Estate of W.W. Jones II, A.C. Jones IV, Independent v. Commissioner , 116 T.C. No. 11 ( 2001 )

116 T.C. No. 11
UNITED STATES TAX COURT
ESTATE OF W.W. JONES II, DECEASED, A.C. JONES IV, INDEPENDENT
EXECUTOR, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 13926-98. Filed March 6, 2001.
D formed a family limited partnership (JBLP) with
his son and transferred assets including real property,
to JBLP in exchange for a 95.5389-percent limited
partnership interest. D also formed a family limited
partnership (AVLP) with his four daughters and
transferred real property to AVLP in exchange for an
88.178-percent limited partnership interest. D’s son
contributed real property in exchange for general and
limited partnership interests in JBLP, and the
daughters contributed real property in exchange for
general and limited partnership interests in AVLP. All
of the contributions were properly reflected in the
capital accounts of the contributing partners.
Immediately after formation of the partnerships, D
transferred by gift an 83.08-percent limited
partnership interest in JBLP to his son and a
16.915-percent limited partnership interest in AVLP to
each of his daughters.
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Held: The transfers of property to the
partnerships were not taxable gifts. See Estate of
Strangi v. Commissioner, 115 T.C. 478 (2000).
Held, further, sec. 2704(b), I.R.C., does not
apply to this transaction. See Kerr v. Commissioner,
113 T.C. 449 (1999).
Held, further, the value of D’s gift to his son
was 83.08-percent of the value of the underlying assets
of JBLP, reduced by a lack-of-marketability (8%)
discount. The value of D’s gift to each of his
daughters was 16.915 percent of the value of the
underlying assets of AVLP, reduced by secondary
market (40%) and lack-of-marketability (8%) discounts.
Held, further, the gifts of limited partnership
interests are not subject to additional lack-of-
marketability discounts for built-in capital gains.
Estate of Davis v. Commissioner, 110 T.C. 530 (1998),
distinguished.
William R. Cousins III, Robert Don Collier, Robert M.
Bolton, and Todd A. Kraft, for petitioner.
Deborah H. Delgado and Gerald L. Brantley, for respondent.
COHEN, Judge: Respondent determined a deficiency of
$4,412,527 in the 1995 Federal gift tax of W.W. Jones II. The
issues for decision are (alternatively): (1) Whether the
transfers of assets on formation of Jones Borregos Limited
Partnership (JBLP) and Alta Vista Limited Partnership (AVLP)
(collectively, “the partnerships”) were taxable gifts pursuant to
section 2512(b); (2) whether the period of limitations for
assessment of gift tax deficiency arising from gifts on formation
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is closed; (3) whether restrictions on liquidation of the
partnerships should be disregarded for gift tax valuation
purposes pursuant to section 2704(b); and (4) the fair market
value of interests in the partnerships transferred by gift after
formation. Unless otherwise indicated, all section references
are to the Internal Revenue Code in effect on the date of the
transfers, and all Rule references are to the Tax Court Rules of
Practice and Procedure.
FINDINGS OF FACT
Some of the facts have been stipulated, and the stipulated
facts are incorporated in our findings by this reference. W.W.
Jones II (decedent), resided in Corpus Christi, Texas, at the
time the petition in this case was filed. Decedent subsequently
died on December 17, 1998, and a motion to substitute the estate
of W.W. Jones II, deceased, A.C. Jones IV, independent executor,
as petitioner was granted. The place of probate of decedent’s
estate is Nueces County, Texas. At the time of his appointment
as executor, A.C. Jones IV (A.C. Jones), also resided in Nueces
County, Texas.
For most of his life, decedent worked as a cattle rancher in
southwest Texas. Decedent had one son, A.C. Jones, and four
daughters, Elizabeth Jones, Susan Jones Miller, Kathleen Jones
Avery, and Lorine Jones Booth.
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During his lifetime, decedent acquired, by gift or bequest,
the surface rights to several large ranches, including the Jones
Borregos Ranch, consisting of 25,669.49 acres, and the Jones Alta
Vista Ranch, consisting of 44,586.35 acres. These ranches were
originally acquired by decedent’s grandfather and have been held
by decedent’s family for several generations. The land on these
ranches is arid natural brushland, and commercial uses include
raising cattle and hunting.
Motivated by his desire to keep the ranches in the family,
decedent became involved in estate planning matters beginning in
1987. In 1994, decedent’s certified public accountant suggested
that decedent use partnerships as estate and business planning
tools. Following up on this suggestion, A.C. Jones prepared
various projections for decedent concerning a hypothetical
transfer of the ranches to partnerships and the discounted values
that would attach to the partnership interests for gift tax
purposes.
A.C. Jones, Elizabeth Jones, Susan Jones Miller, Kathleen
Jones Avery, and Lorine Jones Booth each owned a one-fifth
interest in the surface rights of the Jones El Norte Ranch. They
acquired this ranch by bequest from decedent’s aunt in 1979. The
Jones El Norte Ranch was also originally owned by decedent’s
grandfather and has also been owned by decedent’s extended family
for several generations.
