Filed: May 14, 2003
Latest Update: Mar. 03, 2020
Summary: 120 T.C. No. 13 UNITED STATES TAX COURT CHARLES T. MCCORD, JR., AND MARY S. MCCORD, DONORS, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent Docket No. 7048-00. Filed May 14, 2003. Ps, their children, and their children’s partnership formed a family limited partnership (PT). In 1996, Ps assigned interests in PT to several assignees pursuant to an agreement that contains a formula clause. The formula clause provides that (1) Ps’ children, trusts for their benefit, and S, a charitable o
Summary: 120 T.C. No. 13 UNITED STATES TAX COURT CHARLES T. MCCORD, JR., AND MARY S. MCCORD, DONORS, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent Docket No. 7048-00. Filed May 14, 2003. Ps, their children, and their children’s partnership formed a family limited partnership (PT). In 1996, Ps assigned interests in PT to several assignees pursuant to an agreement that contains a formula clause. The formula clause provides that (1) Ps’ children, trusts for their benefit, and S, a charitable or..
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120 T.C. No. 13
UNITED STATES TAX COURT
CHARLES T. MCCORD, JR., AND MARY S. MCCORD, DONORS, Petitioners
v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 7048-00. Filed May 14, 2003.
Ps, their children, and their children’s
partnership formed a family limited partnership (PT).
In 1996, Ps assigned interests in PT to several
assignees pursuant to an agreement that contains a
formula clause. The formula clause provides that (1)
Ps’ children, trusts for their benefit, and S, a
charitable organization, are to receive interests
having an aggregate fair market value of a set dollar
amount, and (2) C, another charitable organization, is
to receive any remaining portion of the assigned
interests. Ps’ children agreed to pay all transfer
taxes resulting from the transaction, including the
estate tax liability under then sec. 2035(c), I.R.C.
1986, that would arise if one or both Ps were to die
within 3 years of the date of the assignments.
Pursuant to a second agreement, the assignees
allocated the assigned interests among themselves in
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accordance with the formula clause, based on an agreed
aggregate value of $7,369,277.60 for the assigned
interests. Less than 6 months after the date of the
assignment, PT redeemed the interests of S and C
pursuant to a call option contained in PT’s partnership
agreement.
1. Held: Ps assigned only economic rights with
respect to PT; such assignments did not confer partner
status on the assignees.
2. Held, further, the aggregate fair market value
of the interests assigned by Ps on the date of the
gifts was $9,883,832.
3. Held, further, the amount of Ps’ aggregate
charitable contribution deduction under sec. 2522,
I.R.C. 1986, resulting from the transfer to C is
determined on the basis of the fair market value of the
interest actually allocated to C under the second
agreement, rather than the interest that would have
been allocated to C under the second agreement had the
donees determined a fair market value for the assigned
interests equal to the fair market value determined by
the Court.
4. Held, further, Ps’ respective taxable gifts
for 1996 are determined without reference to the
contingent estate tax liability that their children
assumed under the first agreement.
John W. Porter and Stephanie Loomis-Price, for petitioners.
Lillian D. Brigman and Wanda M. Cohen, for respondent.
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Table of Contents
FINDINGS OF FACT.............................................5
OPINION.....................................................15
I. Introduction.........................................15
II. Relevant Statutory Provisions........................16
III. Arguments of the Parties.............................18
IV. Extent of the Rights Assigned........................19
V. Fair Market Value of the Gifted Interest.............25
A. Introduction.....................................25
1. General Principles............................25
2. Expert Opinions...............................26
a. In General....................................26
b. Petitioners’ Expert...........................27
c. Respondent’s Expert...........................28
B. Value of Underlying Assets.......................28
C. Minority Interest (Lack of Control) Discount.....29
1. Introduction..................................29
2. Discount Factors by Asset Class...............30
a. Equity Portfolio..............................30
(1) Measurement Date.............................31
(2) Sample Funds.................................31
(3) Representative Discount Within the Range
of Sample Fund Discounts...................34
(4) Summary......................................36
b. Municipal Bond Portfolio......................37
(1) Measurement Date.............................37
(2) Sample Funds.................................37
(3) Representative Discount Within the Range
of Sample Fund Discounts...................38
(4) Summary......................................40
c. Real Estate Partnerships......................41
(1) The Appropriate Comparables..................41
(2) Determining the Discount Factor..............43
d. Direct Real Estate Holdings...................45
e. Oil and Gas Interests.........................46
3. Determination of the Minority
Interest Discount............................46
D. Marketability Discount...........................46
1. Introduction..................................46
2. Traditional Approaches to Measuring
the Discount.................................47
a. In General....................................47
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b. Rejection of IPO Approach.....................48
3. Mr. Frazier’s Restricted Stock Analysis.......50
4. Dr. Bajaj’s Private Placement Analysis........52
a. Comparison of Registered
and Unregistered Private Placements..........52
b. Refinement of Registered/
Unregistered Discount Differential............53
c. Further Adjustments...........................56
d. Application to MIL............................56
5. Determination of the Marketability Discount...56
a. Discussion....................................56
b. Conclusion....................................59
E. Conclusion.......................................59
VI. Charitable Contribution Deduction for
Transfer to CFT.....................................60
A. Introduction.....................................60
B. The Assignment Agreement.........................61
C. Conclusion.......................................64
VII. Effect of Children’s Agreement To Pay Estate
Tax Liability.......................................65
A. Introduction.....................................65
B. Discussion.......................................69
C. Conclusion.......................................73
VIII. Conclusion...........................................73
Judge Swift’s Concurring Opinion............................74
Judge Chiechi’s Concurring in Part, Dissenting
in Part Opinion...........................................86
Judge Foley’s Concurring in Part, Dissenting
in Part Opinion...........................................94
Judge Laro’s Dissenting Opinion............................109
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HALPERN, Judge: By separate notices of deficiency dated
April 13, 2000 (the notices), respondent determined deficiencies
in Federal gift tax for calendar year 1996 with respect to
petitioner Charles McCord, Jr. (Mr. McCord) and petitioner Mary
McCord (Mrs. McCord) in the amounts of $2,053,525 and $2,047,903,
respectively. The dispute centers around the gift tax
consequence of petitioners’ assignments to several charitable and
noncharitable donees of interests in a family limited
partnership.
Unless otherwise noted, all section references are to the
Internal Revenue Code in effect on the date of the assignments,
and all Rule references are to the Tax Court Rules of Practice
and Procedure. All dollar amounts have been rounded to the
nearest dollar.
FINDINGS OF FACT
Some facts are stipulated and are so found. The stipulation
of facts, with accompanying exhibits, is incorporated herein by
this reference.
Petitioners
Petitioners are husband and wife. They have four sons, all
adults (the children): Charles III, Michael, Frederick, and
Stephen. In response to the notices, petitioners filed a single
petition. At the time they filed the petition, petitioners
resided in Shreveport, Louisiana.
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Formation of McCord Interests, Ltd., L.L.P.
McCord Interests, Ltd., L.L.P. (MIL or the partnership), is
a Texas limited partnership formed on June 30, 1995, among
petitioners, as class A limited partners; petitioners, the
children, and another partnership formed by the children (McCord
Brothers Partnership), as class B limited partners; and the
children as general partners (all such partners being hereafter
referred to as the initial MIL partners).
On formation, as well as on the date of the assignments in
question, the principal assets of MIL were stocks, bonds, real
estate, oil and gas investments, and other closely held business
interests. On the date of the assignments, approximately 65
percent and 30 percent of the partnership’s assets consisted of
marketable securities and interests in real estate limited
partnerships, respectively. The remaining approximately 5
percent of the partnership’s assets consisted of direct real
estate holdings, interests in oil and gas partnerships, and other
oil and gas interests.
In mid-October 1995, the MIL partnership agreement was
amended and restated, effective as of November 1, 1995 (such
amended and restated partnership agreement being referred to
hereafter as, simply, the partnership agreement). Attached to
the partnership agreement is a schedule setting forth the capital
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contributions and ownership interests of the initial MIL
partners, as follows:1
Percentage
Class and Contributor Contribution Interest
Class A limited partners:
Mr. McCord $10,000 --
Mrs. McCord 10,000 --
General partners:
Charles III 40,000 0.26787417
Michael 40,000 0.26787417
Frederick 40,000 0.26787417
Stephen 40,000 0.26787417
Class B limited partners:
Mr. McCord 6,147,192 41.16684918
Mrs. McCord 6,147,192 41.16684918
McCord Brothers 2,478,000 16.59480496
Total 14,952,384 100.0
Relevant Provisions of the Partnership Agreement
Among other things, the partnership agreement provides as
follows:
MIL will continue in existence until December 31, 2025 (the
termination date), unless sooner terminated in accordance with
the terms of the partnership agreement.
Any class B limited partner may withdraw from MIL prior to
the termination date and receive a payment equal to the fair
market value (as determined under the partnership agreement) of
1
Under the terms of the partnership agreement, a class A
limited partnership interest does not carry with it a “Percentage
Interest” (as that term is defined in the partnership agreement)
in MIL.
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such partner’s class B limited partnership interest (the put
right).
Partners may freely assign their partnership interests to or
for the benefit of certain family members and charitable
organizations (permitted assignees).
A partner desiring to assign his partnership interest to
someone other than a permitted assignee must first offer that
interest to MIL and the other partners and assignees, who have
the right to purchase such interest at fair market value (as
determined under the partnership agreement).
The term “partnership interest” means the interest in the
partnership representing any partner’s right to receive
distributions from the partnership and to receive allocations of
partnership profit and loss.
Regardless of the identity of the assignee, no assignee of a
partnership interest can attain the legal status of a partner in
MIL without the unanimous consent of all MIL partners.
MIL may purchase the interest of any “charity assignee”
(i.e., a permitted assignee of a partnership interest that is a
charitable organization that has not been admitted as a partner
of MIL) at any time for fair market value, as determined under
the partnership agreement (the call right).
For purposes of the partnership agreement, (1) a class B
limited partner’s put right is disregarded for purposes of
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determining the fair market value of such partner’s class B
limited partnership interest, and (2) any dispute with respect to
the fair market value of any interest in MIL is to be resolved by
arbitration as provided in Exhibit G attached to the partnership
agreement.
Limited partners generally do not participate in the
management of the partnership’s affairs. However, limited
partners do have veto power with respect to certain “major
decisions”, most notably relating to voluntary bankruptcy
filings. In addition, if any two of the children are not serving
as managing partners, class B limited partners have voting rights
with respect to certain “large dollar” managerial decisions.
Limited partners also have access to certain partnership
financial information.
Southfield School Foundation
On November 20, 1995, petitioners assigned their respective
class A limited partnership interests in MIL to the Hazel Kytle
Endowment Fund of The Southfield School Foundation (the
foundation) pursuant to an Assignment of Partnership Interest and
Addendum Agreement (the Southfield agreement). The recitals to
the Southfield agreement provide that “all of the partners of the
Partnership desire that Assignee become a Class A Limited Partner
of the Partnership upon execution of this Assignment of
Partnership Interest” and “all consents required to effect the
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conveyance of the Assigned Partnership Interest and the admission
of Assignee as a Class A Limited Partner of the Partnership have
been duly obtained and are evidenced by the signatures hereto”.
All of the initial MIL partners executed the Southfield
agreement.
Further Assignments
On January 12, 1996 (the valuation date), petitioners, as
assignors, entered into an assignment agreement (the assignment
agreement) with respect to their class B limited partnership
interests in MIL. The other parties to the assignment agreement
(the assignees) were the children, four trusts for the benefit of
the children (the trusts), and two charitable organizations-–
Communities Foundation of Texas, Inc. (CFT) and Shreveport
Symphony, Inc. (the symphony). By the assignment agreement,
petitioners relinquished all dominion and control over the
assigned partnership interests and assigned to the assignees all
of their rights with respect to those interests. The assignment
agreement does not contain language similar to that quoted above
from the Southfield agreement regarding the admission of the
assignees as partners of the partnership, and two of the partners
of the partnership, McCord Brothers Partnership and the
foundation, did not execute the assignment agreement in any
capacity. The interests that petitioners assigned to the
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assignees by way of the assignment agreement (collectively, the
gifted interest) are the subject of this dispute.
Under the terms of a “formula clause” contained in the
assignment agreement (the formula clause), the children and the
trusts were to receive portions of the gifted interest having an
aggregate fair market value of $6,910,933; if the fair market
value of the gifted interest exceeded $6,910,933, then the
symphony was to receive a portion of the gifted interest having a
fair market value equal to such excess, up to $134,000; and, if
any portion of the gifted interest remained after the allocations
to the children, trusts, and symphony, then CFT was to receive
that portion (i.e., the portion representing any residual value
in excess of $7,044,933). The children (individually and as
trustees of the trusts) agreed to be liable for all transfer
taxes (i.e., Federal gift, estate, and generation-skipping
transfer taxes, and any resulting State taxes) imposed on
petitioners as a result of the conveyance of the gifted interest.
The assignment agreement leaves to the assignees the task of
allocating the gifted interest among themselves; in other words,
in accordance with the formula clause, the assignees were to
allocate among themselves the approximately 82-percent
partnership interest assigned to them by petitioners. In that
regard, the assignment agreement contains the following
instruction concerning valuation (the valuation instruction):
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For purposes of this paragraph, the fair market value
of the Assigned Partnership Interest as of the date of
this Assignment Agreement shall be the price at which
the Assigned Partnership Interest would change hands as
of the date of this Assignment Agreement between a
hypothetical willing buyer and a hypothetical willing
seller, neither being under any compulsion to buy or
sell and both having reasonable knowledge of relevant
facts. Any dispute with respect to the allocation of
the Assigned Partnership Interests among Assignees
shall be resolved by arbitration as provided in the
Partnership Agreement.
The Confirmation Agreement
In March 1996, the assignees executed a Confirmation
Agreement (the confirmation agreement) allocating the gifted
interest among themselves as follows:
Assigned
Partnership
Assignee Interest
Charles T. McCord, III, GST Trust 8.24977954%
Michael S. McCord GST Trust 8.24977954
Frederick R. McCord GST Trust 8.24977954
Stephen L. McCord GST Trust 8.24977954
Charles III 11.05342285
Michael 11.05342285
Frederick 11.05342285
Stephen 11.05342285
CFT 3.62376573
Symphony 1.49712307
Total 82.33369836%
The assignees based that determination on an appraisal report,
dated February 28, 1996, prepared at the behest of the children’s
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counsel2 by Howard Frazier Barker Elliott, Inc. (HFBE). That
report (the 1996 HFBE appraisal report) concludes that, taking
into account discounts for lack of control and lack of
marketability, the fair market value of a 1-percent “assignee’s
interest in the Class B Limited Partnership Interests” on the
valuation date was $89,505.
Representatives of CFT and the symphony, respectively
(including their respective outside counsel), reviewed the 1996
HFBE appraisal report and determined that it was not necessary to
obtain their own appraisals. Furthermore, under the terms of the
confirmation agreement, CFT and the symphony (as well as the
other assignees) agreed not to seek any judicial alteration of
the allocation in the confirmation agreement and waived their
arbitration rights granted under the assignment agreement.
MIL’s Exercise of the Call Right
On June 26, 1996, MIL exercised the call right with respect
to the interests held by the symphony and CFT. It did so
pursuant to a document styled “Agreement-–Exercise of Call Option
By McCord Interests, Ltd., L.L.P.” (the exercise agreement). The
purchase price for the redeemed interests was based on a two-page
letter from HFBE (the HFBE letter) previewing an updated
appraisal report to be prepared by HFBE. The HFBE letter
2
The children’s counsel had also represented petitioners
in connection with the transaction. However, petitioners were
not involved in the allocation of the gifted interest among the
assignees pursuant to the confirmation agreement.
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concludes that the fair market value of a 1-percent “assignee’s
interest in the Class B Limited Partnership Interests” as of June
25, 1996 was $93,540. CFT and the symphony raised no objections
to the value found in the HFBE letter and accepted $338,967 and
$140,041, respectively, in redemption of their interests.
The Gift Tax Returns
Petitioners timely filed Forms 709, United States Gift (and
Generation Skipping Transfer) Tax Return, for 1996 (the Forms
709). In schedules attached to the Form 709, petitioners
reported a gross value of $3,684,639 for their respective shares
of the gifted interest. Each petitioner reduced that amount by
the amount of Federal and State (Louisiana) gift tax generated by
the transfer that the children agreed to pay as a condition of
the gift. Each petitioner further reduced that amount by a
computation of the actuarial value, as of the valuation date, of
the contingent obligation of the children to pay (again, as a
condition of the gift) the additional estate tax that would
result from the transaction if that petitioner were to die within
3 years of the valuation date. Based on those adjustments, Mr.
and Mrs. McCord reported total gifts of $2,475,896 and
$2,482,605, respectively.3 Mr. and Mrs. McCord each claimed an
annual exclusion amount of $60,000 and a charitable contribution
3
Those figures also reflect cash gifts of $10 by each
petitioner to nominally fund the trusts.
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deduction of $209,173, yielding taxable gifts of $2,206,724 and
$2,213,432, respectively.
The Notices
By the notices, respondent determined deficiencies in gift
tax with respect to Mr. and Mrs. McCord in the amounts of
$2,053,525 and $2,047,903, respectively, based on increases in
1996 taxable gifts in the amounts of $3,740,904 and $3,730,439,
respectively. Respondent determined that each petitioner (1)
understated the gross value of his or her share of the gifted
interest, and (2) improperly reduced such gross value by the
actuarial value of the children’s obligation to pay additional
estate taxes potentially attributable to the transaction.
OPINION
I. Introduction
MIL is a Texas limited partnership formed on June 30, 1995.
In exchange for their class B limited partnership interests in
MIL, petitioners contributed to MIL closely held business
interests, oil and gas interests, real estate, stocks, bonds, and
other securities. The parties have stipulated that the value of
petitioners’ contributions in exchange for their class B limited
partnership interests was $12,294,384 ($6,147,192 apiece). On
January 12, 1996, petitioners assigned (as gifts) their
partnership interests in MIL (the gifted interest). On that
date, approximately 65 percent of the partnership’s assets
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consisted of marketable securities and approximately 30 percent
consisted of interests in real estate limited partnerships. The
assignees were petitioners’ children, trusts for the benefit of
the children, and two charitable organizations (Communities
Foundation of Texas, Inc. (CFT) and Shreveport Symphony, Inc.
