A recent Tax Court decision has
caught the attention of estate planners and appraisers because of its implications
for gifts of undivided interests in real property. The case at issue is Ludwick v. Comm'r, T.C. Memo 2010-104 (May 10, 2010). In Ludwick,
the court determined that the value of a married couple's respective one-half interests
in a vacation home they owned as tenants-in-common and transferred to separate
qualified personal residence trusts ("QPRTs") should be discounted at a substantially
lower rate than had been used to calculate the value of the interests on the couple's
gift tax returns. This case illustrates the
difficulties in valuing gifts like this, and it gives the IRS a new tool in the
audit and settlement of cases where valuation of an undivided interest is a
contested issue.
The
facts are as follows. In 2000, the
Ludwicks purchased unimproved real property in Hawaii. By 2003 they had constructed an 8000-square
foot vacation home. In December 2004
they established separate QPRTs, and in February 2005 they transferred their
respective undivided one-half ownership interests to their respective QPRTs. At that time the property had a fair market
value of $7.25 million and annual operating costs of approximately
$350,000. On their 2005 gift tax returns
each spouse reported a gift of $2,537,500, reflecting a 30% discount for lack
of control and lack of marketability. On
audit, the IRS allowed a discount of only 15% and assessed a deficiency, which
led to the Tax Court action. At trial
the taxpayers' expert concluded that a 35% discount should apply, while the IRS
expert testified in favor of an 11% discount.
The court rejected both experts' testimony and determined - using its
own formula - that a discount of 17% was appropriate.
A
key element influencing this decision was the tenancy-in-common ("TIC")
agreement between husband and wife.1 As described in an article authored by the taxpayers'
expert after trial,2 the TIC
agreement was properly executed and contained standard provisions, but included
two sections that directly impacted valuation and that are not typically found
in the same agreement. One section prohibited
either co-tenant from seeking a partition of any part of the property, but
another section gave each tenant the right to sell its undivided interest to
the other co-tenant at a pro rata
value of the whole or, alternatively, to sell the property in its
entirety. Not surprisingly, the
taxpayers' expert argued that the provision prohibiting partition took
precedence over the forced sale provision, and the IRS expert argued the
opposite. The taxpayers' expert states
the following about what occurred at trial on this point: "With minimal discussion about the TIC
Agreement at the onset of trial, the parties agreed that a forced sale was
indeed possible under the TIC Agreement.
With no further discussion of the TIC Agreement, Judge Halpern appears
to have equated the forced sale provision to a partition right, thereby giving
each co-tenant the unrestricted right to force a judicial partition of the
property."3
There
is ample authority that restrictions in a TIC agreement (such as the waiver of the
right to partition) support significant discounts - often well in excess of 35%
- because of their effect on marketability and control. But the opinion focused primarily on a
partition analysis in determining the value of the gifts. Another important factor in this case is that
Judge Halpern found both experts' testimony woefully insufficient. This created a vacuum to which Judge Halpern
responded with a formula. He determined
how to apply the formula to the facts, using some of the experts' data but
developing his own as well. The result
was a formula that started with the fair market value of the property, then
applied factors such as (1) a buyer's expectation of a 10% rate of return
(discount rate), (2) a projected partition period of two years (including a
selling period of one year), (3) operating costs of $175,000 per year, (4) partition
costs of $36,250 per year, and (5) one-half of the projected selling costs. The calculation was further refined to take
into account Judge Halpern's determination that there was only a 10%
probability that partition would be required, to produce a weighted
average.
This
case is distinctive in the degree to which the court provided a well-expressed formula
by which to determine the value of the gift, making several assumptions necessary
to the computation. The formula and its detailed
application - and of course the government-friendly result - are what will make
this case so useful to the IRS in future disputes. As such it is a lesson to estate planners,
both when structuring transactions and later when defending them.
(a) Structuring: No issues appear to have been raised with how
the transaction was structured, other than the use of apparently inconsistent
clauses in the TIC agreement. On the one
hand the parties agreed to waive their rights of partition, but on the other they
agreed that either could force a sale of the property. According to the taxpayers' expert, the court
seems to have viewed the mechanism allowing either investor to force a sale as
"providing a virtually risk-free liquidity option" 4
for that investor. However, in the
expert's view, the court gave no consideration to the fact that under either
scenario (being able to force a partition, or force a sale) the investors would
"give up their ability to enjoy the
amenities of a luxury vacation home without the ability to replicate the
existing benefits at one-half the cost; reason that could significantly
increase the likelihood of a vigorously contested process."5
(b) Defending: Judge Halpern criticized both experts for
failing to provide enough relevant data to support their conclusions. He faulted the taxpayers' expert for the
following: (1) analyzing discounts in 69
undivided interest transactions but failing to include information about the
underlying fair market value or comparables of the properties in those
transactions, and the standard of deviation among them, and (2) using
income-producing properties (and cashflow data) as comparables, when the
property at issue was not a revenue-producing property.6 Judge Halpern also criticized the IRS expert
for: (1) using sales of commercial
properties in the eastern United States as comparables, (2) relying on surveys
from California real property brokers but no underlying data about the
transactions upon which the brokers based their responses, (3) using surveys
regarding pooled public TIC interests, which the expert himself even conceded
were critically different from the property at issue, and (4) relying on a
review of tender offers for majority interests in public companies, and control
premiums, which the court dismissed as "unhelpful."