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Effective January 1, 1995, decedent and A.C Jones formed
JBLP under Texas law. Decedent contributed the surface estate of
the Jones Borregos Ranch, livestock, and certain personal
property in exchange for a 95.5389-percent limited partnership
interest. The entire contribution was reflected in the capital
account of decedent. A.C. Jones contributed his one-fifth
interest in the Jones El Norte Ranch in exchange for a 1-percent
general partnership interest and a 3.4611-percent limited
partnership interest.
On January 1, 1995, the same day that the partnership was
effectively formed, decedent gave to A.C. Jones an 83.08-percent
interest in JBLP, leaving decedent with a 12.4589-percent limited
partnership interest. Decedent used a document entitled “Gift
Assignment of Limited Partnership Interest” to carry out the
transfer. The document stated that decedent intends that A.C.
Jones receive the gift as a limited partnership interest.
Federal income tax returns for 1995, 1996, 1997, and 1998
were filed for JBLP and signed by A.C. Jones as tax matters
partner. Attached to each return were separate Schedules K-1 for
each general partnership interest and each limited partnership
interest. The Schedules K-1 for the limited partnership interest
of A.C. Jones included the interest in partnership received by
gift from decedent.
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Also effective January 1, 1995, decedent and his four
daughters formed AVLP under Texas law. Decedent contributed the
surface estate of the Jones Alta Vista Ranch in exchange for an
88.178-percent limited partnership interest. The contribution
was reflected in decedent’s capital account. Susan Jones Miller
and Elizabeth Jones each contributed their one-fifth interests in
the Jones El Norte Ranch in exchange for 1-percent general
partnership interests and 1.9555-percent limited partnership
interests, and Kathleen Jones Avery and Lorine Jones Booth each
contributed their one-fifth interest in the Jones El Norte Ranch
in exchange for 2.9555-percent limited partnership interests.
The following chart summarizes the ownership structure of AVLP
immediately after formation:
Partner Percentage Interest
Elizabeth Jones 1.0 General
1.9555 Limited
Susan Jones Miller 1.0 General
1.9555 Limited
Kathleen Jones Avery 2.9555 Limited
Lorine Jones Booth 2.9555 Limited
Decedent 88.178 Limited
On January 1, 1995, the same day that the partnership was
effectively formed, decedent gave to each of his four daughters a
16.915-percent interest in AVLP, leaving decedent with a
20.518-percent limited partnership interest. Decedent used four
separate documents, one for each daughter, entitled “Gift
Assignment of Limited Partnership Interest” to carry out the
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transfers. Each document stated that decedent intended for his
daughters to receive the gifts as limited partnership interests.
Federal income tax returns for 1995, 1996, 1997, and 1998
were filed for AVLP and signed by Elizabeth Jones as tax matters
partner. Attached to each return were separate Schedules K-1 for
each general partnership interest and each limited partnership
interest. The Schedules K-1 for each daughter’s limited
partnership interest included the partnership interest received
by gift from decedent.
Decedent’s attorney drafted the partnership agreements of
both JBLP and AVLP with the intention of creating substantial
discounts for the partnership interests that were transferred by
gift. Both partnership agreements set forth conditions for when
an interest that is transferred by gift or by other methods may
convert to a limited partnership interest. Section 8.3 of the
JBLP agreement provides that the general partner and 100 percent
of the limited partners must approve the conversion to a limited
partnership interest in writing, and section 8.3 of the AVLP
agreement provides that the general partners and 75 percent of
the remaining limited partners must approve the conversion in
writing. Both agreements also require that an assignee execute a
writing that gives assurances to the other partners that the
assignee has acquired such interest without the intention to
distribute such interest, and the assignee must execute a
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counterpart to the partnership agreement adopting the conditions
therein.
Sections 8.4 and 8.5 of the partnership agreements provide
that, before a partner may transfer an interest in the
partnerships to anyone other than decedent or any lineal
descendant of decedent, the partnership or remaining partners
shall have the option to purchase the partnership interest for
the lesser of the agreed upon sales price or appraisal value.
The partnership may elect to pay the purchase price in 10 annual
installments with interest set at the minimum rate allowed by the
rules and regulations of the Internal Revenue Service.
Section 9.2 of the agreements provides that the partnerships
will continue for a period of 35 years. Section 9.3 provides
that a limited partner will not be permitted to withdraw from the
partnership, receive a return of contribution to capital, receive
distributions in liquidation, or redemption of interest except
upon dissolution, winding up, and termination of the partnership.
Section 9.4 of the partnership agreements provides for the
removal of a general partner and the dissolution of the
partnership. The AVLP agreement provides that a general partner
may be removed at any time by the act of partners owning an
aggregated 75-percent interest in the partnership. The JBLP
agreement provides that a general partner may be removed at any
time by the act of the partners owning an aggregated 51-percent
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interest in the partnership. After removal, if there is no
remaining general partner, the remaining limited partners shall
designate a successor general partner. If the limited partners
fail to designate a successor general partner within 90 days, the
partnership will dissolve, affairs will be wound up, and the
partnership will terminate. Except upon dissolution, windup, and
termination, both partnership agreements prohibit a limited
partner from withdrawing and receiving a return of capital
contribution, distribution in liquidation, or a redemption of
interest.
