Autumn 2008


Focus on Gift and Estate Tax and Intergenerational Wealth Transfers

Editors for This Issue: Trey Stevens and Timothy J. Meinhart

Gift and Estate Tax Valuation Insights

Feature Article:

Identification and Valuation of Taxpayer Commercial Intangible Assets for Gift & Estate Tax Purposes
Robert F. Reilly
The valuation of intangible assets is relevant in two federal gift tax instances: (1) the taxpayer directly gifts an intangible asset or intellectual property ownership interest and (2) the taxpayer gifts a closely held business, professional practice, joint venture, or similar business interest where the business entity owns or operates a commercial intangible asset. Similarly, the valuation of intangible assets is relevant in two federal estate tax instances: (1) the decedent owns a fee simple interest or a fractional ownership interest in an intangible asset or intellectual property and (2) the decedent owns an equity interest in a closely held business, professional practice, joint venture, or other business entity that owns or operates a commercial intangible asset. There are also numerous federal income tax instances that call for the valuation (or the fair transfer price) of a taxpayer intangible asset. Nonetheless, in these gift and estate (and income) tax situations, the value of the subject commercial intangible asset often becomes an area of controversy between the taxpayer and the Internal Revenue Service.

The Relief from Royalty Method of Intellectual Property Valuation Robert F. Reilly
There are four (and only four) types of intellectual property: patents, trademarks, copyrights, and trade secrets. When they are the subject of an intergenerational gifting program or when they are included in a decedent's estate, intellectual property assets may have to be valued for federal gift and estate tax purposes. There are also numerous instances when intellectual property assets have to be valued for federal income tax purposes. Whether related to gift tax, estate tax, or income tax, intellectual property assets may have to be valued as part of the individual or the corporate taxpayer compliance, audit, appeal, or litigation process. The relief from royalty method (the "RFR method") is a market approach method that valuation analysts often use to value taxpayer intellectual property. This discussion summarizes (1) the conceptual foundation of the RFR method, (2) the procedural application of the RFR method, (3) the common sources of RFR method transactional data, and (4) the analytical strengths and weaknesses of the application of the RFR method.

Further Reflections on the Tax Court Kohler Decision: Service Issues Proposed Regulations
Robert F. Reilly and Robert P. Schweihs One of the central issues in the 2006 Kohler Tax Court decision relates to the Section 2032 alternative valuation date. The Frederic Kohler estate elected to value the subject Kohler Company stock on the alternative valuation date, and the Service did not (and could not) object. However, the Kohler Company went through a Section 368 reorganization between (1) the date of death and (2) the alternative valuation date. The Kohler Company reorganization changed the decedent’s stock so that it was now subject to (1) transferability restrictions and (2) a purchase option. The estate valued the post- reorganization company stock. The Service valued the pre-reorganization company stock. The Tax Court agreed with the estate, disregarding all of the Service’s litigation arguments. In response, the Service has issued proposed regulations that would codify its position—that is, that the effects of a Kohler-type reorganization should be ignored in an alternative valuation date stock valuation.

The Small Business and Work Opportunity Act Increases the Scope of Appraisals Subject to Section 6695A Appraiser Penalties
Kevin M. Zanni
The Pension Protection Act of 2006 provided new penalties applicable to appraisers under Internal Revenue Code Section 6695A. According to Section 6695A, appraisers are subject to penalties if the income tax return based on their appraisal results in a substantial valuation misstatement. With the passing of the Small Business and Work Opportunity Act on May 25, 2007, the Section 6695A penalties are extended to include appraisals performed for estate and gift tax returns.

Claims Court Addresses Valuation of Restricted Stocks in Litman v. United States
Trey Stevens
Valuations of stock subject to either contractual restrictions or Securities and Exchange Commission restrictions (i.e., restricted stock) are often performed for estate tax, gift tax, and income tax purposes. One important procedure in the valuation of restricted stock is the application of an appropriate discount for lack of marketability. The United States Court of Federal Claims decision in Litman v. United States provides a comprehensive analysis of both the empirical models and the theoretical models used by valuation analysts to quantify the discount for lack of marketability applicable to large blocks of restricted stock.

