Wills and Trusts

Wyatt, Tarrant & Combs, LLP

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LLC Interest Value as Membership Interest Not Assignee Interest

The Estate of Diane Tanenblatt et al. v. Commissioner, T.C. Memo. 2013-263, involved two valuation issues. First, the taxpayer argued that the willing buyer-willing seller test must assume a non-family member purchaser who would not be admitted to the LLC as a member. The IRS disagreed and Judge Halpern agreed with the IRS, holding:

We must determine whether respondent and Mr. Thomson [government appraiser] erred in classifying the subject interest as a member’s interest rather than classifying it as an assignee’s interest. A member’s interest is more valuable than an equivalent percentage interest of an assignee because the member’s interest can participate in management and control of the LLC. We think respondent and Mr. Thomson did not err. Decedent was a member of the LLC when she transferred the subject interest to the trust. We assume, therefore, that, until she made the transfer, she enjoyed all of the benefits and was saddled with all of the burdens attendant upon being a “member” of the LLC. The term “member’s interest” (or the term “membership interest”, which the parties use, but which we do not, because it is a term defined in the operating agreement to mean a member’s proportional interest in capital) is both a convenient and an accurate classification for indicating that decedent’s interest in the LLC was of the fullest kind; i.e., she shared in management and control and did not merely share in profits and losses. For the same reasons, the term is a convenient and accurate classification for the subject interest in the hands of the trust, which also was a member of the LLC. Moreover, there is no evidence that, on or before the valuation date, the trust distributed, sold, exchanged, or otherwise disposed of the subject interest, so that, possibly, on that date, it could more accurately be described as an assignee’s interest. Therefore, because the term “member’s interest” conveniently and accurately describes the rights inherent to a subject interest on the date decedent transferred it, on the date she died, and on the valuation date, neither respondent nor Mr. Thomson erred in classifying it as such (or, in their terms, classifying it as a “membership interest”).

* * *

Certainly, in applying the willing buyer-willing seller standard to determine the value of the subject interest, it would be appropriate to take into consideration limitations in the operating agreement on the rights of a nonfamily member transferee to participate in control and management of the LLC and limitations on the transferee’s rights otherwise to be treated as a member. Petitioner, however, seeks to collapse the two steps of the valuation process — i.e., (1) identify the property to be valued and its nature and character, and (2) objectively determine its value — into a single step. Petitioner would expand section 20.2031-1(b), Estate Tax Regs., beyond its intended scope by using the provision to redefine the character of the subject interest as an assignee’s interest. See Kerr v. Commissioner, 113 T.C. 449, 469 (1999), aff’d, 292 F.3d (5th Cir. 2002). As discussed in the immediately preceding paragraph of this report, on the valuation date the subject interest was a member’s interest. The holder of that interest, at that time, enjoyed fully the benefits and burdens of being a member of the LLC, including his or her inability to transfer all of those benefits and burdens to a nonfamily member transferee. The hypothetical willing buyer and hypothetical willing seller — “both having reasonable knowledge of relevant facts”, sec. 20.2031-1(b), Estate Tax Regs. — would understand a member’s interest to be so restricted, and would take that restriction into account in their negotiations of what a member’s interest was worth. Mr. Thomson considered restrictions imposed on transferability of an interest in the LLC as a factor in his marketability discount analysis.

The taxpayer filed with its Tax Court petition a new appraisal which was lower than the appraisal submitted with the Form 706. The Tax Court was asked to consider the new appraisal in an unusual procedural move. A relevant factor for the new appraisal may have been a fee dispute with the original appraiser. The opinion states:

Before trial, petitioner untimely moved to compel respondent to stipulate either the Tindall appraisal or, alternatively, the entire petition (including the attached Tindall appraisal). Petitioner alternatively moved to sanction respondent for failing to so stipulate. We denied petitioner’s pretrial motions and proceeded to hold trial. The parties have stipulated copies of the petition and the answer, which are attachments to the stipulation, and have stipulated separately the text of the averment. They did so subject to the caveat that the stipulations “show the parties’ pleadings in this case and are not admitted in evidence.” Petitioner asks that we reconsider our prior rulings with respect to the Tindall appraisal or otherwise allow it into evidence and consider it expert testimony.

