Timber Case Shows Value of Family Limited Partnership

Originally Published on forbes.com on July 7th,2011

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Estate of Natale B. Giustina, et al. v. Commissioner, TC Memo 2011-141 

 There are many good business reasons to consider putting assets into a family limited partnership.  I can and have discussed them in sober detail, but I will gloss over that for now and skip to what gets people excited.  Valuation discounts.  Natale B. Giustina owned 41.128 % of Giustina Land and Timber Company Limited Partnership (GLT).  The value of that interest was the subject of the case. In cases like, this there will be multiple appraisals with the appraisers disagreeing on various points.  The Court will usually agree with one appraiser on one thing, another on something else and sometimes make something up on its own.  In this case, there was one item on which there was no disagreement.  The gross value of the partnership’s assets (mostly vast tracts of timber land-some 48,000 acres) was approximately $150,000,000.  In arriving at the $150,000,000 the timber lands value of $143,000,000 was net of a 40% discount to reflect the delay in selling the land.)  So if the case was being decided by the simple minded jurors in the Levy case, the value of the interest would be $60,000,000 and change. (Unless the land were actually sold by the time of the trial which would make the partnership interest value higher).

  The Tax Court instead considered the value on the Form 706 based on an appraisal by Columbia Financial Advisors -  $12,678,117.  The estate brought in another appraiser named Robert Reilly (no relation, that I know of, although I do have a brother by that name) who arrived at $12,995,000.  Then there was John Thomson, the IRS expert, who came in at $33,515,000.  The Tax Court, not exactly splitting the difference in this case ended up at $27,454,115 (Or as the Court modestly refers to it “the correct value”).  The as filed value was less than 50% of the “correct value”, but the Court did not allow the IRS to assess a penalty.

How can this be ?  If prior to his death Mr. Giustina had received a distribution of 19,000 or so acres that were representative of the whole and he had held those acres on the date of his death, they would have been worth at least $60,000,000.  Inside a partnership in which he was the largest partner and all seven of the other limited partners had names like Syliva B Giustina and Natalie Giustina Newlove even the IRS is only looking for about 50% and an appraisal at around 20% doesn’t rate a penalty.

Since Mr. Giustina could not force a sale of the assets, the primary valuation of the partnership was based on the discounted present value of the cash flow.  The Court thought Mr. Reilly had done the better job on estimating the cash flow:

 First, as Reilly explained on pages 17-18 of his rebuttal report, there was an internal inconsistency between Thomson’s cashflowestimates and his calculation of the effect of lack of control on the value of the 41.128-percent limited partner interest. The inconsistency led Thomson to overvalue it. Second, Thomson unrealistically assumed that the partnership’s operating expenses would remain fixed, even though he projected that its revenues would increase 3 percent annually. Third, Thomson’s estimate of annual cashflowswas extrapolated from the actual cashflow results of the most recent year. By contrast, Reilly extrapolated from the cashflow results of five consecutive years. Reilly’s use of five years of data is sounder because it reduces the effect of a temporary variation in cashflow.

The Court was not totally satisfied with Mr. Reilly’s valuation based on cash flow.  He had deducted 25% for income taxes, which was inappropriate since he had used a pre-tax rate of return to discount the cash flows.  In addition they quibbled with his discount rate. The rate was built up from four components.  A risk free rate of 4.5%, a beta adjusted risk premium of 3.6% (about half that of the S&P 500), a small stock equity risk premium of 6.4% and an additional risk premium of 3.5% because the timber was concentrated in Oregon.  He then reduced the rate by 4% for assumed growth.  The Court cut the 3.5% to 1.75%, because some of that was based on “unique risk”.   According to the Court the market does not pay for unique risk, since it can be avoided by diversification.

The Court rejected the use of the guideline company method.  The proposed companies Plum Creek Timber Co., Inc., Pope Resources LP, Deltic Timber Corp., and Potlatch Corp, were not comparable enough. Both Deltic and Potlatch have substantial operations other than owning timber land and selling timber.

In the end the Court used the discounted cash flow value prepared by Mr. Reilly, as adjusted, and a liquidation value.  It gave the discounted cash flow method a 75% weight, its prediciton on the probability that the company would continue to operate.  There was no discount for lack of control allowed, since that is reflected in the weight given to the partnership conitnuing to operate rather than liquidate.  There was a discount for lack of marketability of 25% but that was only applied to the operating value not the liquidating value.

There is something about all this that disturbs me intellectually.  The parties seem to agree that if you wanted to buy all the stuff in the Giustina partnership it would cost you $250,000,000 (remember the 40% discount on the land value).  On the other hand a valuation of a 40% interest in all that at less than $13,000,000 was reasonable, although low, the ”correct value” being $27,454,115. There has to be something bizarrely wrong about our capital markets for this to make any sense.  Fortunately, thinking about matters like that is not my job, man.  My motto in tax matters is “It is what is.  Deal with it.”  There are a host of execution issues and numerous ways to screw up family limited partnerships as I have written elsewhere, but the family limited partnership is once again proven to be a very valuable estate planning tool.

Tax Court Values Regional Media Empire

Originally Published on forbes.com on July 5th,2011

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Estate of Louise P. Gallagher, et al. v. Commissioner, TC Memo 2011-148

When Louise Gallagher died in 2004, she was the largest owner of Paxton Media.  Based in Paducah, Kentucky, Paxton owns 32 daily newspapers, numerous weeklies and WPSD-TV, an NBC affiliate serving parts of Kentucky, Illinois and Missouri. Ms. Gallagher’s 3,970 units constituted 15% of the value of Paxton Media Group LLC.  Her estate tax return included the units at a value of $34,396,000.  The IRS audited the return and after failing to settle issued a notice of deficiency based on a value of $49,500,000.  Both parties commissioned new appraisers.  The new appraisals were both lower, but almost as far apart $26,606,940 versus $40,863,000.  Then the estate hired another appraiser, who closed the gap a little with a value of $28,200,000.