Section 5.4 of the AVLP agreement originally provided that
the general partners could not sell any real property interest
that was owned by the partnership without first obtaining the
consent of partners owning a majority interest in the
partnership. This section was later amended so that partners
owning 85 percent of the partnership must consent to a sale of
real property.
On January 1, 1995, the Jones Alta Vista Ranch had a fair
market value of $10,254,860, and the Jones Borregos Ranch,
livestock, and personal property that were contributed by
decedent to JBLP had a fair market value of $7,360,997. Neither
partnership ever made a section 754 election. At the time that
decedent transferred interests in the partnerships by gift to his
children, the net asset values (NAV) of the underlying
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partnership assets that were held by AVLP and JBLP were
$11,629,728 and $7,704,714, respectively. JBLP and AVLP had
bases in their assets of $562,840 and $1,818,708, respectively.
Attached to his 1995 Federal gift tax return, decedent
included a valuation report prepared by Charles L. Elliott, Jr.
(Elliott), who also testified as the estate’s expert at trial.
The partnerships were valued on the return and by Elliott at
trial using the NAV method on a “minority interest,
nonmarketable” basis. Nowhere in his report did Elliott purport
to be valuing assignee interests in the partnership. The
valuation report arrived at an NAV for the partnerships and then
applied secondary market, lack-of-marketability, and built-in
capital gains discounts. The expert report concluded that a
66-percent discount from NAV is applicable to the interest in
JBLP and that a 58-percent discount is applicable to the interest
in AVLP. On the return, decedent reported gifts of “an
83.08 percent limited partnership interest” in JBLP valued at
$2,176,864 and a “16.915 percent limited partnership interest” in
AVLP to each of his four daughters, valued at $821,413 per
interest.
In an affidavit executed on January 12, 1999, A.C. Jones
stated that the gifts that he and his sisters received from
decedent were “limited partnership interests”. The sole activity
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of AVLP is the rental of its real property. AVLP produces an
average annual yield of 3.3 percent of NAV.
OPINION
Gift at the Inception of the Partnerships
In an amendment to the answer, respondent contends that
decedent made taxable gifts upon contributing his property to the
partnerships. Using the value reported by decedent on his gift
tax return, respondent argues that, if decedent gave up property
worth $17,615,857 and received back limited partnership interests
worth only $6,675,156, decedent made taxable gifts upon the
formation of the partnerships equal to the difference in value.
In Estate of Strangi v. Commissioner, 115 T.C. 478, 489-490
(2000), a decedent formed a family limited partnership with his
children and transferred assets to the partnership in return for
a 99-percent limited partnership interest. After his death, his
estate claimed that, due to lack-of-control and lack-of-
marketability discounts, the value of the limited partnership
interest was substantially lower than the value of the property
that was contributed by the decedent. The Commissioner argued
that the decedent had made a gift when he transferred property to
the partnership and received in return a limited partnership
interest of lesser value. The Court held that, because the
taxpayer received a continuing interest in the family limited
partnership and his contribution was allocated to his own capital
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account, the taxpayer had not made a gift at the time of
contribution.
In Shepherd v. Commissioner, 115 T.C. 376, 379-381 (2000),
the taxpayer transferred real property and stock to a newly
formed family partnership in which he was a 50-percent owner and
his two sons were each 25-percent owners. Rather than allocating
contributions to the capital account of the contributing partner,
the partnership agreement provided that any contributions would
be allocated pro rata to the capital accounts of each partner
according to ownership. Because the contributions were reflected
partially in the capital accounts of the noncontributing
partners, the value of the noncontributing partners’ interests
was enhanced by the contributions of the taxpayer. Therefore,
the Court held that the transfers to the partnership were
indirect gifts by the taxpayer to his sons of undivided
25-percent interests in the real property and stock. See id. at
389.
The contributions of property in the case at hand are
similar to the contributions in Estate of Strangi and are
distinguishable from the gifts in Shepherd. Decedent contributed
property to the partnerships and received continuing limited
partnership interests in return. All of the contributions of
property were properly reflected in the capital accounts of
decedent, and the value of the other partners’ interests was not
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enhanced by the contributions of decedent. Therefore, the
contributions do not reflect taxable gifts.
Because the contributions do not reflect taxable gifts, we
need not decide whether the period of limitations for assessment
of a deficiency due to a gift on formation has expired.
Section 2704(b)
Respondent determined in the statutory notice, and argues in
the alternative, that provisions in the partnership agreements
constitute applicable restrictions under section 2704(b) and must
be disregarded when determining the value of the partnership
interests that were transferred by gift.