(the symphony)). In calculations submitted with their Federal
gift tax returns, petitioners reported the gross value of the
gifted interest as $7,369,278 ($3,684,639 apiece). Respondent’s
adjustments reflect his determination that the gross fair market
value of the gifted interest was $12,426,086 ($6,213,043 apiece).
Principally, we must determine the fair market value of the
gifted interest and whether each petitioner may reduce his or her
one-half share thereof to account for the children’s contingent
obligation (as a condition of the gift) to pay the additional
estate tax that would result from the transaction if that
petitioner were to die within 3 years of the date of the gift.
Preliminarily, we must determine whether petitioners transferred
all of their rights as class B limited partners or only their
economic rights with respect to MIL. We must also determine the
amount of the gift to CFT.
II. Relevant Statutory Provisions
Section 2501(a) imposes a tax on the transfer of property by
gift. Section 2512(a) provides that, if a gift is made in
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property, the value of the property on the date of the gift is
considered the amount of the gift. In determining the amount of
“taxable gifts” for any particular year, a donor is entitled to
deduct the amount of gifts made during the year that qualify for
the charitable contribution deduction provided for in section
2522. Sec. 2503(a).
Section 2502(c) provides that the donor is the person liable
for the payment of the gift tax. If a donor makes a gift subject
to the condition that the donee pay the resulting gift tax, the
amount of the gift is reduced by the amount of such gift tax.
Rev. Rul. 75-72, 1975-1 C.B. 310. Such a gift is commonly
referred to as a “net gift” (net gift).
Under section 2035(c) (current section 2035(b)), a
decedent’s gross estate is increased by the amount of any gift
tax paid by the decedent or his estate on any gift made by the
decedent during the 3-year period preceding the decedent’s death.
For purposes of this “gross-up” provision, gift tax “paid by the
decedent or his estate” on gifts made during the relevant 3-year
period is deemed to include gift tax attributable to net gifts
made by the decedent during such period (i.e., even though the
donees are responsible for paying the gift tax in such
situation). Estate of Sachs v. Commissioner, 88 T.C. 769, 777-
778 (1987), affd. in part and revd. in part on another ground
856 F.2d 1158, 1164 (8th Cir. 1988).
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III. Arguments of the Parties
Petitioners contend that they correctly valued the gifted
interest in determining their respective taxable gifts.
Petitioners contend in the alternative that, if we determine an
increased value for the gifted interest, then, by operation of
the formula clause in the assignment agreement, they are entitled
to an identical increase in the amount of their aggregate
charitable contribution deduction under section 2522, resulting
in no additional gift tax due.4 Petitioners also contend that,
under net gift principles enunciated in Rev. Rul. 75-72, supra,
and Estate of Sachs v.
Commissioner, supra, they properly reduced
their respective taxable gifts by the actuarial value of the
children’s contingent obligation, under the terms of the
assignment agreement, to pay additional estate tax under section
2035(c).
Respondent contends that petitioners undervalued the gifted
interest by mischaracterizing the assignment and applying
excessive discounts. Respondent also contends that the formula
clause in the assignment agreement, designed to neutralize the
tax effect of any upward adjustment to the valuation of the
gifted interest, is ineffectual. Finally, respondent contends
that petitioners improperly reduced the amount of their taxable
4
Consistent with that argument, petitioners have preserved
their right to claim an increased charitable contribution
deduction under sec. 170 on an amended income tax return for
1996. Petitioners’ 1996 income tax liability is not before us.
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gifts to account for the possibility that the children would be
obligated to pay additional estate tax under section 2035(c) by
reason of the transaction.
The parties have stipulated that respondent bears the burden
of proof, and we accept that stipulation.5
IV. Extent of the Rights Assigned
The divergence of the parties’ valuations of the gifted
interest is attributable in part to their disagreement regarding
the extent of the rights assigned by petitioners. Petitioners
contend that they assigned to the assignees certain rights with
respect to their class B limited partnership interests in MIL but
did not (and could not) admit the assignees as class B limited
partners. The assignment, they argue, did not entitle the
assignees to exercise certain rights that petitioners possessed
(as partners) under the partnership agreement. Thus, they argue,
the value of the gifted interest is something less than the value
of all of their rights as class B limited partners. Respondent,
on the other hand, argues that the gifted interest consists of
the sum and total of petitioners’ rights as class B limited
partners (i.e., that, as a result of the assignment, the
5
The parties have not informed us of their basis for
stipulating that respondent bears the burden of proof. The
burden of proof is normally on petitioner. See Rule 142(a)(1).
Under certain circumstances, the burden of proof can be shifted
to the Commissioner. See sec. 7491; Rule 142(a)(2). We assume
(without deciding) that the conditions necessary to shift the
burden to respondent have been satisfied.
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assignees became class B limited partners). The parties’ experts
agree that, if the gifted interest does not include all of
petitioners’ rights as class B limited partners, the fair market
value of the gifted interest is lower than it would be if the
gifted interest did include all such rights.
Whenever the concept of “property” is relevant for Federal
tax purposes, it is State law that defines the property interest
to which Federal tax consequences attach. E.g., United States v.
Craft, 535 U.S. 274, 278-279 (2002) (Federal tax lien attaches to
property held, under State law, as tenants by the entireties).
Thus, in order to determine the Federal gift tax consequences
that attach to petitioners’ assignment of the gifted interest, we
look to applicable State law to determine the extent of the
rights transferred. Because petitioners transferred interests in
a Texas limited partnership, Texas law governs our determination
in that regard. Specifically, we look to the Texas Revised
Limited Partnership Act (the Act), Tex. Rev. Civ. Stat. Ann. art.
6132a-1, as in effect on the date of the gift.
Under the Act, a partnership interest is personal property.
Tex. Rev. Civ. Stat. Ann. art. 6132a-1, sec. 7.01 (Vernon 2001).
A partnership interest is assignable in whole or in part unless
the partnership agreement provides otherwise. Id. sec.
7.02(a)(1). However, an assignee of a partnership interest
attains the legal status of a limited partner only if the
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partnership agreement so provides or all of the partners consent.
Id. sec. 7.04(a). Section 8.01 of the partnership agreement
governs the admission of new partners to MIL. That section
provides that, notwithstanding the occurrence of a valid
assignment of a partnership interest in MIL in compliance with
the terms of the partnership agreement, no person shall become a
partner without the unanimous consent of the existing partners.
There is no evidence indicating that all of the MIL partners
explicitly consented to the admission of the assignees as
partners in MIL. Our inquiry does not end there, however. In
Kerr v. Commissioner, 113 T.C. 449 (1999), affd. on another issue
292 F.3d 490 (5th Cir. 2002), we demonstrated our willingness to
look beyond the formalities of intrafamily partnership transfers
to determine what, in substance, was transferred. In that case,
also involving Texas partnership law, the taxpayers argued that
the interests they transferred to two grantor retained annuity
trusts (GRATs) were “assignee interests”6 because the other
general partners of the partnership (the taxpayers’ adult
children, whose trusts were the remainder beneficiaries of the
GRATs) did not consent to the admission of the GRATs as
additional partners.
Id. at 464. We found that such lack of
formal consent did not preclude a finding that the taxpayers
6
For purposes of this report, we use the term “assignee
interest” (assignee interest) to signify the interest held by an
assignee of a partnership interest who has not been admitted as a
partner in the partnership.
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effected a transfer of all their rights as partners. Id. In
essence, we inferred the necessary consent of the other general
partners to admit the GRATs as partners based on all of the facts
and circumstances.
Id. at 464-468.
Our decision in Kerr was influenced by a number of factors
that are not present in this case. For instance, the taxpayers
in Kerr asked us to construe strictly the consent provision in
their partnership agreement in the context of their transfers to
the GRATs, notwithstanding the fact that they had disregarded
that provision in other situations. Id. at 464-465. In
addition, we found it difficult to reconcile the taxpayers’
characterization of the transfers with the language of their
assignment documents, each of which contained the following
statement: “The Assigned Partnership Interest constituted a
Class B Limited Partnership interest in * * * [the partnership at
issue] when owned by Assignor and, when owned by Assignee, shall
constitute a Class B Limited Partnership Interest in said
partnership.”
Id. at 466. Finally, from an economic reality
standpoint, we found it significant that the taxpayers and their
children, being all of the general partners of the partnership,
could have formally admitted the assignee GRATs as partners at
any time without having to obtain the consent of any other
person.
Id. at 468.
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In the instant case, there is no evidence that petitioners
and the other partners of MIL ever disregarded section 8.01 of
the partnership agreement, the provision on which they now rely.
Indeed, when petitioners assigned their class A limited
partnership interests to the foundation in 1995, all of the
initial MIL partners consented in writing to the admission of the
foundation as a class A limited partner, as required by said
section 8.01. Furthermore, the assignment agreement with respect
to the gifted interest does not contain language of the type
quoted above from the Kerr assignment documents, nor does it
contain any of the language in the Southfield agreement relating
to the admission of the assignee as a partner in MIL. Finally,
petitioners and their children could not unilaterally admit the
assignees as partners in MIL; any such admission required the
consent of the foundation, an unrelated third party.
Respondent makes note of the fact that the assignment
agreement provides that “Assignors hereby relinquish all dominion
and control over the Assigned Partnership Interest and assign to
Assignees all of Assignors’ rights with respect to the Assigned
Partnership Interest”. However, the issue in this case is not
whether petitioners transferred partnership interests; under the
terms of the Act, the partnership agreement, and the assignment
agreement, they undoubtedly could and did. That having been
said, both the Act and the partnership agreement define the term
- 24 -
“partnership interest” in terms of economic rights (and do not
equate the term with membership in the partnership).7 Thus, it
is entirely consistent to say that petitioners assigned all of
their rights with respect to their partnership interests, yet did
not assign all of their rights as class B limited partners (i.e.,
did not cause the assignees to be admitted as substitute class B
limited partners).
In sum, we conclude that the facts in this case do not
permit us to infer, as we did in Kerr, that petitioners intended
to transfer all of their rights as partners and that all of the
other partners effectively consented to the admission of the
assignees as partners. Rather, petitioners assigned only
economic rights with respect to MIL, and we shall proceed to
value the gifted interest on that basis.8
7
The partnership agreement provides that the term
“partnership interest” means the interest in the partnership
representing any partner’s right to receive distributions from
the partnership and to receive allocations of partnership profit
and loss. The statutory definition is similarly worded. See
Tex. Rev. Civ. Stat. Ann. art. 6132a-1, sec. 1.02(11) (Vernon
2001) (the Act) and accompanying bar committee comment; see also
id. sec. 7.02(a)(1), (3), and (4) (assignment of partnership
interest entitles the assignee to distributions and allocations,
but the assignor continues to be a partner and to have the power
to exercise any rights or powers of a partner, until the assignee
becomes a partner).
8
To use the terminology favored by the parties, we shall
value the gifted interest as an assignee interest.
- 25 -
V. Fair Market Value of the Gifted Interest
A. Introduction
1. General Principles
Section 25.2512-1, Gift Tax Regs., provides that the value
of property for gift tax purposes is “the price at which such
property would change hands between a willing buyer and a willing
seller, neither being under any compulsion to buy or sell, and
both having reasonable knowledge of relevant facts.”9 The
willing buyer and willing seller are hypothetical persons, rather
than specific individuals or entities, and their characteristics
are not necessarily the same as those of the donor and the donee.
Estate of Newhouse v. Commissioner, 94 T.C. 193, 218 (1990)
(citing Estate of Bright v. United States,
658 F.2d 999, 1006
(5th Cir. 1981)).10 The hypothetical willing buyer and willing
9
Relying on Morrissey v. Commissioner, 243 F.3d 1145, 1148
(9th Cir. 2001), revg. Estate of Kaufman v. Commissioner, T.C.
Memo. 1999-119, and Estate of Smith v. Commissioner, T.C. Memo.
1999-368, petitioners contend that the confirmation agreement is
conclusive proof of the value of the gifted interest because such
agreement was an arm’s-length transaction that was the
“functional equivalent of an actual sale.” We disagree. Suffice
it to say that, in the long run, it is against the economic
interest of a charitable organization to look a gift horse in the
mouth.
10
Although the cited cases involved the estate tax, it is
well settled that the estate tax and the gift tax, being in pari
materia, should be construed together. See, e.g., Shepherd v.
Commissioner, 283 F.3d 1258, 1262 n.7 (11th Cir. 2002) (citing
Harris v. Commissioner,
340 U.S. 106, 107 (1950)), affg.
115 T.C.
376 (2000).
- 26 -
seller are presumed to be dedicated to achieving the maximum
economic advantage. Id. at 218.
2. Expert Opinions
a. In General
In deciding valuation cases, courts often look to the
opinions of expert witnesses. Nonetheless, we are not bound by
the opinion of any expert witness, and we may accept or reject
expert testimony in the exercise of our sound judgment.
Helvering v. Natl. Grocery Co., 304 U.S. 282, 295 (1938); Estate
of Newhouse v.
Commissioner, supra at 217. Although we may
largely accept the opinion of one party’s expert over that of the
other party’s expert, see Buffalo Tool & Die Manufacturing Co. v.
Commissioner,
74 T.C. 441, 452 (1980), we may be selective in
determining what portions of each expert’s opinion, if any, to
accept, Parker v. Commissioner,
86 T.C. 547, 562 (1986).
Finally, because valuation necessarily involves an approximation,
the figure at which we arrive need not be directly traceable to
specific testimony if it is within the range of values that may
be properly derived from consideration of all the evidence.
Estate of True v. Commissioner, T.C. Memo. 2001-167 (citing
Silverman v. Commissioner,
538 F.2d 927, 933 (2d Cir. 1976),
affg. T.C. Memo. 1974-285).
- 27 -
b. Petitioners’ Expert
Petitioners offered William H. Frazier (Mr. Frazier) as an
expert witness to testify concerning the valuation of the gifted
interest. Mr. Frazier is a principal of Howard Frazier Barker
Elliott, Inc. (HFBE), a Houston-based valuation and consulting
firm. He is a senior member of the American Society of
Appraisers and has been involved in valuation and general
investment banking activities since 1975. The Court accepted Mr.
Frazier as an expert in the valuation of closely held entities
and received written reports of HFBE into evidence as Mr.
Frazier’s direct and rebuttal testimony, respectively.
In his direct testimony, Mr. Frazier concludes that, based
on a 22-percent minority interest discount and a 35-percent
marketability discount, the fair market value of a 1-percent
assignee interest in MIL on the valuation date was $89,505.
Based on that figure, Mr. Frazier further concludes that the fair
market value of each petitioner’s one-half share of the gifted
interest on the valuation date was $3,684,634 (a figure that, due
to rounding, is slightly lower than the value reported on the
Forms 709).11
11
Mr. Frazier asserts that a 41.167-percent assignee
interest in MIL (i.e., one-half of the gifted interest) has no
more proportionate value than a 1-percent assignee interest
therein, and respondent’s expert does not dispute that assertion.
- 28 -
c. Respondent’s Expert
Respondent offered Mukesh Bajaj, Ph.D. (Dr. Bajaj), as an
expert witness to testify concerning the valuation of closely
held entities. Dr. Bajaj is the managing director of the finance
and damages practice of LEC, LLC. He also has experience as a
university professor of finance and business economics. Dr.
Bajaj has lectured extensively on valuation issues, and he has
testified as an expert in several valuation cases. The Court
accepted Dr. Bajaj as an expert in the valuation of closely held
entities and received his written reports into evidence as his
direct and rebuttal testimony, respectively.
In his direct testimony, Dr. Bajaj concludes that, based on
an 8.34-percent minority interest discount and a 7-percent
marketability discount, the fair market value of a 1-percent
assignee interest in MIL on the valuation date was $150,665.64.
Based on that figure, Dr. Bajaj further concludes that the fair
market value of each petitioner’s one-half share of the gifted
interest on the valuation date was $6,202,429.67.
B. Value of Underlying Assets
The parties agree that, on the valuation date, MIL’s net
asset value (NAV) was $17,673,760, broken down by asset class as
follows:
Asset Type Value
Equities portfolio $3,641,956
Bond portfolio 8,040,220
Real estate partnerships 5,194,933
- 29 -
Real estate 581,553
Oil and gas interests 215,098
Total 17,673,760
In determining the value of the gifted interest, Mr. Frazier
first (i.e., before applying any discounts) subtracts $20,000
from MIL’s NAV to reflect the class A limited partner’s $20,000
priority claim against MIL’s assets under the terms of the
partnership agreement.12 Dr. Bajaj makes no such preliminary
adjustment. We concur with Mr. Frazier’s approach in that
regard, and, therefore, we conclude that the appropriate base
amount for determining the value of the gifted interest is
$17,653,760.13
C. Minority Interest (Lack of Control) Discount
1. Introduction
A hypothetical buyer of the gifted interest would have
virtually no control over his investment. For instance, such
12
We note that the class A limited partner’s sole economic
interest in MIL consists of a guaranteed payment for the use of
such partner’s (nominal) capital. This case does not require us
to determine whether the class A limited partner is a partner of
MIL for Federal tax purposes.
13
For purposes of determining MIL’s NAV, Mr. Frazier does
not apply discounts to the real estate limited partnership
interests that McCord Brothers Partnership contributed to MIL
upon formation. Mr. Frazier did, however, discount the value of
those real estate limited partnership interests by 57.75 percent
for purposes of valuing McCord Brothers Partnership’s capital
contribution to MIL and determining the MIL partners’ percentage
interests in MIL. This case does not require us to address the
gift tax consequences, if any, of the initial capital
contributions to, and allocation of percentage interests in, MIL.
- 30 -
holder (1) would have no say in MIL’s investment strategy, and
(2) could not unilaterally recoup his investment by forcing MIL
either to redeem his interest or to undergo a complete
liquidation. Mr. Frazier and Dr. Bajaj agree that the
hypothetical “willing buyer” of the gifted interest would account
for such lack of control by demanding a reduced sales price;
i.e., a price that is less than the gifted interest’s pro rata
share of MIL’s NAV. They further agree that, in the case of an
investment company such as MIL, the minority interest discount
should equal the weighted average of minority interest discount
factors determined for each type of investment held by MIL:
equities, municipal bonds, real estate interests, and oil and gas
interests.
2. Discount Factors by Asset Class
a. Equity Portfolio
Mr. Frazier and Dr. Bajaj both determine the minority
interest discount factor for MIL’s equity portfolio by reference
to publicly traded, closed end equity investment funds.
Specifically, they both derive a range of discounts by
determining for a sample of closed end equity funds the discount
at which a share of each sample fund trades relative to its pro
rata share of the NAV of the fund.14 They differ in their
14
Unlike a shareholder of an open-end fund, a shareholder
of a closed end fund cannot, at will, by tendering his shares to
the fund for repurchase, obtain the liquidation value of his
(continued...)
