Part I of this article, published in December 1993, discussed recent court decisions and IRS rulings on disclaimers, debts, claims and administration expenses, gifts, life insurance, marital deduction, powers of appointment and retained interests. Part II, below, covers valuation, special use valuation, Federal income taxation of fiduciaries, charitable matters, miscellaneous estate and gift tax matters and generation-skipping transfers.
Recent developments involving valuation included the following.
* Tax Court relied on estate's appraiser--not government's--for valuation of stock.
* Formula price in shareholder agreement was deemed not binding for Federal estate tax purposes.
* Tax Court relies on estate's appraiser in valuing shares
In Friedberg,(45) the decedent died holding 47% of a thinly traded public company that was the largest independent operator of bowling alleys in the United States. Before his death, the decedent had entered into a "redemption agreement" with the company that was approved by its board of outside directors. Under the agreement, the company was obligated to redeem 942,471 shares at a price equal to 80% of the mean of the bid and asked prices on the day preceding the decedent's death. This agreement was executed to provide liquidity to the decedent's estate and to avoid the significant price erosion that could result if a block of this size was placed on the market. The decedent's remaining 2,443,548 shares were not subject to the agreement. The estate elected alternate valuation under Sec. 2032.
After hearing the testimony of various appraisal experts the taxpayer submitted appraisals by three different experts and the government one), the Tax Court valued the shares at the highest value developed by the taxpayer's appraisers. The government's appraised value exceeded the court's determination by more than $3 million.
Critique: Fair Lanes, inc., began as a family business before 1970. In 1971, when it was still a fairly small operation, it floated a public offering of approximately 16% of its shares. Shortly after that offering, the mean market price rose to over $11 per share. At the time, bowling operations were viewed favorably by the market and Fair Lanes was perceived as a growth company. By the time the decedent died, the company had grown substantially and had become the largest independent bowling alley operator in the country. Although it remained profitable, its market price had fallen to between $5 and $6 per share. Bowling operations were no longer "hot" in the marketplace. Fair Lanes was viewed as a solid, mature company, rather than a growth stock.
The estate's appraisers adopted similar approaches to valuing the two blocks of shares. With respect to the nonredemption shares, each analyzed the status that bowling alley stocks had for the investing public, the effect of dumping a 2.4 million share block into the market (the nonredemption shares represented 148 times the average weekly trading level), the absence of interest by institutional investors and the likelihood of selling a noncontrol block at the existing market price. In addition, each appraiser analyzed various disposition strategies, including a private placement, a secondary offering and a sale in the over-the-counter market. In each instance, the discussion was exhaustive and the valuation experts demonstrated clear and compelling knowledge, both of the company and the market environment in which the shares would be sold. The three independent appraisals submitted by the estate's experts ranged from a high of approximately $9.2 million to a low of approximately $8.2 million for the entire nonredemption block.
With respect to the redemption shares, each appraiser looked beyond the agreement's contract price. The redemption was mandatory, but the company had the option of a lump-sum payment or a cash down payment accompanied by a five-year balloon note at 10% interest. Since the company adopted the latter option, and the estate had elected alternate valuation, the appraisers argued that the Federal estate tax value should be the aggregate values of the consideration received. In particular, the note should be valued at its present value on the alternate valuation date. The appraisers considered such factors as the company's credit-worthiness, the note's unsecured nature and the stated interest rate (which was below the market rate for similar instruments issued by companies like Fair Lanes). The taxpayer's experts valued the redemption shares in a range of approximately $2.2 million to approximately $3.1 million.
With respect to the nonredemption shares, the IRS's expert argued that the secondary offering prices estimated by the estate's experts were far too pessimistic. He noted the company's very successful 1971 public offering and expected similar market enthusiasm to recur for a current offer. In addition, he presented 19 "comparable companies" that had recently undertaken successful public offerings. On that basis, he valued the nonredemption block at approximately $11.7 million.
With respect to the redemption shares, the IRS expert assumed that the entire principal balance would be paid off in five years and that the sole consideration was a present value analysis. The lack of security and the company's credit-worthiness were not considered relevant as Fair Lanes had sufficient cash flow for debt service and a Standard & Poors (S&P) stock rating of A--. The IRS appraiser valued the redemption shares at approximately $3.8 million.
In reaching its decision, the Tax Court expressed a complete lack of confidence in the IRS's expert. It was troubled by the expert's disregard of such issues as creditworthiness, the impact of selling a massive block of shares on a thinly traded market and bowling stocks' changed status in the marketplace. It noted that none of the 19 companies cited by the IRS's expert were truly comparable and that most had been growth stocks. Finally, the court thought it was incredible that the IRS equated a 1971 public offering of a 16% interest in a small growth stock with a proposed public offering of over 20% of a mature, nongrowth company. The Tax Court then indicated that, while all of the estate's experts did an outstanding job in proving their positions, none of them provided it with sufficient information to "pick a precise figure." As such, it selected the highest appraisal submitted by the estate's experts for each share block. This represented an approximately $3.3 million reduction from the IRS's valuation.
Planning hints: Friedberg is an extremely useful case as it clearly demonstrates the advantages of using highly competent appraisal experts when hard to value or nontraded assets are included in an estate. It also demonstrates a continuing trend in the courts. No longer can practitioners expect the courts to simply add the taxpayer's and IRS's appraisals together and divide by two. Contested estate tax value litigation increasingly is an all-or-nothing proposition. The winner will be the litigant supported by the valuation expert found most convincing by the court.
There is another important point. Over the past few years, the IRS has been embarrassed because of the poor quality of its appraisals and its experts' arbitrary approaches. Tax planners must assume that the IRS is beginning to learn its lesson. It will begin to secure better appraisals from more competent professionals. If taxpayers do not do the same, they must accept the risk.
* Buy-sell agreement at book value does not set Federal estate tax value
In Lauder,(46) at the time of his death in 1983, the decedent owned blocks of voting and nonvoting shares in Estee Lauder, Inc., a nontraded family business. The shares were valued in the Federal estate tax return under a 1974 shareholder agreement formula. The formula was based on the company's book value, unadjusted for intangible assets. On audit, the IRS issued a deficiency adjustment of approximately $42.7 million. The Tax Court held that the formula price did not set the estate tax value.
Critique: In reaching its decision, the Tax Court first noted that various criteria have been established for testing whether restrictive stock agreement formula prices are binding for Federal estate tax purposes. These include:
The offering price must be fixed and determinable under the agreement,
The agreement must be binding on the parties both during life and after death,(47) and
The agreement must have been entered into for a bona fide business purpose and not as a substitute for a testamentary disposition.(48)
The formula price was clear and unambiguous. With a few justifiable exceptions, the formula was binding at all times and was treated as binding by all parties to the agreement. The court found that maintaining control within the family was a real and compelling business purpose.
However, the court stated that "it is evident that intrafamily agreements restricting the transfer of stock in a closely held corporation must be subjected to greater scrutiny than that afforded similar agreements between unrelated parties."(49) A significant element of this "additional scrutiny" is a determination that the agreement was "not intended as a device to pass decedent's shares to the natural objects of his bounty for less than an adequate and full consideration in money or money's worth."(50) On this matter, the taxpayer bears the burden of proof.
The court noted that the agreement was the idea of the decedent's son. Apparently very little forethought went into the formula's development. in fact, the son testified that the agreement had been discussed with a family adviser who had suggested book value as the pricing mechanism. This advice was taken. However, no attempt was made to elicit valuation experts' advice or assistance. At trial, both sides' valuation experts indicated that appropriate appraisal methodology included earnings multiples...