Estate of Johnson v. Commissioner

OPINION

Ekman, Judge:^*

Respondent determined a deficiency of $51,687 in petitioner’s Federal estate tax. Concessions having been made by the parties, the sole issue remaining for decision is whether the date of death value of homestead property owned by decedent should be reduced or discounted on account of the homestead rights of decedent’s surviving spouse.

All of the facts have been stipulated and are so found. The stipulation of facts and exhibits attached thereto are incorporated herein by this reference. The pertinent facts are summarized below.

Lolita McNeill Muhm (hereinafter petitioner) is the independent executrix of the Estate of Helen M. Johnson, deceased. Petitioner is the successor to Perry Reese McNeill, Sr., who, as independent executor of the Estate of Helen M. Johnson, deceased, filed a Federal estate tax return with the District Director of Internal Revenue, Austin, Tex. Petitioner’s legal, residence at the time the petition was filed was Richardson, Tex.

Helen M. Johnson (hereinafter decedent), a resident of Brazoria, Brazoria County, Tex., died March 1, 1975, and was survived by her husband, Elmer V. Johnson, who was then 73 years of age.

At the time of her death, decedent owned interests in various tracts and parcels of real property in Brazoria County, Tex. Among them was the property in dispute, an undivided one-half interest in a tract of 297.563 acres (hereinafter tract 2) and the entire fee interest in 2.4378 acres (hereinafter tract 7). These properties, although separately owned by decedent, constituted the homestead of decedent and her husband.

Perry Reese McNeill (decedent’s brother) was the owner of the other undivided one-half interest in the 297.563-acre tract referred to as tract 2. After decedent’s death, Elmer V. Johnson asserted his right to continue to occupy both tracts as his homestead property against the wishes of decedent’s brother.

Petitioner contends that once property is characterized as a homestead, certain rights created under Texas law serve to reduce its value for estate tax purposes. Respondent contends, on the other hand, there should be no reduction in value.

The parties have stipulated that if the homestead character of the property is to be reflected in valuing the property, the aggregate value of the interest in tract 2 and tract 7 is $92,233.73, while, if the homestead character is to be disregarded, the aggregate value is $173,945.50.

This Court faced the present issue in Estate of Hinds v. Commissioner, 11 T.C. 314 (1948), affd. on another issue 180 F.2d 930 (5th Cir. 1950). In response to the contention that in calculating the gross estate there should be deducted from decedent’s community half interest the homestead interest of the surviving spouse, this Court, relying on the predecessor of section 2033 and the regulations thereunder, stated at page 325:

We think this contention is without merit. The Federal' estate tax laws do not contemplate any such deduction. There is nothing particularly unusual about the laws of Texas with respect to the surviving spouse having the right of life occupancy to the homestead property. Many states have laws of a similar nature. The regulations specifically provide that property subject to homestead or other exemptions under local law is includible as part of the gross estate. See Regulations 105, sec. 81.13. Here the decedent had a vested community one-half interest in the homestead property, which interest was terminated by his death. This community one-half interest is, therefore, includible in the decedent’s estate.

Petitioner contends that Estate of Hinds was wrongly decided, that we summarily disposed of the issue therein, and that we should at this time reexamine our holding. Because we find no cases since Hinds bearing on the specific question, we turn to general principles of estate tax law for guidance.¹

Although Federal estate tax laws are controlling, we must first look to State law to determine the property rights and interests created in the parties. Morgan v. Commissioner, 309 U.S. 78 (1940); Lang v. Commissioner, 304 U.S. 264 (1938); see Commissioner v. Estate of Bosch, 387 U.S. 456 (1967).

In Texas, marital property may consist of either separate or community property. Tex. Fam. Code Ann. tit. 1, sec. 5.01 (Vernon); see Estate of Wyly v. Commissioner, 610 F.2d 1282, 1288 (5th Cir. 1980). Article 16, section 51 of the Texas Constitution provides that "the homestead, not in a town or city, shall consist of not more than two hundred acres of land, which may be in one or more parcels, with improvements thereon.” It is well established that a homestead may consist of community property or separate property of either spouse. Sparks v. Robertson, 203 S.W.2d 622 (Tex. Civ. App. 1947); Wicker v. Rowntree, 185 S.W.2d 150 (Tex. Civ. App. 1945); Gillespie v. Gillespie, 110 S.W.2d 89 (Tex. Civ. App. 1937).

Once designated as homestead, the property is protected from all but a limited number of creditors. Tex. Const, art. 16, sec. 50. Generally, neither spouse may convey, encumber, or sell the homestead without joinder of the other. Tex. Fam. Code Ann. tit. 1, sec. 5.81 (Vernon).