- 31 -
selection of measurement dates, sample funds, and representative
discounts within the range of the sample fund discounts.
(1) Measurement Date
Mr. Frazier calculates discounts for his sample of closed
end equity funds on the basis of January 11, 1996, trading prices
and December 22, 1995, NAV information. Dr. Bajaj, on the other
hand, utilizes trading prices and NAV data as of the valuation
date; i.e., January 12, 1996. We agree with Dr. Bajaj that, to
the extent possible, data from January 12, 1996, should be
utilized to determine discounts with respect to the sample funds.
(2) Sample of Funds
Mr. Frazier derives his sample of closed end equity funds
from the list of “domestic equity funds” set forth in
Morningstar’s Mutual Funds Guide. From that list, he purports to
exclude from consideration “special purpose” funds (i.e., those
primarily invested in a specific industry), funds with a stated
maturity, and funds “that had provisions regarding votes to open-
14
(...continued)
investment (i.e., his pro rata share of the fund’s NAV). For
that reason, a share of a closed end fund typically trades at a
discount relative to its pro rata share of the fund’s NAV.
Since, according to the expert witnesses, that discount has no
marketability element, it is, to some extent, considered
reflective of a minority interest discount.
- 32 -
end the fund.”15 That screening process produced a sample of 14
funds.
Dr. Bajaj derives his sample of closed end equity funds from
the list of “general equity” funds set forth in the January 12,
1996 edition of the Wall Street Journal. For reasons not
entirely clear, Dr. Bajaj excludes two of those funds from
consideration, leaving a sample of 20 funds.16
Dr. Bajaj’s sample contains nine funds that Mr. Frazier
excludes from his sample. With regard to the first two of Mr.
Frazier’s three screening criteria, Dr. Bajaj states in his
rebuttal testimony that none of those nine funds was a special
purpose fund and that none had a stated maturity date. With
regard to Mr. Frazier’s third screening criterion, Dr. Bajaj
states that the fact that a fund’s shareholders can vote to open-
end the fund does not mean that such a conversion is imminent.
Dr. Bajaj also states that the summary descriptions (contained in
Mr. Frazier’s direct testimony) of five of the funds included by
15
As noted earlier, a shareholder of an open-end fund
generally can obtain the liquidation value of his investment
(i.e., his pro rata share of the fund’s NAV) by tendering his
shares to the fund for repurchase. It stands to reason that, to
the extent the conversion of a closed end fund to open-end status
is imminent, the share price of such fund will tend to approach
the fund’s NAV per share.
16
In his direct testimony, Dr. Bajaj states that the two
excluded funds “could not be identified in Morningstar Principia
dataset as of December 31, 1996". Since Mr. Frazier excludes
those funds from his sample as well, we similarly exclude them
from consideration.
- 33 -
Mr. Frazier in his sample of funds mention open-ending votes or
procedures, which, according to Mr. Frazier’s criteria, should
have required their exclusion.
In his rebuttal testimony, Mr. Frazier does not directly
challenge Dr. Bajaj’s inclusion of any specific fund in his
sample; rather, he simply asserts that “some of these funds could
have announced their intent to convert to an open-end fund” and
that “other funds may be non-diversified”. In the absence of
more specific objections to Dr. Bajaj’s additional sample funds,
we are persuaded to include such funds in our own analysis.
Mr. Frazier’s sample contains three funds that Dr. Bajaj
excludes from his sample: Gemini II, Quest for Value, and
Liberty All Star Growth Fund. Gemini II and Quest for Value were
“dual purpose” funds, which were scheduled for either liquidation
or open-ending in January 1997.17 Given the effect that the
impending liquidation or conversion may have had on share prices
of those funds, we exclude them from our analysis. Since Dr.
Bajaj’s rebuttal testimony raises no specific objection to the
inclusion of Liberty All Star Growth Fund in the sample, we
include that fund in our analysis.18
17
A dual purpose fund has both income shares and capital
shares. At a set expiration date, the fund redeems all income
shares, and the capital shareholders then vote either to
liquidate the fund or convert it to open-end status.
18
Dr. Bajaj may have excluded Liberty All Star Growth Fund
from his sample due to the lack of NAV information with respect
(continued...)
- 34 -
(3) Representative Discount Within the Range of Sample
Fund Discounts
Mr. Frazier concludes that, because an interest in MIL’s
equity portfolio would not compare favorably to an interest in an
institutional fund, the minority interest discount factor for
MIL’s equity portfolio should derive from the higher end of the
sample’s range of discounts. Dr. Bajaj, on the other hand,
concludes that such discount factor should derive from the lower
end of the range of discounts. For the reasons discussed below,
we find neither expert’s arguments convincing on that point.
Mr. Frazier concludes that a higher than average minority
interest discount factor for MIL’s equity portfolio is warranted
in part because of the relative anonymity of MIL’s investment
managers, the relatively small size of MIL’s equity portfolio,
and MIL’s policy of not making distributions (other than
distributions to satisfy tax obligations). However, Mr. Frazier
elsewhere testifies that, based on his regression analysis, there
is no clear correlation between the discounts observed in his
sample of closed end funds and any of the variables he analyzed,
including Morningstar rating (largely indicative of management
reputation), the size of the fund, and distributions as a
percentage of NAV. We are similarly unpersuaded by Mr. Frazier’s
18
(...continued)
to such fund as of the valuation date. For purposes of our
analysis, we utilize the fund’s NAV and price data as of Jan. 5,
1996, which is in the record.
- 35 -
assertion (unsupported by empirical evidence) that fewer
administrative and regulatory controls on MIL’s investment
activity (as compared to that of institutional funds) should
result in a higher discount factor as a matter of course.19
Dr. Bajaj’s argument that the minority interest discount
factor for MIL’s equity portfolio should derive from the lower
end of the range of observed discounts is based primarily on the
premise that, on the valuation date, MIL was akin to a new
investment fund. Dr. Bajaj’s research, along with that of others
cited in his direct testimony, indicates that new investment
funds tend to trade at lower discounts than seasoned funds.
However, Dr. Bajaj’s analysis fails to recognize that, while MIL
was a relatively new entity on the valuation date, its equity
portfolio had been in place (in the hands of the contributing
partners) for years. Furthermore, of the four factors that Dr.
Bajaj specifically identifies as possible determinants of lower
initial fund discounts, only one-–lack of unrealized capital
gains-–perhaps would have informed the pricing decision of a
hypothetical buyer of an interest in MIL.20 The other factors
19
For instance, less regulation implies lower compliance
costs, which seemingly would offset, at least to some extent, any
pricing effect of relatively lax investor protections.
20
Although MIL inherited any unrealized gain with respect
to assets contributed by the initial MIL partners, see sec. 723,
the portion of such precontribution gain otherwise allocable to a
subsequent purchaser of an interest in MIL, see sec. 1.704-
3(a)(7), Income Tax Regs., generally would be eliminated if the
(continued...)
- 36 -
cited by Dr. Bajaj (the initial diminution of fund NAV relative
to issue proceeds due to flotation and other startup costs, the
prevalence of new funds in “hot” investment sectors, and the
initial lack of management inefficiencies) simply do not readily
translate from the public capital markets to the hypothetical
private sale of an interest in MIL.
Because we are unpersuaded by the respective arguments of
Mr. Frazier and Dr. Bajaj for a higher than average or lower than
average minority interest discount factor for MIL’s equity
portfolio, we utilize the average discount of the sample funds
under consideration.21
(4) Summary
In determining the appropriate minority interest discount
factor for MIL’s equity portfolio, we utilize (1) Dr. Bajaj’s
price and NAV data as of January 12, 1996 (with the exception of
Liberty All Star Growth Fund, for which we utilize NAV data from
January 5, 1996, contained in the record); (2) Dr. Bajaj’s sample
of funds, with the addition of Liberty All Star Growth Fund; and
20
(...continued)
general partners of MIL were to agree to make a timely sec. 754
election with respect to MIL. See secs. 754, 743(b); sec. 1.755-
1(b)(1)(ii), Income Tax Regs. The same would be true with
respect to any postcontribution unrealized appreciation with
respect to MIL’s assets.
21
In their reports, Mr. Frazier and Dr. Bajaj determine
the average, but not the weighted average, of the discounts with
respect to the equity funds in their respective samples. We
follow the same approach here.
- 37 -
(3) the average discount of the sample funds. The resulting
discount factor is 9.96 percent, which we round up to 10 percent.
b. Municipal Bond Portfolio
Both Mr. Frazier and Dr. Bajaj determine the minority
interest discount factor for MIL’s municipal bond portfolio by
reference to publicly traded, closed end municipal bond
investment funds. Once again, they disagree on measurement
dates, sample funds, and representative discounts within the
range of the sample fund discounts.
(1) Measurement Date
Mr. Frazier calculates discounts for his sample closed end
municipal bond funds on the basis of January 11, 1996, trading
prices and December 25, 1995, NAV data. Dr. Bajaj utilizes
trading prices and NAV information as of the valuation date;
i.e., January 12, 1996. We agree with Dr. Bajaj that, to the
extent possible, data from January 12, 1996, should be utilized
in determining discounts with respect to the sample funds.
(2) Sample of Funds
Mr. Frazier derives his sample of closed end municipal bond
funds from the list of municipal bond funds set forth in
Morningstar’s Mutual Funds Guide. In his direct testimony, Mr.
Frazier indicates that he excluded from consideration funds that
were “heavily weighted toward a specific sector” and funds with
scheduled liquidation dates. With regard to the first screening
- 38 -
factor, it appears that Mr. Frazier was referring to single-State
funds. Mr. Frazier’s screening process produced a sample of
eight funds.
Dr. Bajaj derives his sample from the list of 140 closed end
municipal bond funds set forth in the January 15, 1996 edition of
the Wall Street Journal. For reasons not entirely clear, Dr.
Bajaj excludes six of the funds from consideration, leaving a
sample of 134 funds.22 That sample includes numerous single-
State funds and funds with scheduled liquidation dates.
We agree with Mr. Frazier that funds with scheduled
liquidation dates should not be included in the sample. However,
given the fact that Louisiana-based obligations accounted for
approximately 75 percent of the value of MIL’s bond portfolio, we
are somewhat puzzled by Mr. Frazier’s exclusion of single-State
funds from his sample. Indeed, we believe that the sample should
consist entirely of single-State funds. We therefore utilize a
sample consisting of the 62 single-State funds in Dr. Bajaj’s
sample that do not have scheduled liquidation dates.
(3) Representative Discount Within the Range of Sample
Fund Discounts
As is the case with MIL’s equity portfolio, Mr. Frazier
concludes that the minority interest discount factor for MIL’s
bond portfolio should derive from the higher end of the sample’s
22
In his direct testimony, Dr. Bajaj states that the six
excluded funds “could not be identified in Morningstar Principia
dataset as of December 31, 1996".
- 39 -
range of discounts, while Dr. Bajaj concludes that such discount
factor should derive from the lower end of the range of
discounts. Once again, we find neither expert’s arguments
convincing on this point.
Mr. Frazier states that, according to his regression
analysis, the three factors that are the most determinative of
discounts with respect to the closed end funds in his sample are
(1) distributions as a percentage of NAV, (2) built-in gain as a
percentage of NAV, and (3) 3-year average annual return. We see
no error in Mr. Frazier’s calculation of his first factor,
although he seems to take the same factor into account as an
aspect of the discount for lack of marketability. With regard to
the second two factors, Mr. Frazier provides no data with respect
to MIL’s bond portfolio that can be compared to the data from his
sample funds. Mr. Frazier also repeats factors that he deemed
relevant in the context of MIL’s equity portfolio,
notwithstanding the fact that his own regression analysis
indicates little, if any, correlation between those factors
(management quality and the size of the fund) and the level of
discounts in his bond fund sample.23
23
Mr. Frazier’s regression analysis produced R-squared
calculations of 0.29 for the Morningstar rating (management
quality) variable and 0.01 for the fund size variable. Elsewhere
in his direct testimony, Mr. Frazier indicates that an R-squared
calculation of 0.34 is “relatively low”, leading to the
conclusion of “no clear correlation” between the variable in
question and the level of sample fund discounts.
- 40 -
Dr. Bajaj applies his “new fund” analysis, discussed above
in the context of MIL’s equity portfolio, to MIL’s bond portfolio
as well. Again, Dr. Bajaj’s analysis fails to recognize that,
while MIL was a relatively new entity on the valuation date, its
bond portfolio had been in place (in the hands of the
contributing partners) for years. For that reason and the other
reasons discussed supra in section V.C.2.a.(3), we reject this
portion of Dr. Bajaj’s analysis.
Because we are unpersuaded by the respective arguments of
Mr. Frazier and Dr. Bajaj for a higher than average or lower than
average minority interest discount factor for MIL’s bond
portfolio, we utilize the average discount of the sample funds
under consideration.24
(4) Summary
In determining the appropriate minority interest discount
factor for MIL’s bond portfolio, we utilize (1) Dr. Bajaj’s price
and NAV data as of January 12, 1996, (2) a sample of funds
consisting of the 62 single-State funds in Dr. Bajaj’s sample
that do not have scheduled liquidation dates, and (3) the average
discount of the sample funds. The resulting discount factor is
9.76 percent, which we round up to 10 percent.
24
In their reports, Mr. Frazier and Dr. Bajaj determine
the average, but not the weighted average, of the discounts with
respect to the bond funds in their respective samples. We follow
the same approach here.
- 41 -
c. Real Estate Partnerships25
(1) The Appropriate Comparables
In contrast to their opinions regarding MIL’s equity and
bond portfolios, Dr. Bajaj and Mr. Frazier sharply disagree on
the general type of publicly traded entity from which to
extrapolate the minority interest discount factor for MIL’s real
estate partnership interests. Dr. Bajaj argues that the discount
factor should be based on data pertaining to real estate
investment trusts (REITs).26 Mr. Frazier, on the other hand,
excludes REITs from consideration “since they are primarily
priced on a current yield basis because REITs are required by law
to annually pay out a large portion of earnings to shareholders.”
That justification overlooks the fact that the investment funds
Mr. Frazier analyzes in determining the minority interest
discount factors for MIL’s equity and bond portfolios are also
required to distribute substantially all of their income each
year in order to maintain their tax-favored status as regulated
investment companies (RICs). Compare sec. 852(a)(1) (income
distribution requirement for RICs) with sec. 857(a)(1) (income
distribution requirement for REITs). In the absence of any
25
Dr. Bajaj limits his real estate analysis to MIL’s real
estate partnership interests. We address the minority interest
discount factor for MIL’s direct real estate holdings infra in
sec. V.C.2.d.
26
A real estate investment trust is a tax-favored vehicle
through which numerous investors can pool their resources to
invest in real estate. See secs. 856-859.
- 42 -
explanation as to why the current distribution requirement should
disqualify REITs (but not RICs) from consideration in our
analysis, we are persuaded to evaluate the REIT data.
We are further persuaded to utilize the REIT data in light
of the alternative offered by Mr. Frazier. Mr. Frazier’s search
for “comparable” publicly traded real estate companies yielded a
sample of five companies, and he derives his range of discounts
from only three of those companies. While we have utilized small
samples in other valuation contexts, we have also recognized the
basic premise that “[a]s similarity to the company to be valued
decreases, the number of required comparables increases”. Estate
of Heck v. Commissioner, T.C. Memo. 2002-34. One of Mr.
Frazier’s three sample companies developed planned communities,
conducted farming operations, and owned royalty interests in more
than 200 oil and gas wells. Another owned and managed shopping
centers and malls and developed the master-planned community of
Columbia, Maryland. The assets and activities of those companies
are not sufficiently similar to those of MIL’s real estate
partnerships to justify the use of such a small sample.27
In contrast, Dr. Bajaj’s REIT sample consists of 62
companies. In recognition of the fact that two of the real
estate limited partnerships in which MIL was a partner owned
27
Cf. Estate of Desmond v. Commissioner, T.C. Memo.
1999-76 (approving the use of the market approach for valuing an
operating business based on two guideline companies in the same
-–as opposed to similar-–line of business).
- 43 -
unimproved land that could be used for a variety of purposes, Dr.
Bajaj’s sample includes REITs specializing in a broad array of
real estate investments, including office, residential, and
retail properties. Given the size of the sample, we believe that
any dissimilarities in the assets and activities of particular
REITs in the sample as compared to those of MIL’s real estate
partnerships are tolerable.28
(2) Determining the Discount Factor
Because REITs offer investors the opportunity to invest in
an illiquid asset (i.e., the underlying real estate) in liquid
form (i.e., the REIT shares), investors in REITs are willing to
pay a liquidity premium (relative to NAV) to invest in REIT
shares. According to Dr. Bajaj, that does not imply that a
minority discount is nonexistent; it only means that the
difference between price and NAV for a REIT may have two
components, one positive (the liquidity premium) and one negative
(the minority discount). From his sample data, Dr. Bajaj
calculated a median price-to-NAV premium of 3.7 percent. To be
conservative and to reflect MIL’s distribution policy, Dr. Bajaj
looked below the median, to the 25th percentile, and began with a
price-to-NAV discount of 1.3 percent (an adjustment to NAV of
minus (-) 1.3 percent). Since Dr. Bajaj believes that that
28
We note that, while Mr. Frazier questions the
composition of Dr. Bajaj’s sample of REITs, he offers no specific
suggestions for modifying the sample.
- 44 -
adjustment reflects both a minority discount and a (smaller)
liquidity premium, he then proceeded to identify (and eliminate
the effect of) the liquidity premium in order to determine the
minority discount. Based on his opinion that, as of the
valuation date, the prevailing “illiquidity” discount for
privately placed restricted stock was approximately 7 percent, he
calculated a 7.53-percent liquidity premium.29 Based on that
liquidity premium of 7.53 percent and his selected price-to-NAV
discount of 1.3 percent from his REIT sample, Dr. Bajaj added the
two percentages to calculate a minority discount of 8.83 percent
(i.e., he increased the price-to-NAV discount to reflect the
elimination of the effect of the liquidity premium), which he
rounded to 9 percent.