Section 2704(b) generally states that, where a transferor
and his family control a partnership, a restriction on the right
to liquidate the partnership shall be disregarded when
determining the value of the partnership interest that has been
transferred by gift or bequest if, after the transfer, the
restriction on liquidation either lapses or can be removed by the
family. Section 25.2704-2(b), Gift Tax Regs., provides that an
applicable restriction is a restriction on “the ability to
liquidate the entity (in whole or in part) that is more
restrictive than the limitations that would apply under the State
law generally applicable to the entity in the absence of the
restriction.”
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Respondent argues that both partnership agreements contain
provisions limiting the ability of a partner to liquidate that
are more restrictive than the default Texas partnership
provisions. Specifically, respondent points to section 9.2 of
the partnership agreements, which provides that each partnership
shall continue for a period of 35 years. Respondent also points
to section 9.3 of the partnership agreements, which prohibits a
limited partner from withdrawing from the partnership or from
demanding the return of any part of a partner’s capital account
except upon termination of the partnership.
Respondent compares sections 9.2 and 9.3 of the partnership
agreements with section 6.03 of the Texas Revised Limited
Partnership Act (TRLPA). TRLPA section 6.03 provides:
A limited partner may withdraw from a limited
partnership at the time or on the occurrence of events
specified in a written partnership agreement and in
accordance with that written partnership agreement. If
the partnership agreement does not specify such a time
or event or a definite time for the dissolution and
winding up of the limited partnership, a limited
partner may withdraw on giving written notice not less
than six months before the date of withdrawal to each
general partner * * *.
Tex. Rev. Civ. Stat. Ann. art. 6132a-1, sec. 6.03 (West Supp.
1993).
Respondent’s argument is essentially the same as the
argument we rejected in Kerr v. Commissioner, 113 T.C. 449, 469-
474 (1999). In Kerr, the taxpayers and their children formed two
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family limited partnerships with identical liquidation
restrictions. Shortly after formation, the taxpayers transferred
limited partnership interests to their children by gift. On
their Federal gift tax return, the taxpayers claimed substantial
discounts in the value of the interests compared to the value of
the underlying assets due to lack of control and lack of
marketability. The partnership agreements provided that the
partnerships would continue for 50 years.
The Court held:
Respondent’s reliance on TRLPA section 6.03 is
misplaced. TRLPA section 6.03 governs the withdrawal
of a limited partner from the partnership--not the
liquidation of the partnership. TRLPA section 6.03
sets forth limitations on a limited partner’s
withdrawal from a partnership. However, a limited
partner may withdraw from a partnership without
requiring the dissolution and liquidation of the
partnership. In this regard, we conclude that TRLPA
section 6.03 is not a “limitation on the ability to
liquidate the entity” within the meaning of section
25.2704-2(b), Gift Tax Regs.
Id. at 473. In sum, the Court concluded that the partnership
agreements in Kerr were not more restrictive than the limitations
that generally would apply to the partnerships under Texas law.
See id. at 472-474. Respondent acknowledges that Kerr is
applicable to this issue but argues that Kerr was incorrectly
decided. However, we find no reason to reach a result that is
different than the result in Kerr. Thus, section 2704(b) does
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not apply here. See also Knight v. Commissioner, 115 T.C. 506,
519-520 (2000); Harper v. Commissioner, T.C. Memo. 2000-202.
Valuation of Decedent’s Gifts of
Limited Partnership Interests
A gift of property is valued as of the date of the transfer.
See sec. 2512(a). The gift is measured by the value of the
property passing from the donor, rather than by the property
received by the donee or upon the measure of enrichment to the
donee. See sec. 25.2511-2(a), Gift Tax Regs. The fair market
value of the transferred property is the price at which the
property would change hands between a willing buyer and willing
seller, neither being under any compulsion to buy or to sell and
both having reasonable knowledge of relevant facts. See United
States v. Cartwright, 411 U.S. 546, 551 (1973); sec. 25.2512-1,
Gift Tax Regs. The hypothetical willing buyer and the
hypothetical willing seller are presumed to be dedicated to
achieving the maximum economic advantage. See Estate of Davis v.
Commissioner, 110 T.C. 530, 535 (1998). Transactions that are
unlikely and plainly contrary to the economic interests of a
hypothetical willing buyer or a hypothetical willing seller are
not reflective of fair market value. See Estate of Strangi v.
Commissioner, 115 T.C. 478, 491 (2000); Estate of Newhouse v.
Commissioner, 94 T.C. 193, 232 (1990); Estate of Hall v.
Commissioner, 92 T.C. 312, 337 (1989).
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As is customary for valuation issues, the parties rely
extensively on the opinions of their respective experts to
support their differing views about the fair market value of the
gifts of partnership interests. The estate relies on Elliott, a
senior member of the American Society of Appraisers and a
principal in the business valuation firm of Howard Frazier Barker
Elliott, Inc. Respondent relies on Francis X. Burns (Burns), a
candidate member of the American Society of Appraisers and a
principal in the business valuation firm of IPC Group, Inc. Each
expert prepared a report.