I’m going to spare you the suspense here and tell you that the Tax Court came in at $32,601,640.  So the Government would have done better to accept the return as filed.  I have a theory, though, that the real function of the estate tax is to serve as a white collar jobs program.  With a little bit of luck we will be reading another case in a year or so about all the additional expenses that the estate will be deducting because of this litigation.  The analysis that the Tax Court went through to arrive at its value, is, however, instructive and I would like to share some of the highlights.  In the interest of score-keeping here is a list of the five appraisals with the names of the appraisers and the initials I’ll use in the discussion:

David Michael Paxton – (PMG’s President and CEO)(DMP) – $34,396,000                                                                                                                                                                          IRS – $49,500,000                                                                                                                                                                                                                                                                               Sheldrick, McGehee & Kohler, LLC (SMK) - $26,606,940                                                                                                                                                                                                      Richard C. May (RCM) – $28,200,000                                                                                                                                                                                                                                          Klaris, Thomson & Schroeder, Inc. (KTS) -  $40,863,000

 The Tax Court ended up accepting and working with the RCM and KTS appraisals noting where they differ:

The parties disagree over: (1) The date of financial information relevant to a date-of-death valuation of decedent’s units, (2) the appropriate adjustments to PMG’s historical financial statements, (3) the propriety of relying on a market- based valuation approach (specifically the guideline company method) in valuing the units, and, if appropriate, the proper manner of applying that method, (4) the application of the income approach (specifically the discounted cash flow valuation method), (5) the appropriate adjustments to PMG’s enterprise value, and (6) the proper type and size of applicable discounts.

Date of Financial Information

Ms. Gallagher died on June 27, 2004.  The KTS appraisal uses PMG’s internalfinancial statements prepared as of June 27, 2004 and data from public companies for the quarter ended June 30, 2004.  I’m guessing that PMG, which was an S Corporation, did June 27 financial statements in order to accommodate allocation of taxable income based on an interim closing of the books rather than the days method.   RCM maintained that someone valuing the company on June 27 would have been constrained to use PMG’s internal information as of May 30, 2004 and public company data for the quarter ended March 28, 2004.  The Court agreed with using the June numbers:

 Petitioner argues that the June information was not publicly available as of the valuation date, preventing a willing buyer and seller from relying upon it in determining fair market value. That is not to say, however, that our hypothetical actors could not make inquiries of PMG or of the guideline companies (or of financial analysts), which would have elicited non-publicly available information as to end-of-June conditions. Moreover, we understand Mr. Thomson’s testimony to be that the June 2004 financial information accurately depicts the market conditions on the valuation date, not that a willing buyer and seller would have relied upon the data. Importantly, petitioner has not alleged an intervening event between the valuation date and the publication of the June financial statements that would cause them to be incorrect.

I would observe here that in the sale of this type of business there might be an adjuster clause to take into account the actual values of items such as cash, receivables and payable as of the closing date, which of necessity will not be known on the closing date.

Appropriate Adjustments to Historical Financial Statements

A valuation like this is heavily based on a prediction of future EBITDA (Earnings Before Interest Taxes Depreciation Amortization).  The starting point will be the most recent earnings, but those earnings must be adjusted for non-recurring items.

The KTS appraisal made one adjustment to PMG’s income statements, subtracting a $7,895,016 gain on divested newspapers in 2000.

 The RCM appraisal made, among other adjustments, the following three adjustments to PMG’s earnings: (1) Reduced PMG’s 2000 earnings before interest, taxes, depreciation, and amortization (EBITDA) by a $7,900,000 gain on divested newspapers, (2) subtracted from both EBITDA and earnings before interest and taxes (EBIT) a 2003 $700,000 gain from a life insurance policy PMG inherited through an acquisition, and (3) subtracted from both EBITDA and EBIT a 2003 $1,100,000 positive claim experience from PMG’s self-insured health insurance.

Respondent objects to those three adjustments. We are unclear as to why respondent objects to the 2000 newspaper divestiture adjustment since his own expert, on whose appraisal he relies, made the same adjustment. We thus consider respondent to have acquiesced to the adjustment. However, we disregard Mr. May’s self-insured health insurance and life insurance policy adjustments because he provides no explanation as to why the gains were non-recurring.

Why did the IRS attorneys object to an adjustment that their own expert had conceded?  They’re attorneys.  Objecting is what they do.  The more interesting question is why the RCM appraisal did not include any commentary on why the life insurance and health insurance adjustments were not recurring. Perhaps, being number crunchers, the appraisers thought it was apparent, as do I. The $1,100,000 in 2003 could have a substantial effect on the valuation, particularly if some sort of weighted average of EBITDA was being used.  I guess the advice that appraisers might take away from this is what I used to tell my kids when they were little – Use Your Words.

Guideline Companies

The Court found that the four public companies (Journal Register Co., Lee Enterprises, Inc., the McClatchy Co., and Pulitzer, Inc) used in the KTS appraisal were not similar enough to PMG and rejected this approach.  The companies are all much larger than PMG, included more specialty publications and three of them were beginning to enter develop on-line publications.

Discounted Cash Flow Valuation Method

The discussion here really gets into the weeds.  Which appraiser was better at projecting future newsprint cost is an example of something that must be resolved, so I will gloss over much of the discussion.  One issue that is significant is tax affecting the earnings.  This is an S corporation, so we shouldn’t really have to consider taxes – right? That’s pretty much how the Court saw it:

Mr. May tax affected PMG’s earnings by assuming a 39-percent income tax rate in calculating the company’s future cash flows, before discounting PMG’s future earnings to their present value. He also assumed a 40-percent marginal tax rate in calculating the applicable discount rate. In contrast, Mr. Thomson disregarded shareholder-level taxes in projecting both the company’s cash flows and computing the appropriate discount rate.