Using the same procedure as Dr. Bajaj, but substituting an
illiquidity discount of 18 percent for his 7-percent figure, we
arrive at a liquidity premium of 22 percent and therefore
conclude that the minority discount imbedded in the 1.3-percent
price-to-NAV discount selected from the REIT sample is 23.3
percent, which we shall apply to MIL’s real estate partnership
interests. We have substituted 18 percent for 7 percent because,
as discussed infra in section V.D.5.a., Dr. Bajaj has not been
clear in distinguishing between the apparently different (but
29
As Dr. Bajaj explains his calculation: “If an illiquid
security trades at a discount of 7% relative to a liquid asset,
this suggests that the liquid asset is trading at a premium of
about 7.53% relative to the illiquid asset (1/[1-7%]).”
- 45 -
overlapping) concepts of “marketability” and “liquidity”. Our
substitute percentage derives from a published study referenced
in his direct testimony (the Wruck study)30 which reported that,
on average, discounts observed in private placements of
unregistered shares exceeded those observed in private placements
of registered shares (freely tradable in the public market) by
17.6 percentage points, which we round up to 18 percent. The
theory, discussed in more detail infra in section V.D.4., is that
such additional discount represents, to some degree, pure
illiquidity concerns, since a ready, public market is available
to owners of registered shares and unavailable to owners of
restricted shares.
d. Direct Real Estate Holdings
Respondent has instructed Dr. Bajaj to base his value
conclusion regarding MIL’s direct real estate holdings on the 40-
percent minority interest discount factor for those assets
appearing in the 1996 HFBE appraisal report. On that basis, we
find that the minority interest discount factor for MIL’s direct
real estate holdings is 40 percent.
e. Oil and Gas Interests
Mr. Frazier assigns a 33.5-percent minority interest
discount factor to MIL’s oil and gas interests. Respondent has
30
Wruck, “Equity Ownership Concentration and Firm Value:
Evidence from Private Equity Financings,” 23 J. Fin. Econ. 3
(1989).
- 46 -
instructed Dr. Bajaj to base his value conclusion regarding the
oil and gas component of MIL’s portfolio on the 33.5-percent
minority interest discount factor for those assets appearing in
the 1996 HFBE appraisal report. On that basis, we find that the
minority interest discount factor for MIL’s oil and gas
investments is 33.5 percent.
3. Determination of the Minority Interest Discount
The minority interest discount factors determined above
yield a weighted average discount of 15.18 percent, determined as
follows:31
Percent Percent
Asset Percent Disc. Weighted
Class of NAV Factor Average
Equities 20.6 10.0 2.06
Bonds 45.5 10.0 4.55
R.E. pships. 29.4 23.3 6.85
Real estate 3.3 40.0 1.32
Oil and gas 1.2 33.5 0.40
discount 15.18
Rounding to the nearest percentage point, we conclude that the
appropriate minority interest discount with respect to the gifted
interest is 15 percent.
D. Marketability Discount
1. Introduction
The parties agree that, to reflect the lack of a ready
market for assignee interests in MIL, an additional discount
(after applying the minority interest discount) should be applied
31
Mr. Frazier and Dr. Bajaj agree on the percentages of
NAV assigned to each asset class.
- 47 -
to the net asset value of MIL’s assets to determine the fair
market value of the gifted interest. Such a discount is commonly
referred to as a “marketability discount”. The marketability
discount analyses of Mr. Frazier and Dr. Bajaj differ from their
minority interest discount analyses in that they seek to identify
a single, “entity-wide” discount rather than a weighted average
of discount factors specific to each category of assets held by
MIL. The parties disagree as to the amount of that discount.
2. Traditional Approaches to Measuring the Discount
a. In General
Mr. Frazier and Dr. Bajaj agree that empirical studies of
the marketability discount fall into two major categories. The
first major category, the IPO approach, consists of studies that
compare the private-market price of shares sold before a company
goes public with the public-market price obtained in the initial
public offering (IPO) of the shares or shortly thereafter. The
second major category, the restricted stock approach, consists of
studies that compare the private-market price of restricted
shares of public companies (i.e., shares that, because they have
not been registered with the Securities and Exchange Commission,
generally cannot be sold in the public market for a 2-year
period)32 with their coeval public-market price. Mr. Frazier
32
See 17 C.F.R. sec. 230.144(d)(1) (1996). The required
holding period was shortened to 1 year in 1997. See 62 Fed. Reg.
9242 (Feb. 28, 1997).
- 48 -
relies primarily on data from the restricted stock approach to
support a marketability discount of 35 percent, although he also
contends that data from the IPO approach strongly support that
level of discount. Dr. Bajaj relies on a variant of the
restricted stock approach, which we shall refer to as the
private placement approach, to support a marketability discount
of 7 percent.
b. Rejection of IPO Approach
Dr. Bajaj argues that the IPO approach is flawed both in
concept and in application. His principal criticism is that the
IPO premium (over the pre-IPO private market price) may reflect
more than just the availability of a ready market. He believes
that buyers of shares prior to the IPO are likely to be insiders
who provide services to the firm and who are compensated, at
least in part, by a bargain price. More importantly, he believes
that a pre-IPO purchaser demands compensation (in the form of a
lower price) for bearing the risk that the IPO will not occur or
will occur at a lower price than expected. His opinion is:
“[T]he IPO approach probably generates inflated estimates of the
marketability discount. Consequently, it is of limited use in
estimating the value of closely held firms.”
In his rebuttal testimony, Mr. Frazier fails to offer any
rebuttal of Dr. Bajaj’s criticism of the IPO approach. Mr.
Frazier’s support for the IPO approach consists only of his
- 49 -
reference to a series of studies undertaken by Shannon Pratt,
Chairman of Willamette Management Associates, Inc., a national
business valuation firm (the Willamette studies). Without
explaining the basis of his testimony, Mr. Frazier’s opinion is:
“[T]he evidence from the Willamette study was quite compelling
and offered strong support for the hypothesis that the fair
market values of minority interests in privately held companies
were and should be greatly discounted from their publicly-traded
counterparts.”
By contrast, in his rebuttal testimony, Dr. Bajaj offers a
compelling criticism of both the Willamette studies and another
series of studies undertaken by John D. Emory, vice president of
appraisal services at Robert W. Baird and Co., a regional
investment banking firm.33 He concludes that the latest study
conducted by Mr. Emory is biased because it does not adequately
take into account the highest sale prices in pre-IPO
transactions, and he criticizes the Willamette studies for not
disclosing enough data to reveal whether they suffer from a
similar bias. Dr. Bajaj has convinced us to reject as unreliable
Mr. Frazier’s opinion to the extent it is based on the IPO
approach. We shall proceed to consider Mr. Frazier’s restricted
stock analysis and Dr. Bajaj’s private placement analysis.
33
Mr. Frazier relied on Mr. Emory’s studies in the 1996
HFBE appraisal report but makes no mention of those studies in
either his direct testimony or his rebuttal testimony.
- 50 -
3. Mr. Frazier’s Restricted Stock Analysis
Mr. Frazier reviews four studies under the restricted stock
approach34 and then attempts to infer an appropriate
marketability discount by “placing” MIL within the range of
observed discounts in those studies and the Willamette studies,
on the basis of certain characteristics of MIL (revenue, income,
and NAV) and the gifted interest (size of the interest, expressed
both as a percentage of MIL and as a dollar amount). The results
of that attempt are set forth in Table 31 of the report
constituting Mr. Frazier’s direct testimony (Table 31). Based on
data from the five studies, Mr. Frazier identifies 10
hypothetical discount levels for the gifted interest (some
expressed as a specific percentage, e.g., “33.6%”, and some
expressed as being greater or less than a specific percentage,
e.g., “>35%”). Six of the hypothetical discounts were greater
than 35 percent and four were less than 35 percent. He states:
34
Mr. Frazier reviews the following studies (the
restricted stock studies):
1. Securities and Exchange Commission, Discounts Involved
in Purchases of Common Stock (1966-1969), H.R. Doc. No. 64,
Part 5, at 2444-2456 (1971).
2. Silber, “Discounts on Restricted Stock: The Impact of
Illiquidity on Stock Prices,” Financial Analysts Journal,
July-August 1991, at 60.
3. A study only described as “The Standard Research
Consultants (SRC) Study”.
4. Hertzel & Smith, “Market Discounts and Shareholder Gains
for Placing Equity Privately,” 48 J. Fin. 459 (1993).
- 51 -
“Based on these studies alone, we concluded that the discount
applicable to the Partnership’s block should approximate 35
percent.”
We find several flaws in Mr. Frazier’s analysis. For
example, Table 31 indicates that MIL’s projected revenue of
$681,000 is consistent with a discount of 51.9 percent based on
data from the Willamette studies. The Willamette studies are IPO
studies rather than restricted stock studies, and they do not, so
far as we can tell from Mr. Frazier’s testimony, analyze firm
revenues.35 Table 31 also indicates that one can infer a
discount from the “Hertzel and Smith” study based on the
proportional size of the offering, although Mr. Frazier gives no
indication that that study drew any correlations between that
variable and the level of discount. Furthermore, under the
heading “Size of Block as % Total Outstanding” in Table 31, the
entry corresponding to MIL is “1.0%”, when in fact each half of
the gifted interest represents a greater than 40-percent interest
with respect to MIL. Similarly, although there is no entry in
Table 31 for the dollar size of the gifted interest, it is
evident that the “>35%” discount inferred from that variable in
Table 31 is based on the same mischaracterization of each half of
35
Indeed, under the heading “Revenues” in Table 31 of Mr.
Frazier’s direct report, the entry corresponding to “Willamette”
is “NA”.
- 52 -
the gifted interest as a 1-percent interest in MIL.36 In light
of those numerous defects, we give little weight to Mr. Frazier’s
restricted stock analysis.
4. Dr. Bajaj’s Private Placement Analysis
a. Comparison of Registered and Unregistered Private
Placements
Dr. Bajaj believes that the discounts observed in restricted
stock studies are attributable in part to factors other than
impaired marketability.37 In support of his position, Dr. Bajaj
analyzes data from studies (including his own unpublished
study)38 involving both registered private placements and
unregistered private placements (the private placement studies).
He observes that, if discounts found in unregistered (restricted)
private placements are attributable solely to impaired
marketability, then there should be no discounts associated with
36
Specifically, one restricted stock study, the Silber
study, found that the average dollar size of private placements
with discounts in excess of 35 percent was $2.7 million, while
the average dollar size of private placements with discounts less
than 35 percent was $5.8 million. Even taking into account Mr.
Frazier’s suggested minority interest discount of 22 percent, the
“dollar size” of each half of the gifted interest was
approximately $5.7 million. That would indicate that, based on
the Silber study, a discount of less than 35 percent would be
appropriate for each half of the gifted interest.
37
We note that such other factors should not include the
purchaser’s minority ownership position, if applicable;
presumably, a minority interest discount is already reflected in
the market price of a share of the issuer.
38
Other than his own study, he refers to the Wruck study,
supra note 30, and the Hertzel & Smith study, supra note 34.
- 53 -
registered private placements (i.e., because such shares can be
sold in the public market). However, the results of the private
placement studies indicate that even registered private placement
shares are issued at a discount, although such discounts tend to
be lower than those observed in unregistered private placements.
Dr. Bajaj explains that phenomenon by positing that privately
placed shares, whether registered or unregistered, tend to be
issued to purchasers of large blocks of stock who demand
discounts to compensate them for assessment costs and anticipated
monitoring costs. He states: “The discount offered to buyers is
a compensation for the cost of assessing the quality of the firm
and for the anticipated costs of monitoring the future decisions
of its managers.”
b. Refinement of Registered/Unregistered
Discount Differential
Dr. Bajaj further contends that the additional discount
typical of unregistered private placements (as compared to
registered private placements) is not entirely attributable to
the fact that unregistered shares, unlike registered shares,
generally cannot be sold in the public market. Rather, he
contends that such differential is attributable in part to higher
assessment and monitoring costs incurred in unregistered private
placements as compared to registered private placements. In
support of his theory, Dr. Bajaj suggests four factors that might
have a correlative relationship to assessment and monitoring
- 54 -
costs and, by extension, to private placement discounts: (1) the
size of the private placement relative to the issuer’s total
shares outstanding, (2) the volatility of the issuer’s recent
economic performance, (3) the overall financial health of the
issuer, and (4) the size of the private placement in terms of
total proceeds. Dr. Bajaj posits that the additional discount
observed in unregistered issues could be attributable solely to
impaired marketability only if those four additional factors were
present in equal measure among both registered and unregistered
private placements.
Dr. Bajaj analyzes the effects of the four additional
factors listed above and concludes that the first three (but not
the fourth) of those factors are systematically related to the
level of private placement discounts. Specifically, he concludes
that, relatively speaking, a high ratio of privately placed
shares to total shares of the issuer, high issuer volatility, and
weak financial health of the issuer tend to be indicative of
higher discounts. Dr. Bajaj then demonstrates that, as compared
to registered private placements, unregistered private placements
tend to involve a higher percentage of the issuer’s total shares,
higher issuer volatility, and financially weaker issuers. That
being the case, Dr. Bajaj concludes that the registered-
unregistered private placement discount differential must be
attributable in part to those three factors rather than just
- 55 -
impaired marketability. In other words, the additional discount
typical of unregistered private placements as compared to
registered private placements does not represent solely
compensation for impaired marketability but represents in part
compensation for the relatively higher assessment and anticipated
monitoring costs normally associated with unregistered issues.
Having concluded that factors unrelated to impaired
marketability play a variable role in the total discounts
observed in private placement transactions, Dr. Bajaj then
attempts to isolate the effect that impaired marketability has on
such total discounts. To that end, he adds a variable for stock
registration to variables representing the three additional
correlative factors and uses the statistical technique of
multivariate regression to determine the effect of each such
variable on the discounts observed in his sample of private
placements. He concludes from that analysis that, over the 1990
to 1995 period of his study, a private issue that was registered
(thereby allowing purchasers to immediately resell in the public
market) would have required a discount that was 7.23 percentage
points less than an otherwise identical issue (in terms of the
three additional correlative factors) that was unregistered.
c. Further Adjustments
Dr. Bajaj considers and rejects any additional adjustment
(discount) on account of the long-term impaired marketability of
- 56 -
an assignee interest in MIL39 as compared to the limited impaired
marketability of restricted shares of stock. His rejection is
based primarily on his opinion, supported by the economic
analysis of others,40 that the level of discount does not
continue to increase with the time period of impaired
marketability, because investors with long-term horizons would
provide a natural clientele for holding illiquid assets and would
compete to purchase all or a portion of the gifted interest.
d. Application to MIL
Dr. Bajaj concludes:
Considering the available data, the Partnership’s
holdings and history, and the marketability discount of
7.23% suggested by my regression analysis involving a
broad range of economic sectors, I conclude that a
marketability discount of 7% [rounded from 7.23
percent] is appropriate for all the assets held by MIL
when valuing the subject interest. * * *
5. Determination of the Marketability Discount
a. Discussion
Mr. Frazier, in his testimony in rebuttal to Dr. Bajaj,
criticizes Dr. Bajaj for focusing narrowly on “liquidity” at the
expense of other factors that contribute to a lack of
marketability. Mr. Frazier states that “[t]he impediments to
value associated with inability to easily sell an interest in a
39
Both experts operate under the assumption that there
will not be a ready market for assignee interests in family
limited partnerships during the remainder of MIL’s 30-year term.
40
Amihud & Mendelson, “Asset Pricing and Bid-Ask Spread,”
17 J. Fin. Econ. 223 (1986).
- 57 -
closely-held entity go well beyond the narrowly defined
‘liquidity costs’ Dr. Bajaj has isolated in his analysis” and
that “the [marketability] discount is caused not by just
‘liquidity’ but the other negative characteristics that attend
securities issued by small closely-held entities.”
Dr. Bajaj has indeed been helpful in focusing our attention
(and Mr. Frazier’s attention) on the distinction between
illiquidity and other factors (e.g., assessment and monitoring
costs) that contribute to private placement discounts. However,
his apparent confusion regarding the nature of the discount for
lack of marketability (i.e., whether such discount can be
explained purely in terms of illiquidity or whether other factors
may be involved) is troubling. In his direct testimony, Dr.
Bajaj is fairly clear that assessment and monitoring costs
associated with private placements are outside the realm of the
marketability discount. In his rebuttal testimony, however, he
indicates that such costs may contribute to the marketability
discount for a closely held entity. That leads us to question
whether other “negative characteristics” (in the words of
Mr. Frazier) associated with closely held entities may contribute
to the appropriate marketability discount for an assignee
interest in MIL. Therefore, while we are impressed by portions
of Dr. Bajaj’s analysis, he has not convinced us that the
- 58 -
appropriate marketability discount in this case can be inferred
from the illiquidity cost associated with private placements.
Although we reject Dr. Bajaj’s quantification of the
appropriate marketability discount in this case, we look to the
data from his private placement study for two reasons. First, we
believe that, given MIL’s status as an investment company,41 what
Dr. Bajaj refers to in the context of private placements as
assessment and monitoring costs would be relatively low in the
case of a sale of an interest in MIL. That belief, coupled with
Dr. Bajaj’s persuasive argument that such costs are relatively
high in unregistered private placements, leads us to conclude
that a sample consisting entirely of unregistered private
placements would be inappropriately skewed. Second, only Dr.
Bajaj’s study (and not the other private placement studies on
which he relies) covers the period (1990-1995) immediately
preceding the valuation date.
In Table 10 of the report constituting his direct testimony,
Dr. Bajaj separates the 88 private placements in his sample into
three groups according to the level of discounts (i.e., the 29
lowest discounts, the middle 29 discounts, and the 30 highest
discounts). Presumably, the “low” category is dominated by
41
On the valuation date, 65 percent of MIL’s assets
consisted of marketable securities and an additional 30 percent
consisted of real estate limited partnership interests, subject
to well-known and relatively routine appraisal techniques (such
as cashflow analysis or market multiple methods).
- 59 -
registered private placements which, unlike an assignee interest
in MIL, did not suffer from impaired marketability. Similarly,
it is likely that the “high” category is dominated by
unregistered private placements which, unlike the sale of an
interest in an investment company, entailed relatively high
assessment and monitoring costs. Accordingly, we look to the
“middle” group of private placements in Dr. Bajaj’s sample in
determining the appropriate marketability discount for an
assignee interest in MIL. The average discount of that group of
private placements was 20.36 percent.42 We are not persuaded
that we can refine that figure any more to incorporate
characteristics specific to MIL.
b. Conclusion
We find that a discount for lack of marketability of 20
percent (rounded from 20.36 percent) is appropriate in
determining the fair market value of each half of the gifted
interest.
E. Conclusion
We conclude that the fair market value of each half of the
gifted interest is $4,941,916, determined as follows:43
42
That discount is consistent with the average discount
(20.14 percent) observed in the Hertzel & Smith private placement
study, supra note 34, the study (other than his own) primarily
relied upon by Dr. Bajaj.