The
respective experts' input was unhelpful to their cases in the following additional ways:
(1) The taxpayers' expert failed to convince
the court that a buyer would consider more than just the cost of partition and
the marketability risk; in fact, the opinion quotes some of his trial testimony
that seems to have conceded the IRS viewpoint.
The court reasoned from this that "a buyer with a right to partition
could not demand a discount greater than (1) the discount reflecting the cost
and likelihood of partition and (2) the discount representing the marketability
risk because, if he did, another (rational) buyer would be willing to bid
more. That iterative process would drive
the discount down to the discount reflecting the expected cost of partition and
the marketability risk."7
(2) The taxpayers' expert and the IRS expert
provided differing estimates on the costs of a contested partition. The court adopted neither, instead finding
that a contested partition would take two years to resolve (including one year
to sell the property) and that the costs made necessary by the litigation would
be 1% of the value of the property. If
the taxpayers had been able to prove higher costs of a partition action, the
value of the gifts might have been reduced.
(3) The taxpayers did not meet their burden
of proof to show that partition would always, or even often, be necessary. In fact, when IRS counsel suggested that
partition was "relatively unlikely," the court notes that the taxpayers' expert
seemed to agree.8 From this testimony the court determined that
a buyer would expect partition to be necessary only 10% of the time. If the taxpayers had been able to prove a
higher likelihood of partition, the probability rate used in the court's
calculation would have reduced the value of the gifts.
(4) The taxpayers' expert and the IRS expert
provided differing estimates of the cost of selling the property. The court chose neither, finding that the selling
cost would be 6% of the value of the property.
With the right facts it might be possible to project a higher selling cost,
thereby decreasing the value of the gifts.
(5) The IRS expert testified that a buyer
would demand a 10% rate of return to account for the marketability risk; the
taxpayers' expert testified that a buyer would demand a return of 30%. The court stated that the taxpayers' expert
presented no evidence to support his conclusion, and therefore the taxpayers
failed to meet their burden of proof that anything greater than a 10% rate of
return would be expected. Again, if the
taxpayers' expert had been able to produce credible data to support a higher
expected rate of return, this might have reduced the value of the gifts.
Working
through the elements of Judge Halpern's formula, it is clear that if the
taxpayers had been able to meet their burden of proof as to various elements of
the court's formula, the computation would have changed and the taxpayers might
have enjoyed an overall discount greater than 17% on the value of their
respective gifts. This makes it
difficult to predict how Ludwick will
apply in cases with different facts, but certainly it provides a framework for
how other valuation cases might be analyzed.
Commentators
have noted that it is not clear in the Ludwick
case whether the result of focusing on the relatively minor costs associated
with an uncontested sale of the property is a consequence of the TIC agreement
at issue, or a new line of thinking put forth by Judge Halpern for any
undivided interest valuation where a co-tenant retains the right to force a
partition. Either way, from a planning
perspective, the best advice for avoiding a similar result is to engage
knowledgeable attorneys and appraisers when structuring a gift of undivided
interests in property. Also, as the Ludwick case shows, if the parties wish
to waive their right to partition, the waiver should be given overriding
importance in the TIC agreement, and decisions about whether to allow either
party to force a sale should be carefully considered. Should a valuation dispute arise, experts
should be engaged who can heed the lessons of Ludwick and produce data that will keep a court from embarking on
its own valuation.
Morrison & Foerster's Trusts and Estates group
provides sophisticated planning and administration services to a broad variety
of clients. If you would like additional
information or assistance, please contact Patrick McCabe at (415) 268-6926 or
PMcCabe@mofo.com.
© Copyright 2010 Morrison & Foerster LLP. This article is published with permission of
Morrison & Foerster LLP. Further
duplication without the permission of Morrison & Foerster LLP is
prohibited. All rights reserved. The views expressed in this article are those
of the authors only, are intended to be general in nature, and are not
attributable to Morrison & Foerster LLP or any of its clients. The information provided herein may not be
applicable in all situations and should not be acted upon without specific
legal advice based on particular situations.
[1]
Presumably husband and wife entered into the TIC agreement in their capacity as
trustees of the QPRTs.
[2] "TAM
9336002 Bites Taxpayer," Carsten Hoffman, FMV Valuation Alert dated May 12,
2010.
[3] Id.
[4] Id.
[5] Id.
[6] The
dismissal of income-producing properties and cash flow statements as
comparables seems harsh. Even though the
Ludwicks testified that their property was not intended to produce income, this
does not preclude the possibility that it could be used to produce income at a
future date.
[7] Ludwick v. Comm'r, T.C. Memo 2010-104,
§A.2.
[8] Id., §B.1