Mr. May failed to explain his reasons for tax affecting PMG’s earnings and discount rate and for employing two different tax rates (39 percent and 40 percent) in doing so. Absent an argument for tax affecting PMG’s projected earnings and discount rate, we decline to do so. As we stated in Gross v. Commissioner, the principal benefit enjoyed by S corporation shareholders is the reduction in their total tax burden, a benefit that should be considered when valuing an S corporation. Mr. May has advanced no reason for ignoring such a benefit, and we will not impose an unjustified fictitious corporate tax rate burden on PMG’s future earnings.

Here is another instance of an appraiser not using his words, although the tone of the decision seems to indicate that it would not have helped.

Both appraisers used a Weighted Average Cost of Capital to discount the projected cash flows.  The Court generally does not think that WACC is applicable to closely held companies, but allowed it in this case since the appraisers agreed on it in concept.  I won’t comment on the detail it went into in comparing the way each appraiser computed WACC other than to say that it kind of makes me suspicious that the Court came up with 10%, seeing how easy that makes the math, but that’s pretty cynical.

Enterprise Value

Having arrived at the value of the discounted cash flow, enterprise value is determined by adjusting for excess or inadequate working capital and subtracting debt.  Once again the RCM appraisal is faulted for not enough words:

We do not find Mr. May’s analysis to be persuasive. Mr. May once again failed to explain why the public companies that he deemed to be not comparable to PMG under the guideline company method provide a sufficient comparison upon which to base a working capital adjustment. We lend little weight to his seemingly contradictory positions. In addition, although explaining the need for a working capital adjustment under the guideline companies methodology, he failed to do so under the DCF method despite applying the adjustment to the results under both methods. For these reasons, we disregard his working capital deficit adjustment.

The RCM appraisal had also had an add-in to reflect the benefits of PMG being an S corporation.  The Court indicated that this was taken care of by its assumption of a 0% corporate tax rate.

There was also a small difference in the debt numbers based on timing and questions about how the stock options might affect enterprise value.

Discounts

There was not a lot of controversy here.  Although the Court did not think the studies the experts used were necessarily applicable to long term closely held companies, they both used pretty much the same studies, so the marketability discount of 31% allowed by the Court was not a significant adjustment either way.  Oddly the taxpayer’s expert did not have a minority discount while the government’s did.   Apparently the minority discount was built into the RCM method for computing discounted cash flow.  The Court ended up increasing the minority discount allowed in the KTS appraisal from 17% to 23%.

Conclusion

I find it intriguing that of the five valuations the one that the Court came closest to was the value on the return as filed.  They hadn’t even hired an appraiser for that one, but were using the valuation the company used for other purposes.  Even though the Court came out closer to the RCM appraisal, they more often than not seemed to like the conceptual approaches in the KTS appraisal, although sometimes the Court indicated that when the two appraisers agreed on something the Court would go along, but didn’t necessarily approve.  The clearest thing that came out is that its holding inGross v Comm to not tax affect S Corporation earnings does not require a lot of fancy math.  It appears that the RCM appraisal would have done better with more words  and less math.  After all Tax Court judges are lawyers.

Sometimes You Need to Burn First

Originally published on Passive Activities and Other Oxymorons on March 7th, 2011.
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LINTON v. U.S., Cite as 107 AFTR 2d 2011-565, 01/21/2011

One of my earliest blog posts, mentioned the Lintons.  I was toting up the score on family limited partnerships for 2009 declaring the year to be a tie with two wins for the IRS and two for the taxpayers.  So early in the blogs existence I hadn't thought through all the implications of the scoring system.  So I will leave it to the readers to determine whether we need to reopen the score book for 2009.  The Lintons have appealed and appear to have won.  Perhaps it would be more accurate to say they have gotten the game into overtime.  In the first decision, the IRS won on "summary judgement".  The appeals court is sending the case back for reconsideration.

 You may have seen the cartoon on which the bumper sticker is based.  Ferocious barbarians are running around the village with torches while the chieftain reflects that it is better to pillage first.  That would seem to be a universal principle, but there are exceptions.

As I mentioned in a previous post, there are some excellent business and family reasons for establishing family limited partnerships.  The excitement though is about the discounts.  You put the assets in the family limited partnerships.  The resulting value of the partnership interests is less than a proportional amount of the underlying assets.  You need to form the partnership and put the assets in it before you make any gifts.  If you give away an undivided interest in the assets and the donees contribute those undivided interests, it doesn't work.  You need to do the thing that reduces the value, then make the gift - Burn, then pillage.

The parties have assumed that in determining the character of the Lintons' gifts, the sequencing of two transactions is “critical,” Senda v. Comm'r, 433 F.3d 1044, 1046 [97 AFTR 2d 2006-419] (8th Cir. 2006), and we do so too, without deciding whether that is always so in cases of this ilk. The transactions at issue are: (1) the contribution of cash, securities, and real property to the limited liability company, and (2) the transfer of LLC interests to the Lintons' children's trusts. If done in that order (and with some lapse of time between the transactions), as the Lintons contend occurred here, the gifts would ordinarily be characterized as gifts of LLC interests, and the value of those LLC interests might be discountable for tax purposes. If, however, the contributions to the LLC occurred after the transfer of LLC interests to the children's trusts, the gifts would ordinarily be characterized as indirect gifts of the particular contributed assets and would not be discountable.

In the first go round the court had concluded that things were done in the wrong order.  The Lintons, however, insisted that they had done their burning before they pillaged.  The problem is that this stuff is all just paperwork.  The way you tell what order things were done in is by the dates on the paper.  Here were the relevant documents :
Quit Claim Deed: signed by William and conveying a parcel of his separate property real estate to WLFB. The parties agree the quit claim deed was effective on January 22.

Assignment of Assets: signed by William as assignor and by both William and Stacy as assignees on behalf of the LLC.

Letters: signed by William and authorizing the transfer of securities and cash to WLFB. The parties disagree as to when the transfers of securities and cash were effected.