43
For ease of computation, we determine the fair market
value of a 1-percent interest.
- 60 -
Total NAV $17,673,760
Less: Class A preference (20,000)
“Net” NAV 17,653,760
1 percent of net NAV 176,538
Less: 15-percent minority
interest discount (26,481)
Marketable value 150,057
Less: 20-percent
marketability discount (30,011)
FMV of 1-percent interest 120,046
FMV of 41.16684918-percent 4,941,916
interest
VI. Charitable Contribution Deduction for Transfer to CFT
A. Introduction
The gift tax is imposed on the value of what the donor
transfers, not what the donee receives. Shepherd v.
Commissioner, 115 T.C. 376, 385 (2000) (citing, inter alia,
Robinette v. Helvering,
318 U.S. 184, 186 (1943)), affd.
283 F.3d
1258 (11th Cir. 2002). In essence, petitioners contend that
because (1) they transferred to CFT a portion of the gifted
interest corresponding to the excess of the fair market value of
that interest over $7,044,933, and (2) we have determined the
fair market value of the gifted interest to be $9,883,832, it
follows from the maxim beginning this paragraph that they are
entitled to a charitable contribution deduction in the amount of
$2,838,899 for their gift to CFT. Because the assignment
agreement does not equate the term “fair market value” with the
term “fair market value as finally determined for Federal gift
tax purposes,” petitioners’ argument must fail.
- 61 -
B. The Assignment Agreement
By way of the assignment agreement, petitioners transferred
to CFT the right to a portion of the gifted interest. That
portion was not expressed as a specific fraction of the gifted
interest (e.g., one-twentieth), nor did petitioners transfer to
CFT a specific assignee interest in MIL (e.g., a 3-percent
assignee interest). Rather, CFT was to receive a fraction of
the gifted interest to be determined pursuant to the formula
clause contained in the assignment agreement. The formula
clause provides that CFT is to receive that portion of the
gifted interest having a fair market value equal to the excess
of (1) the total fair market value of the gifted interest, over
(2) $7,044,933. The formula clause is not self-effectuating, and
the assignment agreement leaves to the assignees the task of (1)
determining the fair market value of the gifted interest and (2)
plugging that value into the formula clause to determine the
fraction of the gifted interest passing to CFT.
Petitioners argue that, because the assignment agreement
defines fair market value in a manner that closely tracks the
definition of fair market value for Federal gift tax purposes,
see sec. 25.2512-1, Gift Tax Regs., the assignment agreement
effects a transfer to CFT of a portion of the gifted interest
determinable only by reference to the fair market value of that
interest as finally determined for Federal gift tax purposes. We
- 62 -
do not believe that the language of the assignment agreement
supports petitioners’ argument. The assignment agreement
provides a formula to determine not only CFT’s fraction of the
gifted interest but also the symphony’s and the children’s
(including their trusts’) fractions.44 Each of the assignees had
the right to a fraction of the gifted interest based on the value
of that interest as determined under Federal gift tax valuation
principles. If the assignees did not agree on that value, then
such value would be determined (again based on Federal gift tax
valuation principles) by an arbitrator pursuant to the binding
arbitration procedure set forth in the partnership agreement.
There is simply no provision in the assignment agreement that
contemplates the allocation of the gifted interest among the
assignees based on some fixed value that might not be determined
44
If f equals the fair market value of the gifted interest
(determined by the assignees (or an arbitrator) based on Federal
gift tax valuation principles), and the gifted interest is shown
as the 82.33369836 percent class B assignee interest in MIL
transferred by petitioners, then, assuming f is equal to or
greater than $7,044,933, the products of the following formulas
show the percentage assignee interests apportioned to the
children (including the trusts), the symphony, and CFT, expressed
as x1, x2, and x3, respectively:
$6,910,933
× 82.33369836% = x 1
f
$7,044,933 − 6,910,933
× 82.33369836% = x 2
f
f − $7,044,933
× 82.33369836% = x 3
f
- 63 -
for several years. Rather, the assignment agreement contemplates
the allocation of the gifted interest based on the assignees’
best estimation of that value. Moreover, each of the assignees’
percentage interests was determined exactly as contemplated in
the assignment agreement (without recourse to arbitration), and
none can complain that they got any less or more than petitioners
intended them to get.45 Had petitioners provided that each donee
had an enforceable right to a fraction of the gifted interest
determined with reference to the fair market value of the gifted
interest as finally determined for Federal gift tax purposes,46
we might have reached a different result. However, that is not
what the assignment agreement provides.
45
We suppose that, at least in theory, there might be a
difference between (1) petitioners’ and the assignees’
expectation on Jan. 12, 1996 (the valuation date), regarding the
value of the portion of the gifted interest passing to CFT and
(2) the value of that portion as subsequently determined by the
assignees. However, no one has suggested how to value the first
quantity or that, on the facts before us, the difference would be
significant.
46
See, e.g., sec. 1.664-2(a)(1)(iii), Income Tax Regs.
(providing that a sum certain may be expressed as a fraction or
percentage of the value of property “as finally determined for
Federal tax purposes”, but requiring that actual adjusting
payments be made if such finally determined fair market value
differs from the initially determined value); sec. 20.2055-
2(e)(2)(vi)(a), Estate Tax Regs. (similar); sec. 25.2702-
3(b)(1)(ii)(B), Gift Tax Regs. (similar); Rev. Proc. 64-19, 1964-
1 C.B. 682 (discussing conditions under which the Federal estate
tax marital deduction may be allowed where, under the terms of a
will or trust, an executor or trustee is empowered to satisfy a
pecuniary bequest or transfer in trust to a decedent's surviving
spouse with assets at their value as finally determined for
Federal estate tax purposes).
- 64 -
Of course, the assignees’ determination of the fair market
value of the gifted interest, while binding among themselves for
purposes of determining their respective assignee interests, has
no bearing on our determination of the Federal gift tax value of
the assignee interests so allocated. Since we find that the fair
market value of a 1-percent assignee interest in MIL on the
valuation date was $120,046, the following table expresses the
fair market values of the percentage assignee interests passing
to the various assignees:
Percentage Fair Market
Assignee Assignee Interest Value
Children and trusts 77.21280956 $9,269,089
Symphony 1.49712307 179,724
CFT 3.62376573 435,019
9,883,832
C. Conclusion
We find that the fair market value of the property right
transferred by petitioners to CFT was $435,019.47 Taking into
47
The rule is well established that we may approve a
deficiency on the basis of reasons other than those relied on by
the Commissioner. See Wilkes-Barre Carriage Co. v. Commissioner,
39 T.C. 839, 845 (1963) (and cases cited therein), affd.
332 F.2d
421 (2d Cir. 1964). Because our conclusion that the valuation
clause of the assignment agreement does not achieve the claimed
“tax neutralization” effect is based on the language of the
assignment agreement, we need not address respondent’s arguments
that (1) the formula clause is against public policy, and (2) the
transaction should be recast as transfers of cash by petitioners
to CFT and the symphony under an integrated transaction theory.
We note that the application of respondent’s integrated
transaction theory would result in an initial increase in the
amount of petitioners’ aggregate taxable gift of only $90,011
(less than 1 percent), which would be partially offset by the
resulting increase in the gift tax liability that the
noncharitable donees assumed under the assignment agreement.
- 65 -
account annual exclusions, see sections 2503(b) and 2524, each
petitioner is entitled to a charitable contribution deduction
under section 2522 of $207,510 resulting from the transfer to
CFT.48
VII. Effect of Children’s Agreement To Pay Estate Tax Liability
A. Introduction
Recently, in Ripley v. Commissioner, 105 T.C. 358, 369
(1995), revd. on another issue
103 F.3d 332 (4th Cir. 1996), we
described the nature of a net gift as follows:
Where a “net gift” is made, the donor and donee agree
that the donee will bear the burden of the gift tax.
The value of the property transferred is reduced by the
amount of the gift tax paid by the donee, resulting in
the net amount transferred by gift, or the “net gift”.
The IRS has provided an algebraic formula for
determining the amount of gift tax owed on a “net gift”
in Rev. Rul. 75-72, 1975-1 C.B. 310. It is important
to keep in mind that once the “net gift” is calculated,
the full amount of the gift tax is paid on the “net
gift”.
When a “net gift” is made, a portion of the
property is transferred by gift and the remaining
portion is transferred by sale. * * *
The net gift rationale flows from the basic premise that the gift
tax applies to transfers of property only to the extent that the
value of the property transferred exceeds the value in money or
48
We note that, under our analysis, the assignee interest
received by the symphony is worth more than $134,000.
Nevertheless, we do not believe that petitioners have claimed any
increased charitable contribution deduction under sec. 2522 on
account of the transfer to the symphony. If we are mistaken on
that point, petitioners can bring that to our attention (or
perhaps petitioners and respondent can deal with it in the Rule
155 computation).
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money’s worth of any consideration received in exchange therefor.
See sec. 2512(b); sec. 25.2512-8, Gift Tax Regs.
Petitioners each reported his or her transfer of one-half of
the gifted interest as a net gift. Each treated as sales
proceeds (consideration received) (1) the amount of Federal and
State gift taxes that he or she calculated were to be paid by the
children (the gift tax amount) and (2) an amount described on
brief as the “mortality-adjusted present value” (mortality-
adjusted present value) of the children’s contingent obligation
to pay the additional estate tax that would have been incurred on
account of section 2035(c) (the 2035 tax) if that petitioner had
died within 3 years of the date of the gift. Petitioners
describe their computation of the mortality-adjusted present
value as follows:
Petitioners * * * estimated the amount of estate tax
that would be owed under I.R.C. § 2035(b) based on an
expected 55% marginal estate tax rate. Then
Petitioners adjusted that amount to present value at
the applicable discount rate under I.R.C. § 7520 for
January 1996, with further adjustment for the
possibility that they would survive each year of the
three-year period with no estate tax actually being
owed. The probability of death in each of the ensuing
three years was calculated, and then the probability-
weighted tax amounts were discounted to present value
at the required interest rate. All calculations were
made, as required under I.R.C. § 7520, by reference to
Petitioners’ ages as of their nearest birthdays, the
applicable interest rate under I.R.C. § 7520 for
January, 1996, and mortality factors provided by Table
80CNSMT (as found in Respondent’s Pub. 1457, “Actuarial
Values, Alpha Volume”).
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Petitioners computed the mortality-adjusted present values of the
above described obligations as being $149,813 and $139,348 with
respect to Mr. and Mrs. McCord, respectively.
Respondent does not take issue with petitioners’ treatment
of the gift tax amounts as sale proceeds. However, he disputes
petitioners’ treatment of the mortality-adjusted present values
as sale proceeds, primarily on the grounds that those amounts are
too speculative to be taken into account. Respondent cites
Armstrong Trust v. United States, 132 F. Supp. 2d 421 (W.D. Va.
2001), affd. sub nom. Estate of Armstrong v. United States,
277
F.3d 490 (4th Cir. 2002). In Armstrong
Trust, supra, a gift was
made and, because of (current) section 2035(b), the donees were
subject to a potential liability, as transferees, for estate
taxes. See sec. 6324(a)(2). Plaintiffs argued that liens or
encumbrances were created on the gift by reason of the potential
estate tax liability assumed by the donees, thereby reducing the
value of the gift.
Id., 132 F. Supp. 2d at 430. The District
Court found that the possibility of future estate tax liability
was too speculative to reduce the value of the gift.
Relying on an opinion of the United States Court of Claims,
Murray v. United States, 231 Ct. Cl. 481,
687 F.2d 386 (1982),
the Court of Appeals for the Fourth Circuit affirmed the District
Court’s decision in Armstrong Trust, also on the basis that the
donees’ potential liability for the donor’s estate tax was too
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speculative to reduce the value of the gifts. Estate of
Armstrong v. United States, supra at 498. It was of no moment to
the Court of Appeals that the donor had in fact died within 3
years of the gift, thus causing a 2035 tax to be due, or that the
plaintiffs apparently had produced expert calculations of an
amount similar to the mortality-adjusted present value at issue
in this case. The Court of Appeals said:
The litigation attempts of the Estate and the Trust to
quantify through expert calculations the value of
potential estate taxes at the time of the transfers is
irrelevant. What is relevant is that the children’s
obligation to pay any estate taxes was then “highly
conjectural,” Murray, 687 F.2d at 394, and so provides
no ground for applying net gift principles. [Id.]
In Murray v. United States, supra, the donor had made gifts
in trust pursuant to an instrument that obligated the trustees to
pay, among other debts, the donor’s estate and death taxes
liabilities. The plaintiffs (executors of the donor’s estate)
argued that the obligation to pay the donor’s estate and death
taxes rendered the gifts without value when made. The Court of
Claims disagreed, finding that the obligation to pay estate and
death taxes “was not * * * susceptible to valuation at the date
of the gifts because the economic burden of paying these taxes
was then unknown.”
Id., 687 F.2d at 394. The Court questioned
whether it was even possible to approximate the value of the
trustee’s obligation to pay the donor’s estate and death tax
liabilities:
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the amount of estate and death taxes payable from the *
* * [trusts] was highly conjectural. If Oliver lived
until May 1971, the value of the 1968 Family Trust
would no longer have been included in his estate as a
gift in contemplation of death under section 2035,
significantly reducing his estate tax liability.
Moreover, had he lived for several more years, the size
of his estate would have continued to diminish, leaving
the 1970 Family Trusts with an ever-decreasing estate
tax obligation. * * *
Id. at 394-395. The Court of Claims concluded: “Thus,
plaintiffs’ inability to reasonably estimate the amount of tax,
if any, to be paid from the * * * [trusts] made it proper to
compute the gift tax on the basis of the full value of the trust
assets. Robinette v. Helvering,
318 U.S. 184, 188-89 (1943).”
Id. at 395.49
B. Discussion
The specific question before us is whether to treat as part
of the sale proceeds (consideration) received by each petitioner
on the transfer of the gifted interest any amount on account of
the children’s obligation pursuant to the assignment agreement to
pay the 2035 tax that would be occasioned by the death of that
petitioner within 3 years of the valuation date. We have not
faced that specific question before.50 Neither Armstrong Trust
49
In Robinette v. Helvering, 318 U.S. 184, 188-189 (1943),
the Supreme Court held that, in computing the value of a gift of
a remainder interest in property, the value (as an offset) of the
donor’s contingent reversionary remainder interest was to be
disregarded because there was no recognized method of determining
its value.
50
Nevertheless, in Estate of Armstrong v. Commissioner,
(continued...)
- 70 -
v. United States, supra, nor Murray v. United
States, supra, is
binding on us, and, indeed, the facts of both cases are somewhat
different from the facts before us today. Armstrong Trust did
not involve a specific assumption of the potential 2035 tax as a
condition of the underlying gift (as is the case here); rather,
the donees were statutorily liable for any 2035 tax under section
6324(a)(2). In Murray, unlike the instant case, the obligation
was not limited to the “gross-up” tax of (original) section
2035(c), with its preordained inclusion amount and accompanying
3-year window of inclusion (indeed, that provision and the
unified gift and estate tax system had yet to be enacted).
Nevertheless, we agree with what we believe to be the basis of
those two opinions, i.e., that, in advance of the death of a
person, no recognized method exists for approximating the burden
of the estate tax with a sufficient degree of certitude to be
effective for Federal gift tax purposes. See also Estate of
Armstrong v. Commissioner,
119 T.C. 220, 230 (2002).
Petitioners’ computation of the mortality-adjusted present
value of the children’s obligation to pay the 2035 tax does
50
(...continued)
119 T.C. 220, 230 (2002) (addressing certain Federal estate tax
questions with respect to the same gifts in question in Armstrong
Trust v. United States,
132 F. Supp. 2d 421 (W.D. Va. 2001),
affd. sub nom. Estate of Armstrong v. United States,
277 F.3d 490
(4th Cir. 2001)), we said: “The donee children’s mere
conditional promise to pay certain additional gift taxes that
decedent might be determined to owe does not reduce the amount of
decedent’s gift taxes included in the gross estate under section
2035(c).”
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nothing more than demonstrate that, if one assumes a fixed dollar
amount to be paid, contingent on a person of an assumed age not
surviving a 3-year period, one can use mortality tables and
interest assumptions to calculate the amount that (without any
loading charge) an insurance company might demand to bear the
risk that the assumed amount has to be paid. However, the dollar
amount of a potential liability to pay the 2035 tax is by no
means fixed; rather, such amount depends on factors that are
subject to change, including estate tax rates and exemption
amounts (not to mention the continued existence of the estate tax
itself51). For that reason alone, we conclude that petitioners
are not entitled to treat the mortality-adjusted present values
as sale proceeds (consideration received) for purposes of
determining the amounts of their respective gifts at issue.52
See Robinette v. Helvering, 318 U.S. 184, 188-189 (1943) (donor’s
reversionary interest, contingent not only on donor outliving
51
See Economic Growth and Tax Relief Reconciliation Act of
2001, Pub. L. 107-16, secs. 501(a), 901(a), 115 Stat. 38, 69, 150
(repealing the estate tax with respect to decedents dying after
Dec. 31, 2009, and reinstating same with respect to decedents
dying after Dec. 31, 2010).
52
We recognize that, in Harrison v. Commissioner, 17 T.C.
1350, 1354-1355 (1952), we reduced the amount of a gift of a
trust remainder by the present value of the trustee’s obligation,
under the terms of the trust agreement, to pay the settlor-life
beneficiary’s income tax liability attributable to the trust’s
income for the remainder of her life: “Federal income taxes have
become a permanent and growing part of our economy, and there is
no likelihood that such taxes will not continue to be imposed
throughout the life expectancy of petitioner.” We do not have
occasion today to reconsider that opinion.
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30-year old daughter, but also on the failure of any issue of the
daughter to attain the age of 21 years, is disregarded as an
offset in determining the value of the gift; actuarial science
cannot establish the probability of whether the daughter would
marry and have children).
Our conclusion is further buttressed by broader
considerations of Federal gift tax law. Under the “estate
depletion” theory of the gift tax, it is the benefit to the donor
in money or money’s worth, rather than the detriment to the
donee, that determines the existence and amount of any
consideration offset (sale proceeds) in the context of an
otherwise gratuitous transfer. See Commissioner v. Wemyss, 324
U.S. 303, 307-308 (1945); 2 Paul, Federal Estate and Gift
Taxation 1114-1115 (1942). When a donee agrees to pay the gift
tax liability resulting from a gift, the benefit to the donor in
money or money’s worth is readily apparent and ascertainable,
since the donor is relieved of an immediate and definite
liability to pay such tax. If that donee further agrees to pay
the potential 2035 tax that may result from the gift, then any
benefit in money or money’s worth from the arrangement arguably
would accrue to the benefit of the donor’s estate (and the
beneficiaries thereof) rather than the donor. The donor in that
situation might receive peace of mind, but that is not the type
of tangible benefit required to invoke net gift principles.