We evaluate the opinions of the experts in light of the
demonstrated qualifications of each expert and all other evidence
in the record. See Estate of Davis v. Commissioner, supra at
536. We are not bound by the formulae and opinions proffered by
expert witnesses, especially when they are contrary to our
judgment. Instead, we may reach a determination of value based
on our own examination of the evidence in the record. Where
experts offer contradicting estimates of fair market value, we
decide what weight to give those estimates by examining the
factors used by the experts in arriving at their conclusions.
See id. Moreover, because valuation is necessarily an
approximation, it is not required that the value that we
determine be one as to which there is specific testimony,
provided that it is within the range of figures that properly may
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be deduced from the evidence. See Silverman v. Commissioner,
538 F.2d 927, 933 (2d Cir. 1976), affg. T.C. Memo. 1974-285. The
experts in this case agree that, in ascertaining the fair market
value of each gift of interest in the partnerships, one starts
with the fair market value of the underlying assets of each
partnership and then applies discounts for factors that limit the
value of the partnership interests.
A. Nature of Interests Transferred
The first argument of the estate is that the partnership
interests that were transferred by decedent were assignee
interests rather than limited partnership interests. The estate
claims that decedent and the recipients of the gifts did not
fulfill the necessary requirements set forth in the partnership
agreements for transferring limited partnership interests. The
JBLP agreement provides that, upon an exchange of an interest in
the partnership, the general partner and 100 percent of the
remaining limited partners must approve, in writing, of a
transferred interest becoming a limited partnership interest.
The AVLP agreement provides that the general partners and
75 percent of the limited partners must approve, in writing, of a
transferred interest’s becoming a limited partnership interest.
Because these written approvals were not carried out, the estate
contends that the recipients of the gifts are entitled only to
the rights of assignees.
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In Kerr v. Commissioner, 113 T.C. 449, 464 (1999), the
taxpayers held greater than 99 percent of the partnership
interests of two family limited partnerships as general and
limited partners. The taxpayers’ children held the remaining
partnership interests, totaling less than 1 percent of overall
ownership, as general partners. The partnership agreements
provided that no person would be admitted as a limited partner
without the consent of all general partners. In 1994, the
taxpayers transferred a large portion of their limited
partnership interests to trusts for which they served as
trustees. At trial, the taxpayers argued that, although they
made these transfers to themselves as trustees, pursuant to the
family limited partnership agreement, their children as general
partners had to consent to the admission of the trustees as
limited partners. The taxpayers argued that the interests held
by the trusts should be valued as assignee interests. The Court
looked at all of the surrounding facts and circumstances in
holding that the interests that were transferred by the taxpayers
were limited partnership interests. See id. at 464.
On review of the facts and circumstances of the case at
hand, decedent, like the taxpayers in Kerr, transferred limited
partnership interests to his children rather than assignee
interests. The evidence shows that decedent intended for the
transfers to include limited partnership interests and that the
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children consented to the transfer of limited partnership
interests, having waived the requirement of a writing.
Pursuant to the AVLP agreement, Susan Jones Miller and
Elizabeth Jones as general partners would have had to consent in
writing to the transfer of the interests as limited partnership
interests. Also, 75 percent of the remaining limited partners,
i.e., Elizabeth Jones, Susan Jones Miller, Kathleen Jones Avery,
Lorine Jones Booth, and decedent, would have had to consent in
writing. Pursuant to the JBLP agreement, A.C. Jones as general
partner would have had to consent in writing to the transfer as a
limited partnership interest. Also, all of the remaining limited
partners, i.e., A.C. Jones and decedent, would have had to
consent in writing.
Although the estate argues that the absence of written
consents leads to the conclusion that the interests transferred
were assignee interests, it is difficult to reconcile that
position with the language that decedent, his children, and
Elliott used to document and characterize the transfers. First,
the documents entitled “Gift Assignment of Limited Partnership
Interest”, created by decedent to carry out the transfers, state
that, after the transfers are complete, each child will hold his
or her newly acquired interest as a “limited partnership
interest”. Second, in his 1995 Federal gift tax return, decedent
describes the gifts as “limited partnership interests” rather
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than assignee interests. Third, in an affidavit executed on
January 12, 1999, A.C. Jones states that the gifts that he and
his sisters received from decedent were “limited partnership
interests”. Fourth, the 1995, 1996, 1997, and 1998 Federal
income tax returns for JBLP and AVLP, signed by A.C. Jones and
Elizabeth Jones, respectively, designate the interests as limited
partnership interests on the Schedules K-1. Fifth, although he
claimed at trial that he was valuing assignee interests,
Elliott’s written report referred only to limited partnership
interests. These factors lead to the conclusion that the
estate’s argument, that decedent transferred assignee interests,
was an afterthought in the later stages of litigation.
Also, after giving the gifts to his daughters, decedent was
left with a 20.518-percent limited partnership interest. Section
5.4 of the AVLP agreement was modified so that consent of
85 percent of the partners was required in order for a general
partner to sell a real estate interest belonging to the
partnership. With this modification, decedent could retain the
power to block unilaterally a sale of a real estate interest even
after giving the gifts. This amendment would not have been
necessary if the daughters had received only assignee interests.
This case is distinguishable from Estate of Nowell v.