At the same meeting with attorney Hack, William, Stacy, and William's brother James Linton, signed, but left undated, several other documents:

Trust Agreements (four total—one for each child): signed by William and Stacy as grantors and by James as trustee; forming and apparently funding irrevocable trusts for the children.

Gift Documents (eight total—one each from William or Stacy to each trust): signed by William or Stacy as assignor and by James as trustee, gifting 11.25 percentage interests in WLFB to each respective trust.

Even though the burning documents were signed at the same meeting as the pillaging documents, the pillaging documents were not meant to be immediately effective.  Then came the oops moment :

Two or three months later, attorney Hack assembled these key documents. For all undated documents, he filled in the missing date as January 22, 2003. In his deposition, Hack stated this insertion was erroneous, and that these documents should have been dated January 31, 2003. William agrees that January 31 was the correct date. This testimony is consistent with that of Caryl Thorp, an accountant with Moss Adams, LLP, who advised the Lintons on the ordering of the transactions.

Really what good is a lawyer's story with out a CPA to back him up ?

The case goes into a fairly interminable discussion of what constitutes a completed gift under the laws of the State of Washington.  Here is the introduction to that discussion:

Under Washington law, “the elements of a completed gift are (1) an intention of the donor to give; (2) a subject matter capable of delivery; (3) a delivery; and (4) acceptance by the donee.” In re Marriage of Zier, 147 P.3d 624, 628 (Wash. Ct. App. 2006). The transfer of the LLC interests occurred when all four elements of a completed gift first existed simultaneously. We must determine when that was. We discuss each element individually, but we defer discussion of the first element, intention to give, until the end, as here it is both the decisive element and the most difficult to determine.


You probably don't want more of that, trust me.

They also discussed an entertaining theory advanced by the Lintons.  The argument is that if the gift of the LLC interests happened before the transfer of the property, then the Lintons should have gotten credit for the property fair market value in their capital accounts.  Hence if the IRS is right instead of a 47% discount, there is no gift all.  The Court wasn't buying it.

The Lintons' “failed-gift” theory is clever; unfortunately for them, it is too clever. The membership ledger of the LLC shows that the capital accounts of the children's trusts were, in fact, increased, as does the LLC's informational return that its accountants prepared and filed with the IRS in March 2004. The Lintons contend that if we conclude the government is right about the timing of the transactions, these documents were prepared on a mistaken assumption (i.e., that the LLC interests were transferred after the assets, and, therefore, by virtue of the IRC § 704 capital account rules, included a pro rata transfer of the assets from the donors' capital accounts to the donees') and should be ignored. On their theory, the informational return and the ledger would only reflect what everyone believed to be the state of the capital accounts, not the actual state of the capital accounts.

 But tax law is concerned “with the realities of a situation and not with the formalities of title.”...... The membership ledger and the LLC's informational return together reflect the substantive reality of the situation: All parties involved regarded the trusts' capital accounts as having been enhanced. In other words, all concerned parties acted as if William and Stacy Linton had “so parted with dominion and control [over the assets] as to leave in [them] no power to change [their] disposition.”

In the end.  This is not the end.  We will be hearing more about this case.

Genuine issues of material fact exist as to the sequence of transactions by which the gifts were made. We remand this question for the district court to determine, following further proceedings, when the four elements of a gift under Washington state law were simultaneously present, and, in particular, to determine when the Lintons first objectively manifested their intent to make the gifts effective. We also reverse the district court's grant of summary judgment in favor of the government as to the application of the step transaction doctrine. Finally, we affirm the district court's order denying summary judgment to the Lintons, holding that they are not entitled to summary judgment on their failed-gift theory.


I think the moral to the story is that forming a family limited partnership, funding it and making a gift of the partnership interests is probably worth more than one trip to the lawyer's office.  Let the village burn for a month and then go back and pillage it.

OK 2010 This is Really Goodbye

Originally published on Passive Activities and Other Oxymorons on February 21st, 2011.
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In  a previous post,  I explained the need for occasional purges of material that does not transform itself into a full length post.  Now I'll explain the Amazon ads.  All hope of them being a means of monetizing has vanished.  They are purely decorative.  The only thing my readers, who apparently now number in the scores (If you have trouble remembering what a score is here is a little trick.  Remember "Four score and seven years ago".  Now subtract the year of the Declaration of Independence from the year of the Battle of Gettysburg.  Then subtract seven.  Then divide by four.  Piece of cake.). do is come to the site.  I have a little gadget next to where I type the blog and I can search Amazon and then click to move the link and image into the blog.  I thought I would see what I got with Goodbye and up comes one of my favorite books.  It's very short and I read it from time to time to cheer myself up.

As the title indicates this is the last of the 2010 material.  I would have gotten it in sooner, but it got pushed aside by two much more interesting recent developments.  One was about mercenaries and the other was about breasts.  So how was blog housekeeping going to compete? With no further fanfare here is the last of 2010:

Private Letter Ruling 201051024

This was a ruling on exempt status.  Exempt status ruling are a fairly rich source of tax humor, although it will be a while before somebody tops Free Fertility Foundation.  I'm not inclined to mock this particular effort, although it does provide a slightly heightened reading on my bs detector.

You were incorporated under the nonprofit laws of the state of M on x. According to your Articles of Incorporation your purpose is to advance the religious beliefs, cultural traditions and lifestyles of four N churches (the "churches") by providing loans and other assistance for real estate purchases and other farm and business related purchases to members of the churches; to encourage savings and thrift and continue to be committed to Christian principles of operation by providing investment and borrowing opportunities to enhance economic social and spiritual well being of the N Brotherhood; and to operate exclusively for charitable, religious or educational purposes.

Investors are limited to residents of M who are members of the churches. Eligible individuals meeting the minimum-investment requirement ($10,000), up to a maximum of 25 new investors annually (to comply with the requirements for exemption from the security laws of the state of M), will be accepted on a first-come, first-serve basis. 