Gift Tax Valuation Insights

Thomas H. Holman, Jr. and Kim D.L. Holman v. Commissioner
Timothy J. Meinhart
Family limited partnerships and family limited liability companies continue to be an important element in intergenerational wealth transfer planning. As these entities continue to be scrutinized by the Internal Revenue Service, valuation analysts find ourselves with a wealth of Tax Court judicial precedent that address entity formation and valuation issues. In Thomas H. Holman, Jr., and Kim D.L. Holman v. Commissioner, we are provided with recent insight as to how the Tax Court viewed a nondiversified family partnership in the context of gift tax planning. This discussion addresses many of the partnership-specific factors that were considered by the Tax Court in reaching its judicial decision. The published discussion also presents the data that the Tax Court considered in deciding an appropriate (1) discount for lack of control and (2) discount for lack of marketability for the valuation of the partnership’s limited partner units.

Astleford v. Commissioner Addresses Several FLP Valuation Issues
David P. Burdette
The valuation of closely held family limited partnership (FLP) interests requires the valuation analyst to perform several procedures. These procedures include: (1) the valuation of the underlying net assets of the subject entity, (2) an analysis of the rights associated with the subject FLP ownership interest, and (3) the application of the appropriate valuation adjustments (i.e., discounts) to the subject FLP ownership interest. The Astleford v. Commissioner decision addresses each of these issues. Furthermore, the case is notable because the Tax Court concluded that it was appropriate to apply multiple layers of discounts, or tiered discounts, where the taxpayer held a minority interest in an entity that, in turn, held a minority interest in another entity.

Estate Tax Valuation Insights

Kansas Supreme Court/Lower Courts Address the Appropriateness of Valuation Discounts for FLP
Michael R. Ong
Both the increased use of family limited partnerships in the estate and gift tax planning context and the increased number of second marriages may cause many estate planners to revisit how they structure and use these closely held family entities. This discussion explores these issues in greater detail by providing an overview of the Estate of Norman B. Hjersted. In this case, the Probate Court, the Appeals Court, and the Kansas Supreme Court each address the appropriateness of valuation discounts related to family limited partnership interests, specifically in the context of a surviving spouse’s elective share of the probate property.

Family Limited Partnership Planning Update in Light of Three Recent Judicial Decisions
Steve R. Akers
Family limited partnership or family limited liability companies are an integral part of the estate planning of many high net worth individuals. The Internal Revenue Service has attacked valuation discounts that are often associated with the inherent restrictions on the owners of limited partnership interests or member interests. The Service’s primary attack is to disallow valuation discounts for estate tax purposes under Section 2036 following an individual’s death. The Service has also been urging an indirect gift treatment (without valuation discounts) when gifts of limited partnership interests are made soon after the partnership is funded. The Service often takes the position that specific transfer restriction provisions in partnership agreements must be ignored for purposes of valuing partnership interests for estate and gift tax purposes. In addition, the Service sometimes questions multi-level valuation discounts. Three recent judicial decisions address each of these issues.

Second Circuit Addresses Burden of Proof and Accuracy-Related Penalties in Estate of Thompson
Brett Miller
Estate and gift tax disputes involving valuation issues are often impacted by the quality of the valuation experts in the case. When the burden of proof shifts to the Internal Revenue Service, the lack of a credible valuation can lead the Tax Court to adopt the valuation proposed by the taxpayer. Similarly, an inadequate valuation on behalf of the taxpayer may lead to the imposition of a costly accuracy-related penalty. The Second Circuit Court of Appeals addressed both of these issues in its review of the Tax Court decision Estate of Josephine T. Thompson, et al. v. Commissioner.

Eleventh Circuit Attempts to Provide Certainty Regarding the Treatment of the Built- In Capital Gains Tax Liability
Hestian Stoica and Lisa H. Tran
When valuing an ownership interest in an asset holding company, valuation analysts often rely on the asset-based valuation approach. A common methodological procedure in any asset-based approach business valuation is the consideration of any built-in gains (BIG) tax liability related to the appreciated assets. Ever since the BIG tax became an issue as a result of the Tax Reform Act of 1986, valuation analysts have sought professional guidance on how to calculate the BIG tax valuation adjustment in valuing business ownership interests in asset holding companies. This discussion summarizes (1) the history of BIG tax valuation adjustment issue and (2) the U.S. Court of Appeals for the Eleventh Circuit decision reversal of the Tax Court judicial decision in Estate of Jelke. In its judicial decision, the Eleventh Circuit agreed with the treatment of the BIG tax liability valuation adjustment used by the Fifth Circuit in Estate of Dunn. And, the Eleventh Circuit allowed a dollar-for-dollar BIG tax valuation adjustment for purposes of reaching the final value conclusion.