax Court questions use of restricted stock studies for valuing closely held corporations — In Estate of Louise Paxton Gallagher v. Comm'r, T.C. Memo. 2011-148 (June 28, 2011), the court used the DCF method to determine the value of a minority interest in a limited liability company (LLC) that owned 41 newspapers and publications.

Louise Gallagher died on July 5, 2004. The estate tax return stated that the fair market value (FMV) of the LLC units was $34,936,000. On audit, the IRS claimed the units were worth $49.5 million. The estate then obtained another appraisal, which valued the units at $26,606,940. The IRS wouldn't budge, so the estate filed a petition with the Tax Court for redetermination of the deficiency, relying on the second appraisal's FMV determination.

Before the trial started, the estate hired yet another appraiser who valued the units at $28.2 million, and the IRS hired an appraiser who valued the units at $40,863,000.

The court determined that the DCF method was the appropriate method to value the units. The court rejected the IRS' appraiser's use of the guideline company method (comparing value to public companies) because the companies the appraiser used for comparison weren't similar enough to the LLC.

The estate's appraisal used the financial data for the quarter ending on March 31, while the IRS' appraisal used financial data for the quarter ending on June 30. The estate argued that the financial information for the second quarter wasn't publicly available as of Louise's death, as it usually takes a few months to compile and publish that data, and therefore a willing buyer couldn't have relied on it. However, the court used the data through June 30, saying that a willing buying could have made inquiries. This is a common dilemma for closely held businesses: The financial data needed for a valuation isn't available until a few months after the valuation date. According to this court, the estate needs to ascertain this information via inquiries and factor the information into the valuation.

Finally, the court applied a 23 percent minority interest discount and a 31 percent marketability discount and concluded the value of the LLC units was $32,601,640 — much closer to the estate's value than the IRS' and even lower than the value originally claimed on the estate tax return. The court noted that the parties relied on seven independent restricted stock studies, which are routinely cited in appraisals: (1) SEC Institutional Investor Study, (2) Gelman Study, (3) Trout Study, (4) Moroney Study, (5) Maher Study, (6) Silber Study, and (7) Management Planning Study. The IRS' appraiser also considered other restricted stock studies: (1) Standard Research Consultants, (2) Willamette Management Associates, (3) FMV Opinions, and (4) Columbia Financial Advisors. These studies report average and median lack of marketability discounts in restricted stock transactions.

The court determined the value of the LLC units was $32,601,640 — less than the amount originally claimed on the estate tax return.

The court stated:

We have previously disregarded experts' conclusions as to marketability discounts for stock with holding periods of more than 2 years when based upon the above-referenced studies. See Furman v. Commissioner, T.C. Memo. 1998-157 (finding the taxpayer's reliance on the restricted stock studies in calculating a lack of marketability discount to be misplaced since owners of closely held stock held long term do not share the same marketability concerns as restricted stock owners with a holding period of 2 years).

However, since both parties' experts relied on the studies, the court used them to determine the marketability discount. Nonetheless, it's interesting that the Tax Court doesn't consider these studies that are widely (if not universally) cited in appraisals to be appropriate for valuing closely held entities.

Use of formula to allocate funds among trusts and donor advised fund okayed by Tax Court — John and Karolyn Hendrix transferred stock in a closely held S corporation to trusts for their daughters and a donor advised fund (the Foundation). Each parent transferred a stated number of shares to a trust and the Foundation, with the allocation between them based on a formula. The trusts were to receive a specified dollar value ($10,519,136.12), with the Foundation getting the balance. The trusts also were to issue promissory notes for $9,090,000 in exchange for the stock (part gift-part sale) and agreed to pay any gift tax attributable to the transfer.