You state that both your lending and borrowing activities will support your exempt purpose of advancing your religious beliefs, cultural traditions and lifestyles of the churches. You represent that central to your religious doctrine is a belief (i) in Biblical financial truths, including brotherly financial aid, responsibility for stability in family finances, the collective responsibility for all members of the church for each other's well being and personal stewardship and (ii) that deacons of your churches are called by God to oversee and, where applicable, alleviate the financial hardship of their church's members. You state that all of these principles lead to the rejection of laws that permit or facilitate the avoidance of responsibility, such as bankruptcy and insolvency laws.

Although you were initially funded by contributions from founding board members and received a church offering from each of the churches, you do not plan to engage in further fundraising activities. Your primary method of raising capital will be interest bearing loans from investors. Your sole source of income will be interest charged to borrowers. You plan to use the spread between the interest rates paid to investors and those charged to borrowers to pay all necessary future expenses.

The organization did not qualify for exempt status.

Articles 4(a) and (b) of your Articles of Incorporation states that you were formed to provide investment and borrowing opportunities. Providing investment and borrowing opportunities to members is not an exempt purpose described in section 501(c)(3).


Your primary purpose is to operate a trade or business, a lending institution which directly competes with commercial lending institutions. Your business practices are consistent with those of the industry in general. You will be funded by capital from investors. Your method of determining fees is similar to the method used by commercial lending institutions.

The minor mystery in this is what the organization expected to gain by its exempt status since it was planning on just breaking even and would not be getting charitable contributions.  It may be there was some state law benefit.  In my recent post on exempt organizations I note one that was trying to qualify so it could get a liquor license.  Presumably that was not the plan with this one.

I'm not much of a scriptural scholar, but I'd like to know where the stuff about bankruptcy comes from.  I think there is more in there about forgiving debts.

Humphrey E. Igberaese v. Commissioner, TC Memo 2010-284

This is really a run of the mill substantiation case. It concerns a host of deductions including charity.

Cash Charitable Contributions Igberaese asserts that he contributed $200 to his church in cash every week of the year, for a total of $10,400. He said that when he was in town, he would attend church and would personally donate the $200 to the church. He said that when he would be out of town, he would provide the cash to other church members in sealed envelopes to take to the church for him. He said he did not recall, even approximately, how often he provided the cash to other church members to donate for him. Nor did he remember the names of any of these members. He presented a printout of a computer spreadsheet consisting of the name of the church, the date of each contribution (each Sunday of the year), the amount of each contribution ($200), and the yearly total ($10,400). He testified that he made each entry around the time of that week's contribution.

Putting aside the formal substantiation requirements for charitable contributions, I'd advise people like Mr.Igberaeseke to work on their stories a little better.  I don't have personal acquaintance with tax court judges, but I believe I've learned a bit about them from reading their opinions for the last thirty years.  Among the things that I have surmised is that they are not idiots and that they live in the same world that I do.  Some of them probably go to church and will therefore know that people who drop cash in the collection plate mostly still think that George Washington is our holiest president.  If the ushers know who's face is on a C note, it is not from experience gained counting the collection

We do not find the evidence Igberaese introduced to be credible. As we discuss in connection with each deduction, Igberaese presented little beyond his own unpersuasive testimony and self-created documentation to corroborate his series of implausible deductions. Several of his explanations for the absence of further corroboration were also implausible.

We are similarly skeptical of Igberaese's documentary evidence, which shows little more than that he has written down his implausible assertions

Trout Ranch, LLC, et al. v. Commissioner, TC Memo 2010-283

This was a dueling expert case.  The Trout Ranch had donated a conservation easement.  The partnerships expert indicated that it was worth 2.1 million.  He based the valuation on other easements sold in the area. The Tax Court was not greatly impressed :

 In essence, in all three cases the conservation easements all but eliminated residential development. In stark contrast, the Trout Ranch CE restricted development from at least 40 residential lots to 22 lots (a reduction in potential development of 45 percent). We are simply not convinced that the value of a conservation easement that restricts development to at most one residential lot sheds any light on the value of a conservation easement that allows as many as 22 residential lots.

The Service had originally wanted to allow $485,000, but when it came to trial they decided to reduce that to 0.  I mean, what the heck, why not say the property was worth more with the easement and have them pick up income ?  The switch led to some fancy burden of proof discussion, which the Court indicated didn't matter because they were able to determine the true value.

The Tax Court came in at $560,000.  We know that is the right answer, because its what the Tax Court said.  The case is worth reading if you are interested in valuation issues.  It's not great for my purposes as I couldn't find any good quotes.

Richard A. Frimml, et ux. v. Commissioner, TC Summary Opinion 2010-176


My tentative title for this was "Paint Your Horses".  It is a hobby loss (Section 183) case.  The IRS seems to be firmly convinced that people take care of animals much larger than themselves that appear to defecate copiously for fun.  Go figure.  The couple was raising American Paint Horses.  The Tax Court ruled that they were in fact trying to make money.

Petitioners' knowledge at trial was extensive as it related to breeding and artificially inseminating Paint horses. Their knowledge included the genetics, the mechanics and the financial aspects of breeding.  Even the horses aren't having any fun.

The worst thing about people who win hobby loss cases around horse breeding is that the Tax Court gives them extra points for heartlessness.

Petitioners made many business decisions regarding the purchase, care and sale of a number of Paint horses for their horse activity. Petitioners paid extensive amounts to care for Special when he was injured. On the other hand, petitioners decided to put down a 2-year-old foal that hurt her leg in a fence accident because the cost to heal her exceeded the projected price in selling her.

In case you are wondering what was so special about "Special".

They have identified semen production by Special as a potential future source of revenue.

This case is similar to that of Johnny L. Dennis TCM 2010-216 which I gave a brief mention.  Besides doing a cost benefit analysis on the vet bills, the other thing that they have in common was not riding the horses themselves.

U.S. v. RUTH, JR., Cite as 106 AFTR 2d 2010-7443

The decision itself is about criminal procedural issues which are not of great interest to me.  If you have an interest in such things check out Jack Townsend's blog.  I read cases like this because the story behind the story is often interesting.

