by Peter L. Klenk, Esq.

Estate Planning and Valuation are often intertwined. When making gifts of assets from one generation to another, the Federal Gift Tax requires reporting of the assets’ value and when assets are part of an estate, both Federal and State Estate Taxes require a valuation of all estate assets. In asset protection, assets are often transferred to irrevocable trusts, which also require a valuation of the assets involved.

Unless the asset that will be given away during your lifetime (Gift Tax Issue) or that will pass at your death (Estate Tax Issue) has a ready market value, its value is a matter ripe for dispute. Publicly held stock value is an example of an asset with a ready market value, while real estate, closely held stock and antiques are examples of assets where the value can easily end up a litigation issue. The dispute might be between family members, or it might be between an estate and the IRS.

Not surprisingly, when an asset is not subject to continuous buying and selling on an open market, the estimated value can vary widely. Appraisers of excellent reputation and experience can arrive at varying values and conclusions for the same asset and with the same facts.

This is reflected in the recent Tax Court case, Estate of Mitchell, (T.C. Memo. 2011-94, No. 17351-09, 4/28/11). Mitchell offers insight into how a court evaluates the experts when they are not in agreement.

James Mitchell was lucky enough to inherit wealth, but also worked hard and earned a great deal of money in his lifetime though his own efforts. At the end of his life he owned many valuable assets, including real estate and art that included a beachfront home in Montecito, California, a 4,000-acre ranch in Santa Inez, California, and two valuable paintings. Like many others wishing to avoid the expenses of California probate, Mitchell had his lawyers form him a Revocable Trust into which he transferred his assets. As is often the case, Mitchell served as his own trustee during his lifetime and decided to name a corporate fiduciary as successor trustee.

Becoming terminally ill, Mitchell gave via his trust a 5% interest in both the Montecito and Santa Inez land to a Gift Trust for his teenage children. Mitchell’s revocable trust retained a 95% interest in both parcels of land. Mitchell then died, his wife having predeceased him.

The corporate executor reported on the Federal Estate Tax Return (Form 706) a gross estate of approximately $17 million. The Gift Tax Return (Form 709) filed for the 5% gifts reported a value of $365,000. The 706 claimed an Estate Tax due of approximately $7 million. The IRS decided to audit the Mitchell estate return and issued a deficiency of over $10 million. The difference existed because the IRS felt that the executor had undervalued various estate assets. Exercising the option, the executor contested the entire deficiency and filed suit in Tax Court. As is often the case, most of the differences were settled, but they could not agree on the fair market value of the Montecito and Santa Inez properties and the two paintings. When settlement is not found, the Tax Court hears the dispute.

At trial, as is often the case, the numbers used by the parties in prior negotiations were abandoned and the Estate’s experts claimed an even lower number and the IRS experts put forth numbers higher than they had used in negotiations. The Trial Court had only one issue to decide, whether the Estate had a deficiency.

The parties agreed that the Montecito and Santa Inez land should be valued as 100% “leased-fee” interests, because Mitchell had long term tenants in both properties and the IRS agreed that these were leases legitimately leased to defray upkeep of the land. The Revocable Trust’s 95% and the Gift Trust’s 5% ownership would be applied to that number, which would then be reduced by stipulated valuation discounts for the given trust’s fractional undivided interests. The agreed discounts were for the Revocable Trust: Montecito 19% and Santa Inez 35% and for the Gift Trust: Montecito 32% and Santa Inez 40%.

At trial, the expert’s opinions for a value of a 100% leased-fee interest were as follows:

Montecito:
Estate Expert: $6 million
IRS Experts: $12.5 million

Santa Inez:
Estate Experts: $3.370 million
IRS Experts: $20. Million.

Totals:
Estate Experts: $9.370 million
IRS Experts: $32.5 million.

The expert’s opinions varied because of the valuation methods used. The Estate’s Experts used an Income Capitalization approach for each parcel. The IRS Experts used a Lease Buyout approach. An Income Capitalization approach takes into account the present value of the long-term lease payments together with the estate’s reversionary interest at the lease’s end. The Lease Buyout view takes each property’s fee simple value less what it would cost to terminate the tenant’s lease and find a similar property to rent.

The IRS position was that Income Capitalization was only useful in valuing commercial properties, but the Tax Court judge disagreed in this case because Mitchell had used the land to produce income and had put the land to its best use given the goal of preserving it for his children when not living on the land. The judge also ruled that the Lease Buyout approach was “speculative at best…and has not been accepted by any court”.

As to the value of the art, the expert’s valuations also varied:

Remington:
Estate Expert: $1.2 million
IRS Expert: $1.1 million

Russell:
Estate Expert: $750K
IRS Expert: $2 million

Once again, reasonable minds differed. The Tax Court judge observed that experts in the valuation of art consider criteria that are not typically used when valuing other assets. Such other considerations include thematic appeal, the period when the work was created, style, overall quality, provenance, condition and market conditions. Interestingly, the judge found it significant that the Estate’s Experts had extensive experience valuing American Western Art while the IRS Experts did not.

When valuing the Remington, both Experts agreed on the period, the condition, the style, the signature and the market conditions. There was disagreement on the proper comparable sales as well as whether the painting’s subject matter had a positive or negative effect on value.

The judge noted that the Estate’s Experts only examined public art sales whereas the IRS Expert included private sales. The judge found that auction prices were “more probative of value than poorly documented private sales.” The judge noted that the private sales figures failed to provide exact sale price and dates, the buyers or sellers identities, information on the condition of the paintings or discussions on provenance. In addition, even the IRS Expert testified “that he did not put great weight on the private sales.”

As to the Russell, the Judge found convincing the Estate Expert’s observation that the physical quality of the painting poor, how the Expert demonstrated this quality and how the Expert had offered a “reasonably detailed description of nine comparables” that included the condition of each comparable. Given the Expert’s work, the judge found the value to be on the low end of the range of options presented.

Given the judge’s decision, the parties must now recalculate the estate tax owed using the judge’s determinations. The settlement numbers between the parties are unknown, but all indications are that the estate will not have a deficiency and, possibly, may get a refund.

What does this case suggest for other clients? First, it is good if the client is sympathetic. The judge commented Mitchell was successful in his own right and his children were now orphans. Second, the land value was reduced because of long-term leases, which the court found accepted as reasonable under the circumstances. Even though the property was residential, the court believed that the long-term leases were in place to help maintain the properties and preserve them for his sons….not a ploy to reduce the land’s value. As a result, the judge then used the Income Capitalization method of valuation, which was favorable to the estate. Third, it pays to have an expert who specializes in the item being valued. The court liked that the Estate Appraisers had experience in both commercial and residential real estate in the specific area, while the IRS Experts and “little experience” in the Santa Inez area. Fourth, it pays to have credentialed appraisers, as the court noted the Estate Expert’s credentials and backgrounds and noted that the IRS Experts had no such background.

And tax savings? Note the Estate and IRS agreed on the appropriate discounts for the fractional undivided interests in the contested real estate that existed because of a transfer that took place only 6 days before the date of death. These discounts resulted in substantial savings. Creating fractional interests remain a useful weapon for the Estate Planner!

The lesson learned in Mitchell? First, do not skimp on your experts. Judges need information in order to arrive at a decision and you want the judge to feel comfortable using your numbers. Giving the judge an expert upon whom they can rely creates that comfort. Second, creating fractional interests remain an effective way to reduce estate taxes.