Commissioner, T.C. Memo. 1999-15, relied on by petitioner. In
Estate of Nowell, the partnership agreements specified that the
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recipient of limited partnership interests would become an
assignee and not a substitute limited partner unless the general
partners consented to the assignee’s admission as a limited
partner. The Court there decided that interests in the
partnerships should be valued for estate tax purposes as assignee
interests rather than as limited partnership interests.
The transactions in Estate of Nowell differ from the gifts
in the case at hand in that the beneficiaries, the estate, and
the decedent in Estate of Nowell never treated the passing
interests in the partnerships as limited partnership interests.
The record was void of evidence that showed that a limited
partnership interest was in fact transferred. Here, the conduct
of decedent, A.C. Jones, and the daughters reflects that limited
partnership interests were actually transferred by decedent.
B. Value of the Transferred Interest in JBLP
Having concluded that decedent transferred an 83.08-percent
limited partnership interest in JBLP to A.C. Jones, the next
issue for decision is the value of the limited partnership
interest. The estate relies on the conclusions of Elliott, who
opined that the value of the interest in JBLP is subject to a
secondary market discount of 55 percent, a lack-of-marketability
discount of 20 percent, and an additional discount for built-in
capital gains. Respondent relies on the valuation of Burns, who
opined that no discounts apply.
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Section 9.4 of the JBLP agreement provides that a general
partner may be removed at any time by the act of the partners
owning an aggregate 51-percent interest in the partnership.
After removal, if no general partners remain, the limited
partners shall designate a successor general partner. If the
limited partners fail to designate a successor general partner
within 90 days, the partnership will dissolve, affairs will be
wound up, and the partnership will terminate.
Section 9.4 effectively gives ultimate decision-making
authority to the owner of the 83.08-percent limited partnership
interest. Under the threat of removal of the general partner,
the 83.08-percent limited partner would have the power to control
management, to compel a sale of partnership property, and to
compel partnership distributions. If the general partner
refused, the 83.08-percent limited partner could force
liquidation within 90 days. Having the ability to force
liquidation also gives the 83.08-percent limited partner the
right to force a sale of the partnership assets and to receive a
pro rata share of the NAV. Because the 83.08-percent limited
partner has the power to control the general partner or to force
a liquidation, the discounts proffered by Elliott are
unreasonable and unpersuasive. The size of the interest to be
valued and the nature of the underlying assets make the secondary
market an improbable analogy for determining fair market value.
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We do not believe that a seller of the 83.08-percent limited
partnership interest would part with that interest for
substantially less than the proportionate share of the NAV.
Burns opined that no discount for lack of control should
apply for the reasons stated above. We agree. He also concluded
that “the size and the associated rights of the interest would
preclude the need for a marketability discount.” He recognized
that section 8.4 of the partnership agreement purported to give
family members the power to prevent a third-party buyer from
obtaining an interest in the JBLP, but he maintained that “to
adhere to the fair market value standard, an appraiser must
assume that a market exists and that a willing buyer would be
admitted into the partnership.” We believe that there is merit
to this position. Self-imposed limitations on the interest,
created with the purpose of minimizing value for transfer tax
purposes, are likely to be waived or disregarded when the owner
of the interest becomes a hypothetical willing seller, seeking
the highest price that the interest will bring from a willing
buyer. The owner of the 83.08-percent interest has the ability
to persuade or coerce other partners into cooperating with the
proposed sale. Nonetheless, liquidation of a partnership and
sale of its assets, the most likely threat by which the owner of
such a controlling interest would persuade or coerce, would
involve costs and delays. The possibility of litigation over a
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forced liquidation would reduce the amount that a hypothetical
buyer would be willing to pay for the interest. See Adams v.
United States, 218 F.3d 383 (5th Cir. 2000); Estate of Newhouse
v. Commissioner, 94 T.C. 193, 235 (1990). A marketability
discount would apply, but we believe that, under the
circumstances of this case, an 8-percent discount more accurately
reflects reality. This amount approximates the discount for lack
of marketability proposed by Burns with respect to AVLP, as
discussed below.
The experts also disagree about whether a discount
attributable to built-in capital gains to be realized on
liquidation of the partnership should apply. The parties and the
experts agree that tax on the built-in gains could be avoided by
a section 754 election in effect at the time of sale of
partnership assets. If such an election is in effect, and the
property is sold, the basis of the partnership’s assets (the
inside basis) is raised to match the cost basis of the transferee
in the transferred partnership interest (the outside basis) for
the benefit of the transferee. See sec. 743(b). Otherwise, a
hypothetical buyer who forces a liquidation could be subject to
capital gains tax on the buyer’s pro rata share of the amount
realized on the sale of the underlying assets of the partnership
over the buyer’s pro rata share of the partnership’s adjusted
basis in the underlying assets. See sec. 1001. Because the JBLP
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agreement does not give the limited partners the ability to
effect a section 754 election, in this case the election would
have to be made by the general partner.