The conduct at issue began while Ruth and Pilkey were incarcerated at the Federal Correctional Institution in Fort Dix, New Jersey. The defendants submitted tax returns to the IRS claiming refunds in the names of fellow inmates for wages never earned and giving addresses where the inmates never lived. These inmates fell into three groups: (1) those who were aware of the fraud, (2) those who were not aware of the fraud and had instead provided their personal information in order to receive legal assistance from Ruth and Pilkey, and (3) those who testified they did not know the defendants. Ruth and Pilkey were able to avoid having to submit W-2 forms by misrepresenting that fellow prisoners were working at companies that had gone bankrupt. As part of the scheme, defendants obtained employer identification numbers for these bankrupt companies. To avoid detection by prison authorities, defendants enclosed envelopes addressed to the IRS within large envelopes sent to collaborators outside of prison. Defendants had the tax returns sent to mail-forwarding services who would then deliver the returns to their collaborators.

I became interested in accounting in part from reading stories about epic frauds.  I doubt anybody will ever top Alfredo Reis.  Read the book about him if you don't believe me.  He convinced the British bank note printing company that printed the money issued by the Bank of Portugal that he worked for the bank and got them to print money for him.  He used the money to buy stock in the Bank of Portugal which was the only entity that could prosecute counterfeiting.  These fellow aren't in the same league, but given the adverse conditions they were working under (being in prison and all), they really achieved a lot.  Of course you might expect that the IRS computers would catch them eventually.  That's not exactly the way it turned out.

Defendants' scheme resulted in the IRS issuing refunds of tens of thousands of dollars. Eventually the IRS became suspicious of returns filed by persons in federal custody using the same type of form and listing the same employers and addresses. In May 2004, an inmate came forward who informed prison officials about the fraudulent tax scheme. Based on this information, prison officials searched the lockers of several inmates, including Ruth and Pilkey, and recovered records and material used to file the fraudulent tax returns.

So that is it for 2010.  Goodbye 2010.

Survey Says - No Discount For Family Limited Partnership

Originally published on Passive Activities and Other Oxyomorons on December 13, 2010

_________________________________________________________________
LEVY v. U.S., Cite as 106 AFTR 2d 2010-7205, 12/01/2010

Sometime in the last millennium there was a TV situation comedy called Angie.  It was about the early days of a marriage between a fellow from a very wealthy Philadelphia family and a waitress from a family of more modest circumstances.  In one of the episodes the two families compete on the game show Family Feud.  Family Feud is a wonderfully egalitarian contest.  Unlike Jeopardy, which requires you to come up with the one correct answer (Expressed in the form of a question)  the questions in Family Feud are matters of opinion.  If you get one of the top five or ten answers (something like that) that were determined by a survey you get some points.  The more common the answer you come up with the more points it is worth.

I forget how the Angie episode worked out in its entirety, but at least early on the husband's wealthy family (including the butler of course) was getting creamed.  People in the survey did not have champagne and caviar for snacks or start the day by checking stock prices.  At one point the host goes up and explains to them that the survey answers come from average people not the ultra wealthy.  They don't get it.  The lawyers for the Estate of Meyer Levy might have learned something from watching that episode, but they were probably studying hard in law school or taking polo lessons, the better to meet wealthy clients, while I was squandering my time learning life's lessons by watching television.

The case was a family limited partnership case.  Family limited partnerships can be a good idea for a multitude of reasons.  They are particularly attractive to people, who not, yet, having come up with a way to take it with them, want to control it all till they draw their final breath without having it all included in their taxable estate.  There's also the asset protection and as they say on Seinfeld yada yada yada.  The thing that people get excited about, though, is the discounts.  That's what the IRS gets excited about too.  Take a bunch of stuff and put it into a family limited partnership.  Say its a million dollars worth of stuff.  Now give 10% of the partnership to your kid.  How much is the gift worth ?  $100,000 ?  Do you think I would pay $100,000 for it ?  Of course not..  As a limited partner I don't get to vote.  On top of that your kid doesn't even have the right to sell it to me.  You have to hire a valuation expert to value the limited partnership interest (I sometimes think the estate tax is, in reality, a white collar jobs program).  She'll tell you its worth something like $65,000, more or less, depending on well yada yada yada. The IRS doesn't like this and is constantly attacking it.

Until recently they focused on poor execution which I discussed at length in one of my early blog posts.  Assets aren't really transferred to the partnerships.  Personal bills are paid directly by the partnership.  Distributions are not made in proportion to partnership ownership.  Tax returns are not filed or not done correctly.  In a more recent case, Fisher, discounts were not allowed for a single asset partnership, because it lacked business characteristics.  There was no discussion of flawed execution.

No discount was allowed to the Estate of Meyer Levy for the sale of its Plano real estate that was in a partnership.  The estate appealed the verdict alleging error on the part of the trial court.

The Estate argues that the trial court erred when it allowed the admission of

 (1) evidence of the ongoing negotiations over the sale of the property, specifically the offers and proposals;
(2) evidence of the listing price of the property, and the ultimate sale price of the property;
 (3) valuation testimony by the Government's expert based on flawed methodology; and
(4) opinion testimony by a lay witness and hearsay testimony.

Wow.  In a valuation case they considered what people were offering for the property and what it actually sold for.  That's pretty outrageous.  You see the problem was it wasn't a judge that had to think about these things.  It was a jury.  Who ends up on a jury ?  I'm not sure exactly. I suspect that they have more in common with the people Family Feud surveys for its answers than the people I run into at tax conferences.


The Estate contends that the jury arbitrarily disregarded unequivocal, uncontradicted, and unimpeached testimony of an expert witness, bearing on technical questions of causation beyond the competence of lay people. The Government counters that the jury had the partnership agreement in evidence from which it could have determined that there was no lack of control or marketability.

