Thoughts on Estate of Elkins and Valuations (10/21/14)

I write today on the Fifth Circuit's opinion in Estate of Elkins v. Commissioner, ___ F.3d ___, 2014 U.S. App. LEXIS 17882 (5th Cir. 2014), here.  In that case, the Fifth Circuit reversed the Tax Court in a valuation case involving discounts for fractional interests in valuable art.  The Fifth Circuit opens with a summary of its reasoning, such as it is (footnote omitted):

In the Tax Court, the Commissioner steadfastly maintained that absolutely no fractional-ownership discount was allowable. This presumably accounts for his failure to adduce any affirmative evidence—either factual or expert opinion—as to the quantum of such discounts in the event they were found applicable by the court.
The Tax Court rejected the Commissioner's zero-discount position, but also rejected the quantums of the various fractional-ownership discounts adduced by the Estate through the reports, exhibits, and testimony of its three expert witnesses—the only substantive evidence of discount quantum presented to the court.1 Instead, the Tax Court concluded that a "nominal" fractional-ownership discount of 10 percent should apply across the board to Decedent's ratable share of the stipulated FMV of each of the works of art; this despite the absence of any record evidence whatsoever on which to base the quantum of its self-labeled nominal discount.
We agree in large part with the Tax Court's underlying analysis and discrete factual determinations, including its rejection of the Commissioner's zero-discount position (which holding we affirm). We disagree, however, with the ultimate step in the court's analysis that led it not only to reject the quantums of the Estate's proffered fractional-ownership discounts but also to adopt and apply one of its own without any supporting evidence. We therefore affirm in part, reverse in part, and render judgment in favor of Petitioners, holding that the taxable values of Decedent's fractional interests in the works of art are the net amounts reflected for each on Exhibit B of the Tax Court's opinion. This, in turn, produces an aggregate refund owed to the Estate of $14,359,508.21, plus statutory interest.

Just a few paragraphs down, the Fifth Circuit continues:

This entire appeal thus begins and ends with the question of the taxable value of Decedent's fractional interests in those 64 items of non-business, tangible, personal property that were jointly owned in varying percentages by Decedent and his three adult children at the instant of his death. And, the answer to that one question begins and ends with the proper administration of the ubiquitous willing buyer/willing seller test for fair market value: "Fair market value is defined as 'the price at which the 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.'"

The context for the Fifth Circuit’s opinion is the Tax Court’s opinion below.   In Estate of Elkins v. Commissioner, 140 T.C. No. 5, 2013 U.S. Tax Ct. LEXIS 6 (T.C. 2013), here, the issue was the familiar one of the appropriate discounts for fractional interests.  The IRS generally disfavors fractional interests, due in no small part to taxpayers’ frequent – perhaps even common – use of aggressive discounts which will either prevail because they win the audit lottery or, if caught, will be recognized as improperly inflated and reduced accordingly.  (Most practitioners would say that it is entirely proper to assert aggressive discounts -- but not so aggressive that serious penalties would apply in the full expectation that, if contested, there will likely be some adjustment; that is the way the game is played.) Essentially, as I read the opinion, the Tax Court judge, Judge Halperin, found the estate's proffered too aggressive and found an alternative discount.  The estate, of course, had "experts" to testify as to the discounts.  The IRS essentially had no "experts" to testify that no discount or any discount less than testified by the estate's experts was appropriate.  So, on the record presented, Judge Halperin found that the proper discount was 10%, substantially below the discounts claimed by the estate.  He based that on the entire record before him.

Failure of Taxpayers' Proof of Value Loses Case (10/8/14)

In Cavallaro v. Commissioner, T.C. Memo 2014-189, here, the Tax Court held that the parents owning a company merged with a company owned by the children had not received enough value in the merged companies and thereby made a gift to the children.  The court also held that the parents had reasonable cause to rely upon their tax advisors and thus avoided penalties.

I focus here on the valuation issue of whether a gift was made.  The law is clear that a gift can be made under such circumstances if one party shifts value to other related parties.  The Court resolved the actual value issue on the basis of the burden of proof.  Most of the time, valuation issues are decided after each side has proffered expert testimony with the Court finding a value somewhere in between.  Even where the parties are reasonable in their valuations, they are usually reasonably aggressive positions and the value really is somewhere in between.  In Cavallaro, however, the Court found the value the Commissioner claimed because, it found, that taxpayers had failed to meet the burden of proof imposed upon them.  Basically, the potential for a shift in value from the parents to the children occurred only if the parents' company did not own certain valuable technology.  The parents' claim was that the children's company owned the valuable technology, hence the parents did not receive less than they contributed to the merger and did not make a gift to the children.  The parents' experts made their expert reports assuming the validity of the claim that the parents' company did not own the technology.  The Court found, however, that the parents' company did own the technology, thereby rendering the parent's expert witness reports irrelevant.  All the Court then had was the claim by the Commissioner (which had been reduced from the amount originally asserted in the notice of deficiency), supported, of course, by the Commissioner's expert report.  The Court thus had no basis for doing anything other than sustaining the Commissioner based on the taxpayers' failure to meet the burden of proof.

Key components of the holding are:

1.  The Court first held that the taxpayers had the burden of proof even though the IRS had substantially reduced its valuation from the amount originally asserted in the notice of deficiency.  The Court reasoned.

In general, the IRS's notice of deficiency is presumed correct, "and the petitioner has the burden of proving it to be wrong". Welch v. Helvering, 290 U.S. 111, 115, 54 S. Ct. 8, 78 L. Ed. 212, 1933-2 C.B. 112 (1933); see also Rule 142(a). The Commissioner has conceded that the taxable gifts totaled not $46.1 million (as in the notices of deficiency) but instead $29.6 million (as yielded by Mr. Bello's analysis). Where the Commissioner has made a partial concession of the determination in the notice of deficiency, the petitioner has the burden to prove that remaining determination wrong. See Silverman v. Commissioner, 538 F.2d 927, 930 (2d Cir. 1976) [**52]   (holding that the burden of proof does not shift where the Commissioner's change of position operates in favor of the taxpayer), aff'g T.C. Memo. 1974-285; cf. Rule 142 (shifting the burden "in respect of * * * increases in deficiency").

2.  The Court then rejected the argument that the reduction shifted the burden under Tax Court Rule 142(a)(1) which imposes the burden of proof on the commissioner "in respect of a new matter."  For much the same reason as Silverman, the Court rejected the argument.  The Court did say that the IRS's assertion of the accuracy related penalty rather than the fraud penalty was a new matter (even though the taxpayer's claim of reasonable cause would have been a defense to the fraud penalty originally asserted); and in any event, the Court found the defense proved so neither penalty applied.