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C. Conclusion
Because petitioners have failed to show that their
computation of the value of the children’s obligation to pay any
2035 tax is reliable, we do not accept it as establishing any
proceeds received by petitioners and reducing the value of the
net gifts made by them.
VIII. Conclusion
The fair market value of the gifted interest on the date of
the gift was $9,883,832 ($4,941,916 for each half thereof).
Petitioners are entitled to an aggregate charitable contribution
deduction under section 2522 for the transfer to CFT in the
amount of $415,019 ($207,510 apiece).
To reflect the foregoing,
Decision will be
entered under Rule 155.
Reviewed by the Court.
WELLS, COHEN, SWIFT, GERBER, COLVIN, GALE, and THORNTON,
JJ., agree with this majority opinion.
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SWIFT, J., concurring: The majority opinion adopts an
interpretation of the “fair market value” language of the formula
clause that recognizes the sophistication of the tax planning
before us and that gives significance to the failure of that
formula clause to use commonly recognized language in the estate
planning profession under which--had it been intended--a fair
market value determination (and an allocation between the donees
of the gifted interest based thereon) “as finally determined for
Federal gift tax purposes” would have been made explicit. In my
opinion, the failure of the formula clause to reflect such well-
recognized language belies petitioners’ claim that such language,
interpretation, and result were intended and now should be
inferred.
Under the majority’s interpretation of the formula clause,
the abuse potential inherent therein is essentially negated.
If, however, petitioners’ interpretation of the formula
clause were adopted, under which petitioners claim an increasd
charitable deduction equal to all excess value of the gifted
interest over $7,044,093, as finally determined for Federal gift
tax purposes, without property representing such excess value
actually passing to charity, the long-standing “reasonable
probability” and “public policy” doctrines applicable generally
to gifts would become applicable. See, e.g., Hamm v.
Commissioner, T.C. Memo. 1961-347, affd. 325 F.2d 934 (8th Cir.
1963), applying the reasonable probability standard to the
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question of whether a charitable donee will ever receive gifted
property; Commissioner v. Procter, 142 F.2d 824 (4th Cir. 1944),
applying public policy principles to the question of whether
abusive valuation or adjustment clauses are to be respected.
With regard to Judge Foley’s criticism of these doctrines,
see dissenting op. pp. 94-95, 107-108, I would suggest that the
reasonable probability and public policy doctrines should not be
confined to stale factual situations involved in old cases. To
the contrary, these doctrines live and breathe and have a life
that should be broad and flexible enough to apply to contemporary
and overly aggressive gift and estate tax planning (such as that
involved herein)--particularly where charity is involved.
With regard further to the nature or extent of the gift to
charity involved herein, I would emphasize that not “all” of
petitioners’ MIL partnership interest was transferred.
Respondent argues that “all” of petitioners’ MIL partnership
interest was transferred, but petitioners contend otherwise, and
the majority opinion concludes that something less than all of
petitioners’ interest in the MIL partnership was transferred
(namely, only an “assignee” interest was transferred). See
majority op. pp. 19-24. In light of the majority’s conclusion in
that regard, had respondent argued in the alternative that the
“partial interest” gift rules of section 2522(c)(2) and section
25.2522(c)-3(c), Gift Tax Regs., were applicable to petitioners’
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gift to charity, it would appear that petitioners’ claimed
charitable deduction herein would have been completely
disallowable. See the analysis below relating to the
deductibility of gifts to charity of partial interests.
The Gift
Petitioners formed MIL as a Texas family limited partnership
and made gifts of a portion of their interests therein by way of
an assignment agreement and a formula clause which, according to
petitioners and the majority opinion, transferred only assignee
interests in MIL to four levels of donees, generally as follows:
First and Second Level (Noncharitable) Donees: Trusts for
the benefit of the donors’ four children (first level
donees) to receive portions of the gifted interest and
outright gifts to the donors’ four children (second level
donees) with an aggregate fair market value on the valuation
date up to $6,910,933;
Third Level Donee: If the fair market value of the gifted
interest exceeds $6,910,933, Symphony, a charitable donee,
to receive such excess up to a maximum value of $134,000;
Fourth Level Donee: If the fair market value of the gifted
interest exceeds $7,044,933 ($6,910,933 plus $134,000), CFT,
also a charitable donee, to receive such excess without
limit.
Focusing on the gift to the fourth level charitable donee
(the gift to CFT), petitioners themselves allege (in order to
beef up the valuation discounts they seek) and the majority
opinion finds, majority op. pp. 19-24, that the gifted MIL
partnership interest transferred to CFT included only certain
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“economic rights” with regard to the gifted interest and did not
consist of all of the donors’ rights as limited partners in that
particular limited partnership interest. Upon petitioners’
transfer and upon CFT’s receipt of the gifted interest in the MIL
partnership, petitioners retained, and CFT never received, the
following rights associated with petitioners’ interest in MIL
(references are to the MIL amended partnership agreement):
(1) The right to vote on MIL partnership matters (section
3.10);
(2) The right to redeem the MIL partnership interest
(section 9.02(b));
(3) The right to inspect financial and other pertinent
information relating to MIL (section 3.09(d)(i)-(v));
(4) The right to access any properties or assets owned by
MIL (section 3.09(d)(vi)); and
(5) The right to veto early liquidation of MIL, unless such
liquidation is required by State law (section 10.01).
Under section 7.02 of the Texas Revised Limited Partnership
Act, a partnership agreement may, but is not required to, limit
the partnership rights that may be transferred when a partner
transfers or assigns an interest in a partnership. In this case,
petitioners made their retention of the above rights (and the
nonreceipt thereof by CFT) explicit by the terms of the MIL
partnership agreement that they adopted. Section 8.03 of the MIL
partnership agreement, discussing the transfer of a limited
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partnership interest to an assignee, is set forth, in part,
below:
[A]n Assignee shall be entitled only to allocations of
Profits and Losses * * * and distributions * * * which
are attributable to the Assigned Partnership Interests
held by the Assignee and shall not be entitled to
exercise any Powers of Management nor otherwise
participate in the management of the Partnership nor
the control of its business and affairs. * * *
As explained, the above limitations on the charitable gift
transferred by petitioners to CFT are the basis for petitioners’
claimed characterization and valuation of the gift to CFT as an
assignee interest in MIL, as distinguished from an MIL
partnership interest, and (as petitioners themselves contend)
they would appear to constitute substantive and significant
limitations.
Deductibility of Gifts to Charity of Partial Interests
Generally, and apart from certain specified statutory
exceptions noted below, where less than donors’ entire interests
in property are transferred to charity, the charitable
contributions--for Federal gift tax purposes, as well as for
Federal income and estate tax purposes--are to be treated as
partial interests and any claimed gift, income, and estate tax
charitable deductions relating thereto are to be disallowed. See
secs. 2522(c)(2) (gift tax disallowance), 170(f)(3) (income tax
disallowance), 2055(e)(2) (estate tax disallowance).
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Set forth below, in part, is the statutory language of
section 2522(c)(2) that, for Federal gift tax purposes, generally
disallows charitable deductions for gifts to charity of partial
interests:
SEC. 2522(c). Disallowance of Deductions in Certain Cases.--
* * * * * * *
(2) Where a donor transfers an interest in property
(other than an interest described in section 170(f)(3)(B))
to a person, or for a use, described in subsection (a) or
(b) [qualified charities] and an interest in the same
property is retained by the donor, or is transferred or has
been transferred (for less than an adequate and full
consideration in money or money’s worth) from the donor to a
person, or for a use, not described in subsection (a) or
(b), no deduction shall be allowed under this section for
the interest which is, or has been transferred to the
person, or for the use, described in subsection (a) or (b)
* * *
Treasury regulations applicable to the above statutory
provisions provide examples of charitable gifts of partial
interests subject to the above disallowance rule. Section
1.170A-7(d), Example (1), Income Tax Regs., treats as a partial
interest a gift to charity of the rent-free use of one floor of
an office building where the donor owns the entire office
building.
Section 20.2055-2(e)(2)(i), Estate Tax Regs., classifies as
a partial interest a gift to charity of a reversionary interest
in an office building where the decedent transfers to his wife a
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life estate in the office building and where the decedent’s wife
is still living when the reversionary interest passes to charity.
Section 25.2522(c)-3(c)(1)(i), Example (3), Gift Tax Regs.,
treats as a partial interest a gift to charity of the right to
rental income from real property where the remaining interest in
the property is transferred to a noncharitable donee.
Other authorities recognize and discuss the above general
rule under which charitable deductions are disallowed for gifts
to charity of partial interests.
In Stark v. Commissioner, 86 T.C. 243 (1986), we held that a
gift to the U.S. Forest Service of real property constituted a
partial interest where the donor retained a mineral interest in
the real property. The gift to charity, however, of the partial
interest was deductible because the particular restricted mineral
interest retained by the taxpayer was not regarded as
substantial. In interpreting section 170(f)(3) for income tax
purposes, we stated that the partial interest rule “applies to
contributions [to charity] of less than the taxpayer’s entire
interest in property, including, but not limited to,
contributions of the right to use property.”
Id. at 250.
In Rev. Rul. 81-282, 1981-2 C.B. 78, it was held that a gift
to charity of corporate stock constituted a disallowed partial
interest where the donor retains the right to vote the gifted
stock (a gift not dissimilar from the gift to CFT of the
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nonvoting, assignee interest in the MIL partnership). See also
Stewart et al., Charitable Giving and Solicitation, par. 9004 at
9002 (1999), which states that “A donor can run afoul of the
partial interest rules by retaining a property interest or right
while transferring the primary incidents of ownership to
charity.”1
As indicated previously, for Federal gift, income, and
estate tax purposes, certain limited statutory exceptions to the
above rule applicable to partial interests are available under
which specified types of partial interests transferred to charity
will qualify for charitable deductions (namely, certain fixed
income transfers to charity and certain remainder interests
gifted to charitable annuity trusts, to unitrusts, and to pooled
income funds). See secs. 2522(c)(2)(A) and (B) (gift tax),
170(f)(2)(A) and (B) (income tax), 2055(e)(2)(A) and (B) (estate
tax). These statutorily qualified forms of deductible partial
1
Treatises discussing charitable contributions interpret
the relevant Code provisions as outlined above, and I have not
discerned how the situation involved in the instant case would
not be covered by the above Code provisions disallowing a tax
deduction for gifts to charity of partial interests. See, e.g.,
8 Mertens, Law of Federal Income Taxation, secs. 31:97 to 31:112
(1999 rev.); Beckwith, 839 Tax Mgmt. (BNA), “Estate and Gift Tax
Charitable Deductions”, secs. V, XI at A-50 (2001); Kirschten &
Freitag, 521-2d Tax Mgmt. (BNA), “Charitable Contributions:
Income Tax Aspects”, sec. II-F (2002); Samansky, Charitable
Contributions and Federal Taxes, ch. 8 (1993); Stephens et al.,
Federal Estate and Gift Taxation, secs. 5.05, 11.02 (8th ed.
2002); Stewart et al., Charitable Giving and Solicitation, pars.
9001-9012, 10,022, 11,012 (1999).
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interest charitable gifts are subject to strict guidelines which
provide assurance that the charitable deductions to be allowed
reflect the approximate amount to be received by charity. See
sec. 25.2522(c)-3(d)(2)(iv), Gift Tax Regs.
In addition to the above statutorily qualified forms of
deductible partial interests transferred to charity, section
170(f)(3)(B) sets forth a number of other types of partial
interest gifts with respect to which charitable deductions are
allowable. Under section 170(f)(3)(B), charitable deductions are
allowed for gifts not in trust of remainder interests in a
personal residence or farm (sec. 170(f)(3)(B)(i)), gifts to
charity not in trust of an “undivided portion” of a transferor’s
entire interest in property (sec. 170(f)(3)(B)(ii)), and
qualified conservation contributions (sec. 170(f)(3)(B)(iii)).
With regard to charitable gifts of an undivided portion of a
transferor’s entire interest in property, section 25.2522(c)-
3(c)(2)(i), Gift Tax Regs., provides, in part, as follows:
An undivided portion of a donor’s entire interest in
property must consist of a fraction or percentage of
each and every substantial interest or right owned by
the donor in such property * * *.2 * * *
2
Parallel provisions for income and estate tax purposes
with regard to deductions relating to charitable gifts of an
undivided portion of a taxpayer’s entire interest in property are
set forth in sec. 1.170A-7(b)(1)(i), Income Tax Regs., and sec.
20.2055-2(e)(2)(i), Estate Tax Regs.
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In Stark v. Commissioner, supra at 252-253, we explained as
follows:
Where the interest retained by the taxpayer is so
insubstantial that he has, in substance, transferred
his entire interest in the property, the tax treatment
should so reflect. * * *
* * * A charitable contribution deduction should
be allowed only where the retained interest has a de
minimis value. Moreover, the insubstantial retained
interest must not potentially interfere in any manner
with the donee’s interest. * * * [Citation omitted.]
In Rev. Rul. 81-282, 1981-2 C.B. 78, it was concluded that a
taxpayer’s retention of a right to vote shares of stock
contributed to charity constitutes a substantial right because a
right to vote gives the holder a voice in the management of the
company and is crucial to protecting a stockholder’s financial
interest.
In Miami Natl. Bank v. Commissioner, 67 T.C. 793, 800
(1977), (involving the transfer of stock into a subordinated
securities account), we concluded that retained voting rights,
among others, constitute substantial rights.
Application to McCord
As stated, the retained rights involved in Rev. Rul. 81-282,
1981-2 C.B. 78, appear to be analogous to the rights retained by
petitioners herein. By providing in the MIL partnership
agreement limitations on transfers of MIL partnership interests
and by transferring to CFT only an assignee interest in MIL,
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petitioners retained the voting and the other rights in the MIL
limited partnership associated with the assignee interest
transferred to charity. Because the rights retained by
petitioners with regard to their MIL limited partnership interest
would be treated as substantial, under section 170(f)(3)(B)(ii)
the portion thereof transferred to CFT would appear not to
qualify as an undivided portion of petitioners’ entire MIL
limited partnership interest.
I would reiterate that it is the perceived substantial
significance of petitioners’ retained rights on which petitioners
themselves, petitioners’ valuation experts, and the majority
opinion rely to justify assignee status and increased valuation
discounts for the gifted interest.
It would appear that for the above analysis not to apply to
the gift involved in the instant case, petitioners’ MIL limited
partnership interest would have to be interpreted as consisting
of two separate and distinct interests (an economic interest and
a noneconomic interest) with petitioners transferring to CFT an
undivided portion of the separate economic interest.
I submit that the correct interpretation would be to treat
petitioners’ MIL limited partnership interest as one interest
consisting of both economic and noneconomic rights, with
petitioners having transferred to CFT only their economic rights
therein. Under this interpretation, it would appear that
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petitioners should be regarded as having made a charitable gift
to CFT of a partial interest in their MIL limited partnership
interest, which charitable gift would be subject to the gift tax
disallowance provision of section 2522(c)(2).3
3
I recognize that under the disallowance rule of sec.
2522(c)(2), as suggested herein, petitioners’ claimed charitable
deduction for their gift to Symphony also would be disallowed as
a gift of a partial interest.
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CHIECHI, J., concurring in part and dissenting in part: I
concur in result with respect to the portions of the majority
opinion under the headings “IV. Extent of the Rights Assigned”
and “VII. Effect of Children’s Agreement To Pay Estate Tax
Liability”.
I cannot responsibly cast an affirmative vote with respect
to the portion of the majority opinion under the heading “V.
Fair Market Value of the Gifted Interest”. The determination of
fair market value is a factual determination and is necessarily a
matter of judgment and approximation. See, e.g., Estate of Davis
v. Commissioner, 110 T.C. 530, 537 (1998). I am not in a
position to state that I agree with every judgment and every
approximation made by the majority opinion in determining the
fair market value of the gifted interest. Moreover, because
valuation is a factual matter and necessarily an approximation
and a matter of judgment, I do not believe that the Court is
bound in other cases by the judgments and approximations in the
majority opinion.
I dissent from the portion of the majority opinion under the
heading “VI. Charitable Contribution Deduction for Transfer to
CFT” and from the ultimate holding of the majority opinion under
the heading “VIII. Conclusion”. Although I join Judge Foley’s
dissent, I write separately to express additional reasons for my
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dissent and to emphasize certain of the reasons for Judge Foley’s
dissent.
I disagree with the following characterization by the
majority opinion of what petitioners transferred to CFT under the
assignment agreement: “By way of the assignment agreement,
petitioners transferred to CFT the right to a portion of the
gifted interest.” Majority op. p. 61 (emphasis added). Under
the assignment agreement, petitioners did not transfer to CFT
merely “the right to” a specified portion of the gifted interest.
On January 12, 1996, petitioners transferred to CFT the portion
of the gifted interest described in that agreement. In other
words, on that date, petitioners transferred to CFT that portion,
if any, of the 82.33369836-percent assignee interest in MIL
remaining after the respective transfers under the assignment
agreement to petitioners’ children, the trusts, and the Symphony;
i.e., that portion of such assignee interest having a fair market
value as of the date of that agreement in excess of $7,044,933.
I also disagree with the position of the majority opinion,
see majority op. pp. 61-65, that under the assignment agreement
petitioners transferred to CFT a 3.62376573-percent assignee
interest in MIL. The 3.62376573-percent assignee interest was
set forth in the confirmation agreement that was executed in
March 1996. The majority opinion does not mention the
confirmation agreement but nevertheless requires that agreement
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to control for purposes of determining the assignee percentage
interest that petitioners transferred under the assignment
agreement to CFT (as well as the respective assignee percentage
interests that petitioners transferred under the assignment
agreement to petitioners’ children, the trusts, and the
Symphony). The confirmation agreement on which the majority
opinion relies was not executed until March 1996, 2 months after
the assignment agreement was effective, and is not the
controlling donative instrument.