The record contains ample evidence to support the jury's verdict valuing the property at $25 million. The Estate listed the property, and eventually sold the property, for $25 million. It was immediately resold for $26.5 million. Sophisticated developers with no stake in the current litigation engaged in ongoing negotiations for the property for prices in the $20–25 million range. The Estate's expert testified that the market in Plano remained relatively flat during the period between Levy's death and the sale of the property. Also Jordan testified regarding the value of the property. Any of these provides sufficient support for the jury's verdict on the property.

The jury verdict regarding the discount also finds support in the record. The partnership agreement itself would be sufficient evidence. The jury could have rationally found that no discounts for lack of control or marketability were merited because the Estate controlled the general partner interest, which had nearly unfettered control over the Partnership's assets. The trial court did not abuse its discretion when it denied the Estate's motion for new trial.

I'm not a lawyer and I don't even play one on TV.  I prepare and review tax returns and do tax planning.  I also represent people who are being audited by the IRS, but there I'm generally dealing with accountants.  If my clients end up in Tax Court and win I'll still think that I lost.  I am fairly certain though, that it was the choice of the estate's lawyers to bring this matter to a jury.  To have that privilege, they had to pay at least part of the tax in order to be able to sue for refund in district court.  They could have instead gone to Tax Court where they would have had people who dealt with "technical questions beyond the competence of lay people" all the time and frequently allow discounts.  Somehow though they thought they would do better with a jury.

Apparently though the government lawyers saw to it that the jury found out that the Estate got $25,000,000 and these simple minded people thought that might be indicative of whatever the estate had was worth.  I suppose there was some sort of trial strategy that would keep this information undisclosed.  In which case the jury would have had to weigh the government's yada, yada, yada against the Estate's yada, yada, yada.  There might have been some logic to that.  If I was playing Family Feud and the question was "Name a class of people that are very popular" I would venture neither multi-millionaires or IRS agents.  If the question was "Name a class of people that are despised"  I think I might score higher with "IRS agents".  I mean no disrespect to IRS agents, their unpopularity is inherent in their jobs.

In  a refund suit in district court either the government or the taxpayer can ask for a jury.  I haven't been able to figure out which it was.  I did find that the executor had been a potential candidate for mayor of Austin Texas and the late Mr. Levy had established a fairly well known charitable foundation.  So there may have been a feeling that there was a home town advantage.  There was also a sense in which the Estate was playing with the house's money if it was the one that gambled on a jury, as is noted in a footnote:

Although we have declined to set aside the jury's verdict of zero discount, we note that the actual discount applied in taxing the Estate was thirty percent. Given the valuation found by the jury, it would have had to find a discount of larger than thirty percent for the verdict to make a difference to the judgment in this case.


I don't know whether this case will have a chilling effect on family limited partnerships or not.  My cumulative sense is that you should only do them if you think they are a good idea anyway.  Oddly enough, that will make it more likely that you will succeed on the discount issue.  I think the key planning point to take away from the case is the Court's comment that it would have been reasonable to find a zero discount because of the Estate's general partnership interest.

The Powder To Blow It Away

Theodore R. Rolfs, et ux. v. Commissioner, 135 T.C. No. 24

This was originally published on PAOO on November 14th, 2010.

We few, we happy few, we band of brothers — joined in the serious business of keeping our food, shelter, clothing and loved ones from combining with oxygen.

As the writer of an award winning blog that has attracted possibly scores of readers, it is to be expected that I will know some celebrities. One of them is the noted science fiction author, John Sundman. What is really impressive about John is that even though he is as advanced in age as I am, he is still a volunteer firefighter. He has given me a great deal of encouragement, so coming on a case touching, however, lightly on firefighting I decided to acknowledge his support.

Theodore Rolfs purchased some lakefront property in 1996. For some time, he pondered exactly what he wanted to do with it. Then his mother-in-law suggested that he build a residence on it to her specifications and exchange it for her residence. He decided that was a good idea and began planning accordingly. There was, however, already a residence on the property. Originally built in 1900, the existing structure could not be made mother-in-law worthy. Mr. Rolfe determined that it would cost him about $10,000 to have it torn down. Then he came up with a better idea.

He wrote to Gary Wieczorek, who was chief of police and also of the volunteer fire department of the Village of Chenequa, where the house was located :

As we have discussed, I would like to donate our house located at 5192 [2] Oakland Road in the Village of Chenequa to the Fire and Police departments of the Village for training and eventually demolition. This letter shall serve as an acknowledgment that it is my intention to donate the house for such purposes. The house is available immediately. If any further approvals are needed please contact me.



Chief Wieczorek had a clear understanding that his department was not the recipient of a new recreational facility. He understood that the house was to be used exclusively for training purposes and that Mr. Rolfs expected that it would be burned down sometime in the first half of 1998. Matters developed in accordance with Mr. Rolf's expectations :

Sometime shortly before February 18, 1998, the Chenequa Police Department used the lake house for a training exercise. On February 18, 1998, the VFD conducted an initial training exercise at the lake house. On February 21, 1998, 11 days after petitioner's letter donating the lake house, the VFD conducted a second training exercise and burned the structure to the ground.


The firefighter training exercises at the lake house allowed the VFD to satisfy monthly training requirements imposed under Wisconsin State law. Chief Wieczorek believed the firefighter training exercises conducted at the lake house were superior to the training exercises otherwise available to the VFD.

Mr. Rolf arranged for an appraisal of his property. The appraiser did a valuation of the property with and without the structure that after standing nearly century went out in a blaze of glory to the edification of the Chenequa Volunteer Fire Department. The appraiser determined that the value of Mr. Rolf's property had declined from $655,000 to $579,000. Accordingly he claimed a charitable contribution of $76,000.

The IRS denied the charitable contribution and asserted a 20% accuracy related penalty. Mr. Rolf filed a petition to Tax Court now claiming a deduction of $235,250, the appraiser's estimate of the reproduction cost of the house. The Service responded by switching to a 40% gross valuation penalty.