Elliott opined that a hypothetical buyer would demand a
discount for built-in gains. He acknowledged in his report a 75-
to 80-percent chance that an election would be made and that the
election would not create any adverse consequences or burdens on
the partnership. His opinion that the election was not certain
to be made was based solely on the position of A.C. Jones,
asserted in his trial testimony, that, as general partner, he
might refuse to cooperate with an unrelated buyer of the
83.08-percent limited partnership interest (i.e., the interest he
received as a gift from his father). We view A.C. Jones’
testimony as an attempt to bootstrap the facts to justify a
discount that is not reasonable under the circumstances.
Burns, on the other hand, opined, and respondent contends,
that a hypothetical willing seller of the 83.08-percent interest
would not accept a price based on a reduction for built-in
capital gains. The owner of that interest has effective control,
as discussed above, and would influence the general partner to
make a section 754 election, eliminating any gains for the
purchaser and getting the highest price for the seller. Such an
election would have no material or adverse impact on the
preexisting partners. We agree with Burns.
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Petitioner relies on Eisenberg v. Commissioner, 155 F.3d 50
(2d Cir. 1998), revg. T.C. Memo. 1997-483, and Estate of Davis v.
Commissioner, 110 T.C. 530, 546-547 (1998). Those cases,
however, are distinguishable. In the contexts of those cases,
the hypothetical buyer and seller would have considered a factor
for built-in capital gains in determining a price for closely
held stock in a corporation. In Eisenberg, the Court of Appeals
emphasized that earlier Tax Court cases declining to recognize a
discount for unrealized capital gains were based on the ability
of the corporation, under the doctrine of General Utilities &
Operating Co. v. Helvering, 296 U.S. 200 (1935), to liquidate and
distribute property to its shareholders without recognizing
built-in gain or loss and thus circumvent double taxation. The
Court of Appeals went on to explain that the tax-favorable
options ended with the Tax Reform Act of 1986, Pub. L. 99-514,
sec. 631, 100 Stat. 2085, 2269. In reversing our grant of
summary judgment on this issue and remanding the case for
determination of gift tax liability, the Court of Appeals cited
and quoted from Estate of Davis v. Commissioner, supra, in
support of its reasoning.
In Estate of Davis, the Court rejected the Government’s
argument that no discount for built-in capital gains should apply
because of the possibility that the corporation could convert to
an S corporation and avoid recognition of gains on assets
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retained for 10 years. Applying the hypothetical buyer and
seller test, the Court, based on the record presented, including
the testimony of experts for both parties, concluded that a
discount for tax on built-in gains would be applied.
In the cases in which the discount was allowed, there was no
readily available means by which the tax on built-in gains would
be avoided. By contrast, disregarding the bootstrapping
testimony of A.C. Jones in this case, the only situation
identified in the record where a section 754 election would not
be made by a partnership is an example by Elliott of a publicly
syndicated partnership with “lots of partners * * * and a lot of
assets” where the administrative burden would be great if an
election were made. We do not believe that this scenario has
application to the facts regarding the partnerships in issue in
this case. We are persuaded that, in this case, the buyer and
seller of the partnership interest would negotiate with the
understanding that an election would be made and the price agreed
upon would not reflect a discount for built-in gains.
C. Value of Interests in AVLP
The estate relies on the conclusions of Elliott, who opined
that the value of each transferred interest in AVLP is subject to
a secondary market discount of 45 percent, a discount for lack of
marketability equal to 20 percent, and an additional discount for
built-in capital gains. Burns opined that the transferred
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interests are entitled to a secondary market discount of
38 percent, a discount for lack of marketability equal to
7.5 percent, and no discount for built-in capital gains.
An owner of a 16.915-percent limited partnership interest in
AVLP does not have the ability to remove a general partner. As
such, a hypothetical buyer would have minimal control over the
management and business operations. Also, a 16.915-percent
limited partnership interest in AVLP is not readily marketable,
and any hypothetical purchaser would demand a significant
discount. In calculating the overall discount for the AVLP
interests, both experts use data from different issues of the
same publication regarding sales of limited partnership interests
on the secondary market. The publication was the primary tool
used by both experts.
Burns, using the May/June 1995 issue, opined that interests
in real estate-oriented partnerships with characteristics similar
to AVLP traded at discounts due to lack of control equal to
38 percent on January 1, 1995. The May/June 1995 issue contained
data regarding the sale of limited partnership interests during
the 60-day period ended May 31, 1995. Burns classified AVLP as a
low-debt partnership making current distributions.
Elliott, using the May/June 1994 issue, opined that similar
partnerships traded at a secondary market discount of 45 percent.
The secondary market discount is an overall discount encompassing
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discounts for both lack of control and lack of marketability for
minority interests in syndicated limited partnerships. The
May/June 1994 issue contained data regarding the sale of limited
partnership interests during the 60-day period ended May 31,
1994.
The estate argues that Burns’ conclusion, which is based on
data found in the May/June 1995 issue, is flawed because such
information was not available on January 1, 1995, the date the
gift was made. The estate contends that, since a gift of
property is valued, pursuant to section 2512(a), as of the date
of the transfer, posttransfer data cannot affect our decision.