Instead of referring to the confirmation agreement in
support of the position that petitioners transferred to CFT a
3.62376573-percent assignee interest in MIL, the majority opinion
maintains that there is in effect a valuation instruction in the
assignment agreement which mandates that result. According to
the majority opinion, pursuant to that purported valuation
instruction, the fair market value agreed upon by the donees to
determine the assignee percentage interest transferred to CFT (as
well as to determine the respective assignee percentage interests
transferred to petitioners’ children, the trusts, and the
Symphony) is fixed and may never change for purposes of
determining such interest, even if such value agreed upon by the
donees is ultimately determined not to be the fair market value
of such interest. The majority opinion concludes that therefore
the resulting assignee percentage interest transferred to CFT (as
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well as the respective assignee percentage interests transferred
to petitioners’ children, the trusts, and the Symphony), as set
forth in the confirmation agreement, is fixed and may never
change.
The assignment agreement does not contain a valuation
instruction that requires what the majority opinion indicates
that agreement requires. According to the majority opinion, that
valuation instruction appears in the following paragraph in the
assignment agreement:
For purposes of this paragraph [the paragraph
transferring to petitioners’ children, the trusts, the
Symphony, and CFT certain portions of the 82.33369836-
percent assignee interest in MIL that petitioners
transferred under the assignment agreement], the fair
market value of the Assigned Partnership Interest [the
gifted interest consisting of the 82.33369836-percent
assignee interest in MIL] as of the date of this
Assignment Agreement shall be the price at which the
Assigned Partnership Interest would change hands as of
the date of this Assignment Agreement between a
hypothetical willing buyer and a hypothetical willing
seller, neither being under any compulsion to buy or
sell and both having reasonable knowledge of relevant
facts. Any dispute with respect to the allocation of
the Assigned Partnership Interests among Assignees
shall be resolved by arbitration as provided in the
Partnership Agreement.
As can be seen from reading the foregoing paragraph, the
purported valuation instruction consists of a paragraph in the
assignment agreement which defines the term “fair market value”.
Petitioners required the donees to use that definition when they
allocated among themselves the respective portions of the gifted
interest which petitioners transferred to them under the
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assignment agreement. The definition of the term “fair market
value” for that purpose is the same definition used for Federal
gift tax purposes. See sec. 25.2512-1, Gift Tax Regs. The last
sentence of the above-quoted paragraph merely requires that any
dispute with respect to the allocation of the gifted interest
among the donees be resolved by arbitration as provided in the
partnership agreement. Nothing in that paragraph mandates that
if the fair market value of the gifted interest to which the
various donees agreed is ultimately determined not to be the fair
market value of that interest, no adjustment may be made to the
respective assignee percentage interests allocated to CFT and the
other donees, as set forth in the confirmation agreement. I
believe that the majority opinion’s construction of the above-
quoted paragraph is strained, unreasonable, and improper and
leads to illogical results.
In essence, the majority opinion concludes that the donees
of the gifted interest made a mistake in determining the fair
market value of that interest and that petitioners are stuck with
that mistaken value solely for purposes of determining the
respective assignee percentage interests transferred to the
donees under that agreement.
The majority opinion states that
the assignment agreement contemplates the allocation of
the gifted interest based on the assignees’ best
estimation of that value. Moreover, each of the
assignees’ percentage interests was determined
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exactly as contemplated in the assignment agreement
(without recourse to arbitration), and none can
complain that they got any less or more than
petitioners intended them to get. * * * [Majority op.
p. 63.]
The assignment agreement does not “contemplate”, as the
majority opinion states, that the allocation of the gifted
interest be “based on the assignees’ best estimation of that
[fair market] value.” Id. Under the assignment agreement,
petitioners transferred to the donees specified portions of the
gifted interest determined by reference to the fair market value
of such portions, as defined in that agreement, and not upon some
“best estimation of that value.”
The assignment agreement required that the allocation be
based upon fair market value as defined in that agreement, which
the majority opinion acknowledges is the same definition of that
term for Federal gift tax purposes. The majority opinion has
found that the donees did not make the allocation on the basis of
that definition. The donees thus failed to implement the donors’
(i.e., petitioners’) mandate in the assignment agreement when
they arrived at amounts which they believed to be the respective
fair market values of the specified portions of the gifted
interest that petitioners transferred to them but which the
majority opinion has found are not the fair market values of such
portions.
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The majority opinion, using the definition of fair market
value in the Federal gift tax regulations and the assignment
agreement, determines that the fair market value of the gifted
interest used by the donees is not the fair market value of such
interest. It follows that the assignee percentage interest
allocated to CFT in the confirmation agreement in March 1996 (as
well as the respective assignee percentage interests allocated in
that confirmation agreement to petitioners’ children, the trusts,
and the Symphony) is not the assignee percentage interest that
petitioners transferred in the assignment agreement to that donee
on January 12, 1996.
The position of the majority opinion conflicts with the
provisions of the assignment agreement as to the respective
portions of the gifted interest that petitioners transferred
under that agreement to petitioners’ children, the trusts, the
Symphony, and CFT. Consequently, that position leads to results
that are in violation of what petitioners transferred to the
donees under that agreement. According to the majority opinion,
the aggregate fair market value of the aggregate 77.21280956-
percent assignee interests allocated to petitioners’ children and
the trusts is $9,269,089. Majority op. p. 64. However, under
the assignment agreement, petitioners transferred to their
children and the trusts portions of the gifted interest having an
aggregate fair market value equal to $6,910,933, determined
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according to the definition of the term “fair market value” in
the assignment agreement, which is the same definition in the
Federal gift tax regulations.1 Thus, the aggregate fair market
value of the aggregate assignee percentage interests transferred
to petitioners’ children and the trusts, as determined by the
majority opinion (i.e., $9,269,089), exceeds the aggregate fair
market value of such interests that petitioners transferred to
those donees in the assignment agreement (i.e., $6,910,933).
Such a result is rejected by and violates that agreement.2
FOLEY, J., agrees with this concurring in part and
dissenting in part opinion.
1
According to the majority opinion, the fair market value of
the 1.49712307-percent assignee interest allocated to the
Symphony is $179,724. Majority op. p. 64. However, under the
assignment agreement, petitioners transferred to the Symphony a
portion of the gifted interest having an aggregate fair market
value of at most $134,000, determined according to the definition
of the term “fair market value” in the assignment agreement,
which is the same definition in the Federal gift tax regulations.
2
The same is true of the result with respect to the Symphony
under the majority opinion’s analysis.
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FOLEY, J., concurring in part1 and dissenting in part:
Undaunted by the facts, well-established legal precedent, and
respondent’s failure to present sufficient evidence to establish
his determinations, the majority allow their olfaction to
displace sound legal reasoning and adherence to the rule of law.
The gift closed on January 12, 1996, and on that date petitioners
transferred to CFT all of petitioners’ assigned partnership
interests exceeding $7,044,933 (i.e., the amount exceeding the
$6,910,933 transferred to the sons and the trusts plus the
$134,000 transferred to the Symphony).
As the trial judge, I concluded that, on January 12, 1996,
petitioners transferred a $2,838,899 assignee interest to CFT.
On that date, the interest was accepted and received by CFT, and
not subject to a condition precedent or subsequent. Sec.
25.2522(c)-3(b)(1), Gift Tax Regs.; see also Commissioner v.
Sternberger’s Estate, 348 U.S. 187 (1955); Hamm v. Commissioner,
T.C. Memo. 1961-347, affd.
325 F.2d 934 (8th Cir. 1963).
Furthermore, I concluded that respondent fell woefully short of
meeting his burden2 regarding the applicability of the substance
over form, violation of public policy, and reasonable probability
1
I concur only in result with respect to secs. IV, V(E),
and VII(C) of the majority opinion.
2
The parties agree that respondent, pursuant to sec. 7491,
had the burden of proof.
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of receipt doctrines.3 Inexplicably, the majority ignore
respondent’s primary contentions (i.e., that the substance over
form and violation of public policy doctrines are applicable) and
base their holding on an interpretation of the assignment
agreement that respondent never raised. In section I, I address
the majority’s holding. In sections II and III, respectively, I
address respondent’s contentions relating to the substance over
form and violation of public policy doctrines.
I. The Majority’s Analysis of the Assignment Agreement Is
Faulty
The majority begin by stating correctly that the “gift tax
is imposed on the value of what the donor transfers, not what the
donee receives.” Majority op. p. 60. Yet, they then proceed to
rely on a tortured analysis of the assignment agreement that is,
ostensibly, justification for shifting the determination of
transfer tax consequences from the date of the transfer (i.e.,
January 12, 1996, the date of the assignment setting forth what
petitioners transferred) to March 1996 (i.e., the date of the
confirmation agreement). The majority’s analysis of the
assignment agreement requires that petitioners use the Court’s
valuation to determine the value of the transferred interests,
but the donees’ appraiser’s valuation to determine the percentage
3
The reasonable probability of receipt doctrine was not
one of respondent’s primary contentions, but it was referenced in
his opening brief.
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interests transferred to the charitable organizations. There is
no factual, legal, or logical basis for this conclusion.
A. The Gift Was Complete on January 12, 1996
The value of the transferred property and the amount of the
transferor’s charitable deduction are determined as of the date
the gift became complete. Sec. 2512(a). Pursuant to Texas law,
the transfer became complete on January 12, 1996, the date
petitioners and the donees executed the assignment agreement. In
fact, respondent states:
It is undisputed that the January 12, 1996 Assignment
Agreement was executed by competent donors, evidenced the
donors’ present intent to irrevocably divest themselves of
ownership of the partnership interests, delivered to the
partnership, and signed and accepted by donees competent to
receive such a transfer. Accordingly, the Assignment
Agreement effected the present transfer under Texas law of
beneficial and legal title to the partnership interests to
the donees. (Emphasis added.)
The Court, like petitioners and respondent, is bound by
section 2512(a), which requires us to value the property “at the
date of the gift” (emphasis added). The charitable donees and
the amount allocated to them were specifically identified, and
thus ascertainable, upon the execution of the assignment
agreement. Respondent readily acknowledges, and petitioners
undoubtedly agree, that the January 12, 1996, assignment
agreement was “signed and accepted by donees competent to receive
such a transfer.” Yet, in determining the charitable deduction,
the majority rely on the confirmation agreement without regard to
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the fact that petitioners were not parties to this agreement, and
that this agreement was executed by the donees more than 2 months
after the transfer.4
The majority state that the property transferred to CFT
“was not expressed as a specific fraction of the gifted interest
(e.g., one-twentieth), nor did petitioners transfer to CFT a
specific assignee interest in MIL (e.g., a 3-percent assignee
interest).” Majority op. p. 61. The majority appear to assert,
without any authority, that petitioners’ charitable deduction
cannot be determined unless the gifted interest is expressed in
terms of a percentage or fractional share.5 The assignment
agreement specifically identified the transferees and the
transferred property. Regardless of how the transferred interest
was described, it had an ascertainable value.
4
Subsequent events typically do not affect the value of
transferred property. See Ithaca Trust Co. v. United States, 279
U.S. 151 (1929); Estate of McMorris v. Commissioner,
243 F.3d
1254 (10th Cir. 2001), revg. T.C. Memo. 1999-82; Estate of Smith
v. Commissioner,
198 F.3d 515 (5th Cir. 1999), revg.
108 T.C. 412
(1997); Propstra v. United States,
680 F.2d 1248 (9th Cir. 1982).
5
This position is reminiscent of previous attempts by
respondent to impose a fractional, or percentile, share rule in
the marital deduction context–-a position that was consistently
rejected by the courts and not implemented until Congress amended
sec. 2056 to conform with respondent’s position. See sec.
2056(b)(5), (7) and (10); Northeastern Pa. Natl. Bank & Trust Co.
v. United States, 387 U.S. 213 (1967); James v. United States,
366 U.S. 213 (1961); Estate of Alexander v. Commissioner,
82 T.C.
34 (1984), affd. without published opinion
760 F.2d 264 (4th Cir.
1985).
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Accordingly, pursuant to section 2501, the entire $9,883,832
transfer is subject to gift tax, and a charitable deduction is
allowed for the $2,972,899 (i.e., $9,883,832 - $6,910,933)
transferred to or for the use of the Symphony and CFT. Sec.
2522. CFT’s retention of a much smaller interest (i.e.,
3.62376573 percent) than what petitioners transferred to it has
no effect on the value of the transferred property on the date
the gift became complete.6
B. Determination by the Donees Does Not Bind This Court
The majority conclude that petitioners may deduct the
$2,838,899 (i.e., $9,883,832 - $7,044,933) transferred to CFT on
January 12, 1996, only if the agreement gave each donee “an
enforceable right to a fraction of the gifted interest determined
with reference to the fair market value of the gifted interest as
finally determined for Federal gift tax purposes”. Majority op.
p. 63 (emphasis added). Simply put, the majority are wrong.
First, a $2,838,899 MIL interest was transferred to or for
the use of CFT. In their fervor to reject this transaction, the
6
CFT’s subsequent transfer of MIL interests may have
conferred an impermissible private benefit on petitioners’ sons.
See Am. Campaign Acad. v. Commissioner, 92 T.C. 1053
(1989)(holding that conferral of a benefit on an unrelated person
may constitute an impermissible private benefit). The deduction
pursuant to sec. 2522 is not allowed for a transfer to an
organization unless such organization is operated exclusively for
one or more of its charitable purposes. Sec. 25.2522(a)-1(b),
Gift Tax Regs. Respondent, however, did not raise, or present
any evidence relating to, this issue.
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majority assert a line of analysis that is contrary to both the
established facts and respondent’s litigating position. Pursuant
to the assignment agreement, the gift closed, and beneficial and
legal title to the assigned interest was transferred to CFT on
January 12, 1996. Respondent contends that, irrespective of when
the gift closed, the Court must ignore all intermediate steps and
focus on the end result (i.e., the cash received in redemption).
The majority sidestep the assignment agreement and redemption,
and focus on the allocation in the confirmation agreement.
Second, the majority cite regulations that are inapplicable
to petitioners’ transfer. See sec. 1.664-2(a)(1)(iii), Income
Tax Regs. (relating to charitable remainder annuity trusts); sec.
20.2055-2(e)(2)(v) and (vi)(a), Estate Tax Regs. (relating to
guaranteed annuity interests), and 25.2702-3(b)(1)(ii)(B) and
(b)(2), Gift Tax Regs. (relating to qualified annuity interests).
Majority op. pp. 63-64 note 46. The deductibility of all
transfers to charities is not governed by these requirements.
Third, as the majority acknowledge, petitioners transferred
to the donees “a fraction of the gifted interest based on the
value of that interest as determined under Federal gift tax
valuation principles.” Majority op. p. 62. There is no material
difference between fair market value “as determined under Federal
gift tax valuation principles” and fair market value “as finally
determined for Federal gift tax purposes”. Once this Court’s
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jurisdiction is properly invoked, the fair market value of any
property is what this Court determines it is, and a determination
relating to a charitable deduction pursuant to section 2522
requires use of the Court’s fair market value of the transferred
property. Our determination of fair market value is both fair
market value under gift tax principles and as finally determined
for Federal gift tax purposes. Moreover, had petitioners’
assignment agreement included the magical words “as finally
determined for Federal gift tax purposes”, the majority assert
only that they “might have reached a different result.” Majority
op. p. 63.
Fourth, the majority state:
There is simply no provision in the assignment
agreement that contemplates the allocation of the
gifted interest among the assignees based on some
fixed value that might not be determined for several
years. Rather, the assignment agreement contemplates
the allocation of the gifted interest based on the
assignees’ best estimation of that value. [Majority
op. pp. 62-63.]
The fact is, the assignment agreement effected the transfer of an
assignee interest. Petitioners’ assignment agreement could not,
and does not, limit the Court’s ability to correctly determine
the fair market value of such interest. Nor could the assignment
agreement mandate that the donees’ determination of fair market
value is conclusive and final for gift tax purposes.
Finally, unlike respondent, who contends that the charitable
deduction is limited to the $338,967 CFT received in the
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redemption, the majority seek to restrict petitioners’ charitable
deduction to the $435,019 interest (i.e., 3.62376573 percent) CFT
retained pursuant to the confirmation agreement. In essence, the
reasoning set forth by the majority borrows from both the
integrated transaction and violation of public policy doctrines.
The majority’s disregard of the transfer of property interests
pursuant to the assignment agreement, and focus on the allocation
of interests pursuant to the confirmation agreement, implicates
the integrated transaction doctrine. Similarly, the majority’s
refusal to adhere to the explicit terms of the assignment
agreement implicates the violation of public policy doctrine.
II. Respondent Did Not Establish Applicability of the Substance
Over Form Doctrine
Respondent contended that formation of the limited
partnership, assignment of partnership interests, confirmation of
the assignment, and redemption of the charities’ partnership
interests were all part of an integrated transaction where
petitioners intended to transfer all of their assets to their
sons and the trusts. Respondent simply failed to meet his
burden.
Courts have employed the substance over form doctrine where
a taxpayer, intending to avoid the gift tax, transfers property
to an intermediary who then transfers such property to the
intended beneficiary.7 In some instances the intermediary was
7
The Court of Appeals for the Fifth Circuit and other
(continued...)
- 102 -
used to disguise the transferor. See Schultz v. United States,
493 F.2d 1225, 1226 (4th Cir. 1974) (finding that brothers
planned to avoid gift taxes through repeated reciprocal gifts to
each others’ children); Griffin v. United States,
42 F. Supp. 2d
700, 707 (W.D. Tex. 1998) (finding that husband and wife engaged
in a scheme where the wife “was merely the intermediary through
which the stock passed on its way to the ultimate beneficiary”);
Estate of Murphy v. Commissioner, T.C. Memo. 1990-472
(disregarding an intrafamily stock transfer where the Court found
an informal family agreement to control the stock collectively).
In Heyen v. United States,
945 F.2d 359 (10th Cir. 1991)
(disregarding as shams 27 transfers of stock to intermediate
beneficiaries who then transferred the stock to the original
transferor’s family), however, the intermediary was used in an
attempt to disguise the transferee. Respondent, relying on
Heyen, asserts that the Symphony and CFT were merely
intermediaries in petitioners’ plan to transfer their MIL
interests to their sons and the trusts.
In Heyen, a taxpayer, seeking to avoid the gift tax by
taking advantage of the annual gift tax exclusion, transferred
stock to 29 intermediate recipients, all but two of whom made
7
(...continued)
courts have been reluctant to use substance over form in certain
cases involving completed gifts to charity. E.g., Carrington v.
Commissioner, 476 F.2d 704 (5th Cir. 1973) (holding, in an income
tax case, that where respondent seeks to use the step transaction
doctrine to disregard a donation of appreciated property to a
charitable organization, the central inquiry is whether the donor
parted with all dominion and control), affg. T.C. Memo. 1971-222.