Petitioner’s path for attempting to introduce the Tindall appraisal into evidence as expert testimony is, to say the least, unusual. Generally, a party obtains the testimony of an expert witness by calling that witness to testify. See Rule 143(g)(1). Pursuant to that Rule, the expert witness must prepare a written report, which is marked as an exhibit and, after having been identified by the witness and adopted by him, received into evidence as his direct testimony unless the Court determines that the witness is not qualified as an expert. The Rule [*11] further provides that, not less than 30 days before the call of the trial calendar on which a case appears, a party calling an expert witness shall serve on each other party and submit to the Court a copy of the expert’s report. Finally, the Rule also provides that, generally, we will exclude an expert witness’ testimony altogether for failure to comply with the Rule. Those requirements are echoed in our standing pretrial order, which was served on petitioner.

Petitioner’s chosen means for seeking to introduce the Tindall appraisal into evidence is perhaps explained by a conversation we had with his counsel at the hearing during which we considered petitioner’s pretrial motions along with respondent’s motion in limine to exclude the Tindall appraisal on various grounds, including that petitioner had not submitted and served a copy of the report as required by Rule 143(g)(1) and our standing pretrial order. Petitioner had filed no response to respondent’s motion in limine, and, at the hearing, in response to the Court’s question as to whether petitioner was just relying on his own motions (with respect to stipulating the Tindall appraisal into evidence), petitioner’s counsel candidly responded: “Probably. Your honor, because right now my client’s in a fee dispute with the appraiser, so right now I cannot get the appraiser to come in and testify.” Apparently, counsel’s time is less dear than was Dr. Tindall’s.

The court refused to consider the Tindall appraisal:

Petitioner did not call Dr. Tindall as a witness but asks us to rely on her report (which, under our Rules, would serve as her direct testimony) as her expert opinion. Petitioner has neither qualified Dr. Tindall as an expert entitled pursuant to rule 702 of the Federal Rules of Evidence to give her opinion on technical matters nor has he satisfied our procedural rules for expert testimony, found in Rule 143(g) and in our standing pretrial order. In other words, petitioner has failed to satisfy the preconditions for our receiving Dr. Tindall’s opinion into evidence. Because her report (i.e., the Tindall appraisal) is not in evidence, we may not consider her opinion.

The gap between the government’s position and the Form 706 filing was not enormous. Each began with the same underlying value for a New York City office building owned by the LLC. The transferred interest was 16.67%. The taxpayer’s Form 706 appraiser took a 20% lack of control discount and a 35% discount for lack of marketability. The government expert reduced those to 10% and 20%. The increase in the value of the estate was $687,882.

Turney P. Berry
Louisville, Kentucky


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Valuation of Art; §2703 Application to Family Agreement

Estate of James A. Elkins, Jr., et al. v. Commissioner, 140 T.C. No. 5 (2013) involved the valuation for estate tax purposes of 64 fractional interests in art, with Mr. Elkins’ children owning the other interests. The art was subject to a co-tenancy agreement and lease and the estate’s appraiser applied a 44.75% discount.

Judge Halpern ignored the co-tenancy and lease agreement under §2703 and held that a 10% discount was appropriate. The co-tenancy agreement provided:

1. Beginning on the date of this Agreement, each Cotenant shall have the right of possession, dominion, and control of each item of the Property for a total number of days out [of] a twelve month period that is equal to his or her percentage interest in such item times the number of days in such twelve month period. During a short calendar year, the number of days to which a Cotenant is entitled to possession, dominion and control of each item of the Property shall be prorated.

2. Each Cotenant, with respect to the exercise of his or her right of possession, dominion, and control, shall request possession of an item of the Property by giving 30 days’ written notice of such request to the Cotenant in possession of such item. The notice shall specify the number of days to which such Cotenant is entitled to possession and the number of days remaining thereof during the twelve month period (or a fewer number of months for a short calendar year). In the event of a conflict among the Cotenants at any time as to which Cotenant is entitled to possession of an item of the Property, Cotenant James A. Elkins, Jr. shall determine which Cotenant is entitled to possession and the number of days remaining thereof.

3. The Cotenant requesting possession (the “Receiving Cotenant”) of an item of the Property shall be responsible for arranging and paying for the transport of such item to the Receiving Cotenant’s residence.

* * * * * * *

6. Each Cotenant shall be responsible, to the extent of his or her percentage interest in the Property, for the cost of maintaining and restoring the Property.