The IRS got testimony from a professional "house mover", who indicated that it would have cost on the order of $100,000 to relocate the structure. Given its relatively modest nature and the high cost of land in the vicinity there would not have been anyone willing to pay to relocate it. They also brought on someone from the State of Wisconsin responsible for knocking down houses to make roads who reiterated that this was not the type of house that could be moved somewhere else.

In the end the tax court ruled that Mr. Rolfs was not entitled to a deduction since he had received a "quid pro quo" in the form of the removal of the structure that could not be brought up to mother-in-law standards. Since he had diligently followed all reporting procedures and a similar deduction had been allowed in Scharf v. Commissioner no penalties were assessed.

All in all, the satisfaction of helping the fire department should have been enough for Mr. Rolfs, winning on the deduction would have been icing on the cake. Samuel Johnson said "Every man thinks meanly of himself for not having been a soldier, or not having been at sea." Firefighting had not developed as a profession in his time or I am sure the would have added it. So I will close with a second quotation this one from an office worker's tribute to firefighters :
And when we met them on the stairs
They said we were too slow.
"Get out! Get out!" they yelled at us -
"The whole thing's going to go"
They didn't have to tell us twice -
We'd seen the world on fire.
We kept on running down the stairs
While they kept climbing higher

The collection of unidentified quotations continues to expand. A hint on the leading one is the fictional character also had a great deal of admiration for infantrymen.

Time To Purge The Draft Posts

This was originally published on PAOO on November 12th, 2010.

In case you have ever wondered what the secret is to having a tax blog with conceivably scores of readers, who rarely click on ads, here is how I do it. Whenever I get a chance I scan all the primary source federal tax stuff I have that is available to me through RIA. Federal court decisions, private letter rulings, revenue procedures, chief counsel advice, program manager technical assistance, etc. etc. If something looks promising, I copy it into a draft post. I then work on which ever one the spirit moves me to whenever I get a chance. I've committed to publishing posts on Monday, Wednesday and Friday and have kept up pretty well. The draft posts accumulate at a faster rate than three per week. There are ones that I find kind of interesting, but just don't seem to be able to expand on to have something worth saying.

So in order to keep my draft posts from being cluttered with material that is going stale, I'm going to do a bit of a purge. However, when I first looked at these things, I thought there was something worth sharing, so I at least want to mention them. Once I have done that I will delete them which will make me feel more pressure when I am scanning new stuff, because I am always worried about running out. You can rescue any of these embryonic posts from oblivion by posting a comment.

Martha A. Olson v. Commissioner, TC Summary Opinion 2010-96 is a classic tax court summary opinion, the reality TV of the system. The taxpayers were trying to deduct expenses from a business that they had run several years before. They explained why they hadn't reported the business (a pay day loan operation) in the years it actually operated as follows:

Petitioner did not believe that she needed to report anything from the Checkrite business on the 1996 and 1997 returns because, in her view, she reinvested all the income back into the business; i.e., as customers would make payments against their outstanding liabilities, petitioner would collect the payments and then make additional loans to new or existing customers.

I thought that was kind of amusing and was going to title the post "Consider Taking Accounting 101"

Estate of Marie J. Jensen, et al. v. Commissioner, TC Memo 2010-182 is a valuation case. In valuing a C corporation that owned a moribund summer camp, there was a substantial discount allowed for the potential corporate income taxes on a sale of the property. I gave it a brief mention in my post on purging earnings and profits, since I believe their income tax problem might have been somewhat more manageable than they either thought or at least let on. I haven't felt inspired to give it a full treatment though.


PLR 201016053 is an example of something that is incredibly interesting if you are a total tax geek and rather difficult to make meaningful for a normal human being. Here is the headnote:
:
Self-created customer relationships are severable and distinct asset from acquired customer relationships such that any gain with respect to sale of self-created customer relationships won't be subject to Code Sec. 1245; recapture as result of amortization deductions claimed with respect to acquired customer relationships

I swear if they ever have a machine to test for tax geekiness where they attach and insert all sorts of devices that monitor your reactions and then flash things on the screen that will be one of the things they use. If you just had a WOW - That's really interesting, you are a total tax geek (Maybe some sort of highly specialized business broker just to be open to other possibilities. ). If you just had a WTF (That stands for What The ?) you are a normal human being.

Gordon Kaufman, et ux. v. Commissioner, 134 T.C. No. 9 was about a charitable contribution of a facade easement. The IRS was granted summary judgement on the issue of a deduction for the easement because the property was mortgaged, but it was not granted summary judgement on the issue of the cash contribution that the taxpayers made as part of the deal or their reliance on their accountant to be relieved of penalties. Who knows ? Maybe this case will be back on those two issues.


Gregory J. Bahas, et ux. v. Commissioner, TC Summary Opinion 2010-115 is about the real estate professional exception to the passive activity loss rules. I gave it a brief mention in one of my other posts on that topic. The interesting thing is that I think there is a mistake in it:

Mrs. Bahas misconstrues section 469. Because petitioners did not elect to aggregate their real estate rental activities, pursuant to section 469(c)(7)(A) petitioners must treat each of these interests in the rental real estate as if it were a separate activity. See sec. 469(c)(7)(A)(ii). Thus, Mrs. Bahas is required to establish that she worked for more than 750 hours each year with respect to each of the three rental properties. But, petitioners presented no documents or other evidence with respect to the number of hours Mrs. Bahas worked managing the three rental properties in question. Indeed, the parties stipulated that “petitioners spent less than 750 hours managing the rental properties” in question.

Absent the election, I don't think you need 750 hours in each of the properties. I think you would just have to materially participate in each of the properties. At any rate, I'm beginning to wonder if the actual real estate professionals are beginning to regret that they lobbied for this relief given the number of amateurs that it ends up attracting. Regardless I've probably said enough about Bahas.

Well I guess those five are enough for this post. I still have a decent backlog. If nothing interesting comes out between now and January, I'll be out of material. Not very likely.