However, Burns does not use the posttransfer data to prove
directly the value of the transferred interests. Instead, he
uses the May/June 1995 issue to show what value would have been
calculated if, on January 1, 1995, decedent had looked at
transactions involving the sale of interests in similarly
situated partnerships occurring at that point in time. Data
regarding such transactions involving similarly situated
partnerships were available on the valuation date. Therefore,
the data available in the May/June 1995 issue are relevant as
they provide insight into what information would have been found
if, on January 1, 1995, decedent had looked at transactions
occurring on or near the valuation date.
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The data on which Burns relied show that interests in
similarly situated partnerships were trading at a 38-percent
discount from April 2 to May 31, 1995. The data on which Elliott
relied show that interests in similarly situated partnerships
were trading at a 45-percent discount from April 2 to May 31,
1994. Therefore, transfers of interests on or around January 1,
1995, would have been trading at a discount somewhere between 38
and 45 percent. Because the data on which Burns relied are
closer in time to the transfer date of the 16.915-percent AVLP
interests, we give greater weight to his determination.
Recognizing that the valuation process is always imprecise, a
40-percent discount is reasonable. This discount is a reduction
in value for an interest trading on the secondary market and
encompasses discounts for lack of control and lack of
marketability.
Elliott opines that an additional 20-percent discount for
lack of marketability is applicable because the partnerships that
are the subject of the data in the publication are syndicated
limited partnerships. He believes that, although there is a
viable market for syndicated limited partnership interests, a
market for nonsyndicated, family limited partnership interests
does not exist. The additional 20-percent discount opined by
Elliot is also attributable to sections 8.4 and 8.5 of the AVLP
agreement, which attempt to limit the transferability of
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interests in AVLP. In calculating the additional discount,
Elliott relied on data found in various restricted stock and
initial public offering studies.
Elliott acknowledges that the secondary market for
syndicated partnerships is not a strong market and that a large
discount for lack of marketability is already built into the
secondary market discount. Although Elliott adjusts his analysis
of the data found in the restricted stock and initial public
offering studies to take into consideration the lack-of-
marketability discount already allowed, his adjustment is
inadequate. His cumulation of discounts does not survive a
sanity check.
Sections 8.4 and 8.5 of the AVLP agreement do not justify an
additional 20-percent discount. An option of the partnership or
the other partners to purchase an interest for fair market value
before it is transferred to a third party, standing alone, would
not significantly reduce the value of the partnership interest.
Nevertheless, the right of the partnership to elect to pay the
purchase price in 10 annual installments with interest set at the
minimum rate allowed by the rules and regulations of the Internal
Revenue Service would increase the discount for lack of
marketability. Texas courts have been willing to disregard
option clauses that unreasonably restrain alienation. See
Procter v. Foxmeyer Drug Co., 884 S.W.2d 853, 859 (Tex. App.
- 33 -
1994). We express no opinion whether this election is
enforceable under Texas law. Because this clause would cause
uncertainty as to the rights of an owner to receive fair market
value for an interest in AVLP, a hypothetical buyer would pay
less for the partnership interest. See Estate of Newhouse v.
Commissioner, 94 T.C. 193, 232-233 (1990); Estate of Moore v.
Commissioner, T.C. Memo. 1991-546. We believe that an additional
discount equal to 8 percent for lack of marketability, to the NAV
previously discounted by 40 percent, is justified.
For the reasons set forth in the built-in capital gains
analysis for JBLP, an additional discount for lack of
marketability due to built-in gains in AVLP is not justified.
Although the owner of the percentage interests to be valued with
respect to AVLP would not exercise effective control, there is no
reason why a section 754 election would not be made. Elliott
admits that, because AVLP has relatively few assets, a section
754 election would not cause any detriment or hardship to the
partnership or the other partners. Thus, we agree with Burns
that the hypothetical seller and buyer would negotiate with the
understanding that an election would be made. Elliott’s
assumption that Elizabeth Jones and Susan Jones Miller, as
general partners, might refuse to cooperate with a third-party
purchaser is disregarded as an attempt to bootstrap the facts to
justify a discount that is not reasonable under the
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circumstances. Therefore, a further discount for built-in
capital gains is not appropriate in this case.
D. Conclusion
The schedules below summarize our conclusions as to fair
market value for the transferred JBLP and AVLP limited
partnership interests:
83.08-Percent Interest in JBLP
NAV of limited partnership $ 7,704,714
83.08%
Pro rata NAV 6,401,076
Lack of marketability (8%) (512,086)
Fair market value $ 5,888,990
16.915-Percent Interest in AVLP
NAV of limited partnership $11,629,728
16.915%
Pro rata NAV 1,967,168
Secondary market (40%) (786,867)
1,180,301
Lack of marketability (8%) (94,424)
Fair market value $ 1,085,877
We have considered all remaining arguments made by both
parties for a result contrary to those expressed herein, and, to
the extent not discussed above, they are irrelevant or without
merit.
To reflect the foregoing,
Decision will be entered
under Rule 155.