7. An item of the Property may only be sold with the unanimous consent of all of the Cotenants. Any net proceeds from the sale of such item shall be payable to the Cotenants in accordance with their respective percentage interests in the Property.

8. This Agreement shall be binding on Cotenants and on their respective heirs, personal representatives, successors and assigns.

9. This Agreement shall be governed and construed under the laws of the State of Texas.

With respect to the §2703 issue the opinion states:

During trial, we queried Mr. Miller, petitioners’ expert on partition, about paragraph 7 of the cotenants’ agreement. We pointed out to him that, for a sale of any of the jointly owned properties (i.e., works of art) to occur, all of the cotenants would have to agree, and that would be so independent of the language of paragraph 7 of the cotenants’ agreement. He agreed. We added: “So that the statement that an item of property may only be sold with the unanimous consent of all of the cotenants is a rather unremarkable statement of the obvious.” He responded: “I do agree.” With respect to what the language of paragraph 7 accomplished, he testified: “If this language was not in the co-tenancy agreement, any individual interest owner would have the right to commence a partition action.” That is in accord with his direct, written testimony, wherein he states that the right to partition is absolute, although cotenants may expressly or impliedly agree not to partition, and that he has “assumed that Provision 7 * * * is, in essence, an agreement by the Co-Owners not to partition.” With exceptions not here relevant, section 2703(a)(2) instructs that “the value of any property shall be determined without regard to * * * any restriction on the right to sell or use such property.” Whether paragraph 7 of the cotenants’ agreement is a restriction on decedent’s right to sell the cotenant art or is a restriction on his right to use the cotenant art is not important. It is clear that, pursuant to paragraph 7 of the cotenants’ agreement, decedent, in effect, waived his right to institute a partition action, and, in so doing, he relinquished an important use of his fractional interests in the cotenant art. While, as we shall explain, it makes little or no difference to our conclusion as to the value of the art, we shall, in determining the value of each of the items of cotenant art, disregard any restriction on decedent’s right to partition.

[emphasis added]

The decedent’s children argued that large discounts were appropriate because they would fight any sale; the court turned that on its head and concluded the children’s desire to keep the art meant they would “pay up” and not at a discounted price. Some might argue that the court came close to ignoring, if it did not actually ignore the hypothetical willing buyer-willing seller test, in favor of assuming particular parties to a transaction. The opinion states:

The actual bargaining position that a hypothetical buyer of decedent’s interests in the art would have vis-a-vis the interests of the Elkins children constitutes one of the “relevant facts” that we must deem to be considered by a hypothetical buyer and seller pursuant to section 20.2031-1(b), Estate Tax Regs. See Estate of Winkler v. Commissioner, T.C. Memo. 1989-231, where, in valuing a 10% block of voting stock in a closely held corporation, we took into account the fact that the hypothetical buyer thereof would represent the “swing vote” between the two families that owned the other 90% (50% and 40%) of the voting stock. On that basis, we held that a buyer, unrelated to either family, “would be willing to pay a premium for a 10 percent block of voting stock that could be pivotal as between the two families” and that “a minority discount would be inappropriate here.” See also Estate of Andrews v. Commissioner, 79 T.C. 938, 956 (1982) (“Certainly, the hypothetical sale should not be constructed in a vacuum isolated from the actual facts that affect the value of the stock in the hands of the decedent[.]”); True v. United States, 547 F. Supp. 201, 203 (D. Wyo. 1982) (“Hypothetical analysis can be a valuable tool; however, when real considerations exist, those realities should not and cannot be ignored.”).

The logic of assuming that the Elkins children would pay a hypothetical buyer of decedent’s interests in the art more than a disinterested collector or speculator would have paid for those interests is also confirmed by cases recognizing that certain properties possess an enhanced “assemblage” value. See, e.g., Pittsburgh Terminal Corp. v. Commissioner, 60 T.C. 80, 90 (1973) (dicta: “[W]e do not quarrel with * * * [the taxpayer’s] assertion that aggregation increases the value of coal lands[.]”), aff’d without published opinion, 500 F.2d 1400 (3d Cir. 1974); Serdar v. Commissioner, T.C. Memo. 1986-504.20 In Serdar, the taxpayer gave two parcels of real property to Smith in exchange for a single parcel valued at more than what the Commissioner considered to be the combined value of the taxpayer’s two properties. The Commissioner determined that the difference constituted ordinary income to the taxpayer attributable to a prepayment penalty, owed by Smith to the taxpayer, related to a prior transaction. In rejecting the Commissioner’s argument, we reasoned as follows:

We think that * * * [the Commissioner’s] appraisal failed to adequately take into account factors that made the properties peculiarly adaptable to Smith’s use, and that their fair market value equaled the value of the consideration received for them. The factors that the appraisal failed to adequately take into account are the value to Smith of the road and railroad access that the properties provided and their assemblage value, and, with respect to the Wadsworth Property, the value to Smith of eliminating a tract of land that would have jutted north into his assemblage.

* * * * * * *

In sum, we believe that Smith was convinced that it was essential to acquire * * * [the two properties] to enable him to develop his property as he planned, that he was therefore willing to pay a high price for those properties, and that * * * [the taxpayer] knew of Smith’s plans and drove a hard bargain.

In this case, the hypothetical willing buyer (whether he be a collector or a speculator) and seller of decedent’s fractional interests in the art would know of the Elkins children’s strong desire to own the art in whole. Therefore, the buyer and seller would recognize the former’s ability to drive “a hard bargain” in negotiating a resale of that art to the children.21

Moreover, the hypothetical buyer-collector might very well be content to possess the art for 73.055% (or 50%) of each year. In his written report, Mr. Nash states:

It is not uncommon for two museums, acting together, to buy a work of art. * * * They each take turns in exhibiting the works in proportion to their interests. This would not work in this circumstance because the other owners would be the Elkins Children, and not another museum or institution. Consequently, museums would not be interested in purchasing the interest.

Mr. Nash offers no reason for his conclusion that a museum would not be as willing to share ownership with the Elkins children as it would with another museum or institution, nor do we see one. Moreover, we see no basis for concluding that only a museum jointly owning art with another museum would be content to retain its fractional interest and shared right of possession with another joint owner for an indefinite period. The point, of course, is that a hypothetical buyer-collector, in no rush to sell his or her acquired interests in the art, would be in an even stronger bargaining position than a speculator or art dealer in negotiating a purchase price with the Elkins children.

In short, we find petitioners’ experts’ analyses and conclusions to be unreliable because they are based, in large part, on the false or at least highly dubious assumption that the Elkins children would mount an unrelenting defense of the status quo, ignoring the very high probability that, instead, the children would seek to purchase the hypothetical buyer’s interests in the art. Because we reject that assumption, we find Mr. Mitchell’s discounted values for the art to be unrealistically low.

Looking at all this, the Court arrived at a 10% discount without discussion. Interestingly, in Stone v. United States, 2007 U.S. Dist. Lexis 58611 (N.D.Cal.) (affirmed by the 9th Circuit in an unpublished opinion), the court allowed a 5% discount for fractional interests in art. Experts note that fractional interests in art never, or very rarely, trade at a discount between dealers or museums. Rev. Rul. 58-455 holds that no discount need be taken when a fractional interest is given to charity and Rev. Rul. 57-293 holds the same for remainder interests.

Turney P. Berry
Louisville, Kentucky

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7.5% Discount for Lack of Marketability

In Estate of John F. Koons v. Commissioner, T.C. Memo 2013-94, Judge Morrison agreed with the government’s expert and applied a 7.5% discount for lack of marketability for an LLC holding mostly liquid assets. At date of death, the decedent’s revocable trust owned a 46.94% voting interest in an LLC and an overall 50.50% interest. However, certain redemptions had been agreed to by the decedent’s children and did in fact occur within about a year after the decedent’s death; those redemptions gave the revocable trust a 70.42% voting majority. The government’s expert for the most part ignored the restrictions in the LLC regarding transfers and distributions, concluding that in fact any onerous restriction could be removed by the trust. On the other hand, the LLC did impose a barrier between the trust and the LLC’s assets which justified the 7.5% discount.  The taxpayer’s expert arrived at a 31.7% discount by comparing the LLC to 88 publicly traded companies. Among the problems the court found with the taxpayer’s expert was that the size of the blocks of stock in the studies was much smaller than the LLC interest owned by the revocable trust.

Turney P. Berry
Louisville, Kentucky