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blank endorsements of the stock, which the issuing bank
subsequently reissued to the intended beneficiaries. The court
stated:
The [intermediate] recipients either did not know they
were receiving a gift of stock and believed they were
merely participating in stock transfers or had agreed
before receiving the stock that they would endorse the
stock certificates in order that the stock could be
reissued to decedent’s family. [Id. at 361.]
The court further stated:
The evidence at trial indicated decedent intended to
transfer the stock to her family rather than to the
intermediate recipients. The intermediary recipients
only received the stock certificates and signed them in
blank so that the stock could be reissued to a member
of decedent’s family. Decedent merely used those
recipients to create gift tax exclusions to avoid
paying gift tax on indirect gifts to the actual family
member beneficiaries. [Id. at 363.]
In order for us to ignore petitioners’ allocation in the
assignment agreement, respondent must establish that petitioners
coordinated, and the charities colluded in or acquiesced to, a
plan to avoid petitioners’ gift taxes by undervaluing the
transferred interests and intended to divert CFT’s interest to
their sons and the trusts. See Heyen v. United States, supra;
Schultz v. United
States, supra; Griffin v. United
States, supra;
Estate of Murphy v.
Commissioner, supra. Respondent did not
present the requisite evidence for us to invoke the substance
over form doctrine.
Respondent stated on brief that, after execution of the
assignment agreement, petitioners “washed their hands” of the
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transaction, and the donees took over. Petitioners’ sons’
involvement in the subsequent allocation of the transferred
interests does not affect the petitioners’ gift tax liability,
particularly in the absence of a showing that petitioners
retained some control over the subsequent allocation. See sec.
25.2511-2(a), Gift Tax Regs. (stating that the gift tax is
measured by the value of the property passing from the donor).
Petitioners’ sons and the estate planner made all the
arrangements relating to the valuation. This Court, however,
will not impute to petitioners an intent to avoid the gift tax
merely from the appraiser’s valuation of the transferred
partnership interests, the sons’ involvement in the planning
process, or the hiring of an estate planner charged with tax
minimization. See Estate of Strangi v. Commissioner, 115 T.C.
478, 484-485 (2000) (“Mere suspicion and speculation about a
decedent’s estate planning and testamentary objectives are not
sufficient to disregard an agreement in the absence of persuasive
evidence”), revd. on other grounds
293 F.3d 279 (5th Cir. 2002);
Hall v. Commissioner,
92 T.C. 312 (1989).
Respondent failed to establish that the Symphony or CFT
participated, knowingly or otherwise, in a plan to facilitate
petitioners’ purported avoidance of gift tax. Indeed, the
testimony and evidence established that the Symphony and CFT
acted independently. CFT did not hire its own appraiser because
it had confidence in the appraiser hired by petitioners’ sons.
While in hindsight (i.e., after this Court’s valuation) it was
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imprudent for the charitable organizations to forgo an
independent appraisal,8 these organizations were not sham
intermediaries. Prior to signing the confirmation agreement, the
Symphony and CFT could have independently valued MIL, forced
arbitration, and thwarted any purported plan to avoid the gift
tax. Cf. Compaq v. Commissioner, 277 F.3d 778, 784 (5th Cir.
2001) (declining, in an income tax case, to disregard a
transaction that involved even a minimal amount of risk and was
conducted by entities separate and apart from the taxpayer),
revg.
113 T.C. 214 (1999).
There is no evidence of an implicit or explicit agreement,
between petitioners and either the Symphony or CFT, that the
Symphony or CFT would accept less than that which petitioners
transferred to each organization. In fact, respondent stipulated
that “Before the call right was exercised, there was no agreement
among Mr. or Mrs. McCord, the McCord brothers, the Symphony or
CFT as to when such a buyout would occur or to the price at which
the buyout would occur.”
In sum, respondent failed to establish that the
undervaluation of MIL, reallocation of MIL interests, and
8
Ms. Willhoite, president of the Symphony, and Mr.
Fjordback, president of CFT, each had an obligation to ensure
receipt of the property interests petitioners transferred to the
Symphony and CFT, respectively. See Tex. Socy. DAR, Inc. v. Ft.
Bend Chapter, 590 S.W.2d 156, 164 (Tex. Civ. App. 1979), (citing
Intl. Bankers Life Ins. Co. v. Holloway,
368 S.W.2d 567 (Tex.
Sup. Ct. 1963)); see also Texas Non-Profit Corporation Act, Tex.
Rev. Civ. Stat. art. 1396-2.22 (2002).
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subsequent transfer of a portion of CFT’s MIL interest to the
sons and the trusts, were parts of a plan by petitioners to avoid
the gift tax. CFT’s retention of a much smaller interest (i.e.,
3.62376573 percent) than petitioners transferred, pursuant to the
assignment agreement, has no effect on the value of the
transferred property on January 12, 1996, the date the gift
became complete.
III. Formula Clause Does Not Violate Public Policy
Relying primarily on Commissioner v. Procter, 142 F.2d 824
(4th Cir. 1944), respondent contended that petitioners’ formula
clause was against public policy, and therefore void, because
such clause “is a ‘poison pill’ created to discourage audit of
the gifts and to fabricate phantom charitable gift and income tax
deductions.”
In Commissioner v. Procter, supra, the court considered a
clause causing a gift to revert to the donor if a court
determined that the gift was taxable. The court held that such a
clause “is clearly a condition subsequent and void because
contrary to public policy.”
Id. at 827. The court reasoned that
the clause would discourage the collection of tax because
attempted collection would defeat the gift, the clause would
“obstruct the administration of justice by requiring the courts
to pass upon a moot case”, and the clause, if allowed to stand,
would defeat the judgment of a court.
Id. Likewise, in Ward v.
Commissioner,
87 T.C. 78 (1986), a clause allowed the taxpayer to
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revoke a gift of stock if it was determined that, for gift tax
purposes, the fair market value of such stock exceeded $2,000 per
share. The Court similarly concluded that such a clause was a
condition subsequent and void because it was against public
policy.
Contrary to the valuation clauses in Commissioner v.
Procter, supra, and Ward v.
Commissioner, supra, which adjusted
the amount transferred based upon a condition subsequent,
petitioners’ valuation clause defined the amount of property
transferred. Simply put, petitioners’ gift does not fail upon a
judicial redetermination of the transferred property’s value.
Petitioners made a legally enforceable transfer of assignee
interests to CFT, with no provision for the gift to revert to
petitioners or pass to any other party on the occurrence of
adverse tax consequences. CFT merely failed to protect its
interest adequately. Procter and Ward are distinguishable.
Petitioners’ formula clause was not against public policy.
IV. Conclusion
The majority seek to restrict petitioners’ charitable
deduction to that which CFT accepted in the confirmation
agreement. The parties agree that the gift closed upon the
execution of the assignment agreement. At that moment,
petitioners transferred and CFT had a $2,838,899 MIL interest.
CFT waived its arbitration rights, and petitioners did not
participate in the subsequent allocation. Whether CFT failed to
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adequately protect its interest or was swindled by petitioners’
sons does not affect the value of what petitioners transferred to
CFT.
The majority prudently avoid using the substance over form,
violation of public policy, or realistic possibility of receipt
doctrines as support for their holding. The majority, however,
disregard the assignment agreement, other established facts, and
applicable case law in order to support a line of analysis and
conclusion that even respondent did not advocate. We are not
responsible for protecting the fisc. Rather, our role and duty
are to interpret and adhere to the rule of law–-even if
uncomfortable with the result.
CHIECHI, J., agrees with this concurring in part and
dissenting in part opinion.
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LARO, J., dissenting: A thin majority holds today that
“each petitioner is entitled to a charitable contribution
deduction under section 2522 of $207,510 resulting from the
transfer to CFT [Communities Foundations of Texas, Inc.].”
Majority op. at 65. Each petitioner reported for that transfer a
charitable deduction of $162,172.60, and CFT is not entitled to
enjoy any funds in excess of that amount. In that the majority
respects the subject transaction and allows each petitioner to
deduct a charitable contribution of approximately $45,000 for
value that a charity will never enjoy, I dissent.
1. Majority Applies Its Own Approach
To reach the result that the majority desires, the majority
decides this case on the basis of a novel approach neither
advanced nor briefed by either party and concludes that the Court
need not address respondent’s arguments as to public policy and
integrated transaction. Majority op. p. 64 note 47.
Specifically, under the majority’s approach (majority’s
approach), the term “fair market value” as used in the assignment
agreement denotes simply the value ascertained by the parties to
that agreement (or, in certain cases by an arbitrator) and not
the actual amount determined under the firmly established
hypothetical willing buyer/hypothetical willing seller test that
has been a fundamental part of our Federal tax system for decades
on end. Majority op. p. 64 note 47; see also United States v.
Cartwright, 411 U.S. 546, 550-551 (1973) (“The willing buyer-
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willing seller test of fair market value is nearly as old as the
federal income, estate, and gifts taxes themselves”). Whereas
the majority ostensibly recognizes that firmly established test
in its determination of the fair market value of the subject
property, majority op. p. 64 note 46, the majority essentially
holds that the parties to the assignment agreement are not bound
by that test when they themselves ascertain the fair market value
of that property, id. at 61-64.
As I understand the majority’s rationale, the parties to the
assignment agreement are not bound by that test because the
assignment agreement only uses the phrase “fair market value” and
not the phrase “fair market value as finally determined for
Federal gift tax purposes”. To my mind, the subject property’s
fair market value is its fair market value, notwithstanding
whether fair market value is ascertained by the parties or
“finally determined for Federal gift tax purposes”. I know of
nothing in the tax law (nor has the majority mentioned anything)
that provides that property such as the subject property may on
the same valuation date have one “fair market value” when
“finally determined” and a totally different “fair market value”
if ascertained beforehand.1 The majority’s interpretation of the
1
The three regulatory provisions relied upon by the
majority (majority op. p. 64 note 46) in support of its position
do not adequately support that position. Sec. 1.664-
2(a)(1)(iii), Income Tax Regs., for example, uses the phrase
(continued...)
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assignment agreement is at odds with the interpretation given
that agreement by not only the trial Judge, but by both parties
as well.
The majority allows petitioners an increased charitable
contribution that would be disallowed under either the public
policy or integrated transaction doctrine. In that both of these
doctrines are fundamental to a proper disposition of this case,
it is incumbent upon the Court to address one or both of them.
The majority inappropriately avoids discussion of these doctrines
by relying on the principle that the Court “may approve a
deficiency on the basis of reasons other than those relied upon
by the Commissioner”. Majority op. p. 64 note 47. The majority,
however, fails to recognize that the majority is not approving
respondent’s deficiency in full but is rejecting a portion of it.
In fact, the majority even acknowledges that “the application of
respondent’s integrated transaction theory would result in an
initial increase in the amount of petitioners’ aggregate taxable
gift by only $90,011". Id. Whereas the majority attempts to
downsize the significance of a $90,011 adjustment by
recharacterizing it as “only” and “less than 1 percent”,
id., the
fact of the matter is that the dollar magnitude of a $90,011
1
(...continued)
“fair market value * * * incorrectly determined by the fiduciary”
to refer to an earlier determination of fair market value that is
inconsistent with the fair market value “finally determined for
Federal tax purposes”.
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increase is significant to the fisc (as well as to most people in
general) notwithstanding that it may constitute a small
percentage of the aggregate taxable gift as found by the
majority.2 I know of no principle of tax law (nor has the
majority cited one) that provides that an adjustment otherwise
required by the tax law is inappropriate when it is a small
percentage of a base figure such as aggregate taxable gifts.
2. Increased Charitable Deduction Is Against Public Policy
Allowing petitioners to deduct as a charitable contribution
the increase in value determined by the Court is against public
policy and is plainly wrong. No one disputes that CFT will never
benefit from the approximately $45,000 that each petitioner is
entitled to deduct as a charitable contribution pursuant to the
majority opinion. Nor does anyone dispute that the only persons
benefiting from the increased value are petitioners and that the
only one suffering any detriment from the increased value is the
fisc. I do not believe that Congress intended that individuals
such as petitioners be entitled to deduct charitable
contributions for amounts not actually retained by a charity.
See Hamm v. Commissioner, T.C. Memo. 1961-347 (charitable
contribution under sec. 2522 requires “a reasonable probability
2
The majority does not state what the $90,011 is less than
1 percent of. I believe the majority is referring to the
relationship of the $90,011 to the aggregate taxable gift as
found by the majority.
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that the charity actually will receive the use and benefit of the
gift, for which the deduction is claimed”), affd. 325 F.2d 934
(8th Cir. 1963).
I would deny a charitable deduction for the increased value
by applying to this case a public policy doctrine that is similar
to the doctrine applied by the Courts in Commissioner v. Procter,
142 F.2d 824, 827 (4th Cir. 1944), revg. on other grounds a
Memorandum Opinion of this Court, and Ward v. Commissioner,
87 T.C. 78 (1986). In Commissioner v.
Procter, supra, the
taxpayer transferred certain property interests to a trust
benefiting his children. The trust instrument provided that, if
a competent Federal court of last resort should find any part of
the transfer to be subject to gift tax, then that portion of the
property subject to such tax would not be considered to have been
transferred to the trust. The Court of Appeals for the Fourth
Circuit declined to respect this adjustment provision. The court
stated:
We do not think that the gift tax can be avoided by any
such device as this. Taxpayer has made a present gift
of a future interest in property. He attempts to
provide that, if a federal court of last resort shall
hold the gift subject to gift tax, it shall be void as
to such part of the property given as is subject to the
tax. This is clearly a condition subsequent and void
because contrary to public policy. A contrary holding
would mean that upon a decision that the gift was
subject to tax, the court making such decision must
hold it not a gift and therefore not subject to tax.
Such holding, however, being made in a tax suit to
which the donees of the property are not parties, would
not be binding upon them and they might later enforce
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the gift notwithstanding the decision of the Tax Court.
It is manifest that a condition which involves this
sort of trifling with the judicial process cannot be
sustained. [Id. at 827. * * *]
The court also noted that the adjustment clause was contrary to
public policy because: (1) Public officials would be discouraged
from attempting to collect the tax since the only effect would be
to defeat the gift; (2) the adjustment provision would tend to
obstruct the administration of justice by requiring the court to
address a moot case; and (3) the provisions should not be
permitted to defeat a judgment rendered by the court.
Id.
We followed Procter in Ward v.
Commissioner, supra. In
Ward, the taxpayers, husband and wife, each transferred 25 shares
of stock to each of their three sons. At the time of the gifts,
the taxpayers and their sons executed a “gift adjustment
agreement” that was intended to ensure that the taxpayers’ gift
tax liability for the stock transfers would not exceed the
unified credit against gift tax that the taxpayers were entitled
to at that time.
Id. at 87-88. The agreement stated that, if it
should be finally determined for Federal gift tax purposes that
the fair market value of the transferred stock either was less
than or greater than $2,000 per share, an adjustment would be
made to the number of shares conveyed so that each donor would
have transferred $50,000 worth of stock to each donee.
Id. We
concluded that the fair market value of the stock exceeded $2,000
per share for each of the relevant years.
Id. at 109.
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More importantly, we declined to give effect to the gift
adjustment agreement. We noted that honoring the adjustment
agreement would run counter to the policy concerns articulated in
Commissioner v. Procter, supra. Ward v.
Commissioner, supra at
113. We also concluded that upholding the adjustment agreement
would result in unwarranted interference with the judicial
process, stating:
Furthermore, a condition that causes a part of a
gift to lapse if it is determined for Federal gift tax
purposes that the value of the gift exceeds a given
amount, so as to avoid a gift tax deficiency, involves
the same sort of “trifling with the judicial process”
condemned in Procter. If valid, such condition would
compel us to issue, in effect, a declaratory judgment
as to the stock’s value, while rendering the case moot
as a consequence. Yet, there is no assurance that the
petitioners will actually reclaim a portion of the
stock previously conveyed to their sons, and our
decision on the question of valuation in a gift tax
suit is not binding upon the sons, who are not parties
to this action. The sons may yet enforce the gifts.
[Id. at 114.]
Here, CFT receives no benefit from the Court-determined
increase in the value of the subject property, but petitioners
benefit in that they are entitled to an additional charitable
deduction. As was true in Commissioner v. Procter, supra, the
possibility of an increased charitable deduction serves to
discourage respondent from collecting tax on the transaction
because any attempt to enforce the tax due on the transaction is
of no advantage to the fisc.
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3. Each Step of the Transaction Is Part of an Integrated
Transaction
All of the steps which were taken to effect the transfer of
petitioners’ partnership interests to their sons (inclusive of
the trusts) were part of a single integrated transaction. The
purpose of that transaction was to transfer the interests with an
avoidance of Federal gift taxes, while, at the same time,
discouraging audit of the transfer and manufacturing phantom
charitable gift and income tax deductions in the event that the
value of the transfer was later increased. I reach my conclusion
in light of the following facts which were found by the trial
judge or are reasonable inferences therefrom: (1) Petitioners
were seeking expert advice on the transfer of their wealth with
minimal tax consequences, (2) the transaction contemplated that
the charities would be out of the picture shortly after the gift
was made, (3) the transfers of the partnership interests to the
charities were subject to a call provision that could be
exercised at any time, (4) the call provisions were exercised
almost contemporaneously with the transfers to the charities,
(5) the call price was significantly below fair market value,
(6) the charities never obtained a separate and independent
appraisal of their interests (including whether the call price
was actually the fair market value of those interests),
(7) neither charity ever had any managerial control over the
partnership, (8) the charities agreed to waive their arbitration
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rights as to the allocation of the partnership interests, and
(9) petitioners’ sons were at all times in control of the
transaction. I also query as to this case why a charity would
ever want to receive a minority limited partnership interest, but
for an understanding that this interest would be redeemed quickly
for cash, and find relevant that the interest was subject to the
call provision that could be exercised at any time.
4. Conclusion
The majority has placed its stamp of approval on a
transaction that not only is a prime example of clear taxpayer
abuse but has as its predominant (if not sole) purpose the
avoidance of Federal taxes. The majority has done so either
because it does not recognize the abuse or, more likely, that it
feels impotent to stop the abuse. The majority has gone as far
as to condone taxpayer-abusive behavior by allowing petitioners
to deduct a charitable contribution for amounts which will never
benefit a charity. For these and the other reasons stated
herein, I dissent.
VASQUEZ, J., agrees with this dissenting opinion.
