IRS Position Is That Only Market Conditions Impact Alternate Valuation of Estate Assets
In general, property is valued for federal estate tax purposes as of the date of the decedent’s death. However, the executor can make an election if the value of the property in the gross estate and the estate’s federal estate tax liability are both reduced by making the election and the gross estate exceeds $2,000,000 (for 2008). This is an alternate valuation election and is specifically allowed by the Internal Revenue Code – I.R.C. §2032. The purpose of alternate valuation is to lessen the federal estate tax burden if the value of assets contained in the estate decline in the six-month period immediately following the decedent’s death. In that event, the estate can be valued for federal estate tax purposes at its value six months after death.
For most estates, the application of the election is straightforward – property that was in existence at the time of death is simply valued six months after death, and property that comes into existence during the six-month period after death is ignored (e.g., a crop that is planted after death). The election is to account for a downturn in the market that impacts the estate’s assets negatively. But, what about non-market influences on value that occur during the post-death six-month period? Do those events count for alternate valuation purposes? In 2006, the U.S. Tax Court said that if the event is a tax-free corporate reorganization the answer is “Yes.”
The case involved post-death changes in the character of stock owned by a decedent pursuant to a tax-free reorganization of a privately held (but international) company that manufactures plumbing products. The estate claimed that the value of the stock was slightly over $47 million, but the IRS said it was worth $144.5 million. During the six month post-death period, as a result of a corporate reorganization in the year of the decedent’s death, the stock in the estate became subject to transfer restrictions and a purchase option designed to ensure that the decedent’s family members would own all of the corporate stock. The result was that the restrictions reduced the value of the shares, and the use of the alternate date value saved significant estate taxes. The Tax Court held that alternate value election would be recognized and the stock transfer restrictions could be taken into account to determine the value of the stock for estate tax purposes.
IRS has issued a non-acquiescence to the Tax Court’s opinion. But, their non-acquiescence is solely on the basis that the alternative valuation election should not have been allowed. The position of the IRS is that the purpose of the alternate valuation election is to provide relief for estates when the market causes a substantial diminution in value of an estate asset - that is, the election is only meant to apply if unfavorable market conditions (as distinguished from voluntary acts changing the character of the property) result in a lessening of the estate’s fair market value. IRS noted that the change in asset values in the case did not relate to changes in market conditions, but came from the affirmative and voluntary act of the corporation and its shareholders changing the character of its outstanding stock. However, the statute doesn’t distinguish between market influences and non-market influences on value during the six-month period immediately following death. So, it will be interesting to see if this is going to be an issue that IRS will raise in subsequent cases involving non-market valuation changes and alternate valuation elections.
But, the IRS objection to the Tax Court’s opinion is somewhat misplaced. The court noted that estate property that is “distributed, sold, exchanged, or otherwise disposed of” within six months after death is to be valued as of the date of such transaction (I.R.C. §2032(a)(1)), and that property that has not been so disposed of is to be valued under the alternate valuation election if it is made. The court also noted that IRS, via regulation, provides an exemption for tax-free reorganizations. Stock transfers in a tax-free reorganization are not treated as having been distributed, sold or otherwise disposed of (Treas. Reg. §20.2032-1(c)(1)). So, IRS’s own regulation hurt them. Still, however, that is not really why IRS lost the case. They lost the case because the court determined that IRS bore the burden of proof. Through its introduction of fact witnesses and experts, the estate presented credible evidence thereby shifting the burden to the IRS. As such, IRS could no longer simply rely on the presumption of correctness of the deficiency. To top it off, the court also determined that the IRS’s valuation expert was lousy – the expert didn’t understand the underlying business, only spent about two hours with management, invented his own business expense structure to craft an income analysis, and did not have a legitimate reason for not using the dividend-based method for valuing the business (the company had a history of paying large dividends). As such, the court gave no weight to the IRS’ valuation expert. Since the party bearing the burden of proof produced no evidence, the court ruled for the estate. That would have also been the outcome, by the way, if the estate had produced no evidence. Kohler, et. al. v. Com’r., T.C. Memo. 2006-152, non-acq., AOD 2008-1.
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