Upon the death of one spouse, the homestead property retains its exemption from creditors. Tex. Prob. Code Ann. tit. 17c, sec. 270 (Vernon). The property is not part of the estate for administrative purposes and it is delivered directly to the surviving spouse if there is one and if not, to the guardian of the minor children and unmarried surviving children, if any, living with the family. Tex. Prob. Code Ann. tit. 17c, sec. 271, sec. 272 (Vernon). The homestead vests and descends like any other real property; however the surviving spouse (or children) may continue to use and occupy the property so long as he or she elects to use and occupy it as the homestead. Tex! Const, art. 16, sec. 52.

Section 2033 states simply "The value of the gross estate shall include the value of all property to the extent of the interest therein of the decedent at the time of his death.” A decedent’s gross estate for Federal estate tax purposes may be very different from the same decedent’s estate for local probate purposes. Sec. 20.0-2(b)(2), Estate Tax Regs. Thus, section 20.2033-l(b), Estate Tax Regs., provides that property subject to homestead or other exemptions under local law is included in the gross estate.

Petitioner concedes that the homestead property is includa-ble in decedent’s estate but contends that the value of the interest that decedent possessed at death must be reduced due to these homestead rights. Petitioner has submitted the report of an expert to support her contention that the homestead rights created under Texas law are restrictions which, like encumbrances on the property, reduce its value. Respondent on the other hand would have us ignore any effect which the homestead rights might have on fair market value. We agree with petitioner. The value of the interest decedent possessed at death is less than that of the same property unencumbered by homestead rights, and we cannot totally disregard those rights in determining values.²

Section 20.2031-l(b), Estate Tax Regs., provides generally that the value of every item includable in a decedent’s gross estate under sections 2031 through 2044 is its fair market value at the time of death or alternate valuation date under section 2032. As Judge Wisdom stated in United States v. Land, 303 F.2d 170, 172 (5th Cir. 1962):

Brief as is the instant of death, the court must pinpoint its valuation at this instant — the moment of truth, when the ownership of the decedent ends and the ownership of the successors begins. It is a fallacy, therefore, to argue value before-or-after death on the notion that valuation must be determined by the value either of the interest that ceases or of the interest that begins. Instead, the valuation is determined by the interest that passes, and the value of the interest before or after death is pertinent only as it serves to indicate the value at death.

Section 20.2031-l(b), Estate Tax Regs., defines fair market value as the "price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.” That regulation further provides that all the relevant facts and elements of value as of the applicable valuation date are to be considered in every case. As we said in Estate of Reynolds v. Commissioner, 55 T.C. 172, 195 (1970):

"Fair market value” is not an incantation whose ritualistic use will immediately reveal the worth of unusual types of property. The basis of the definition of fair market value is the assumption that hypothetical willing buyer and hypothetical willing seller, neither being under compulsion to buy or sell and both having reasonable knowledge of the relevant facts, will arrive at some sale price for the property in question. Sec. 20.2031-l(b), Estate Tax Regs.; sec. 25.2512-1, Gift Tax Regs. In reality, no willing buyers or willing sellers may exist. * * *

Petitioner urges us to consider Elmer V. Johnson’s rights as surviving spouse as a life estate. Numerous Texas cases do indeed discuss the homestead rights of a surviving spouse in terms of life estate or "in the nature of a life estate.” See Sargeant v. Sargeant, 118 Tex. 343, 15 S.W.2d 589 (Tex. Commission App. 1929), Williams v. Williams, 569 S.W.2d 867, 869 (Tex. 1978), Sparks v. Robertson, 203 S.W.2d 622, 623 (Tex. Civ. App. 1947). However, we need not, for purposes of the present determination, define the specific character and nature of the homestead interest.³

Respondent analogizes the homestead rights under Texas law to common law rights of dower and curtesy and maintains that although technically not within the reach of section 2034, homestead rights are within the spirit and intent of section 2034. Thus, continues respondent, it would be unfair if dower and curtesy rights did not affect valuation while homestead rights did.

Section 20.2034-1, Estate Tax Regs., provides:

Dower or curtesy interests. A decedent’s gross estate includes under section 2034 any interest in property of the decedent’s surviving spouse existing at the time of the decedent’s death as dower or curtesy, or any interest created by statute in lieu thereof (although such other interest may differ in character from dower or curtesy). Thus, the full value of property is included in the decedent’s gross estate, without deduction of such an interest of the surviving husband or wife, and without regard to when the right to such an interest arose.

However, as respondent concedes, homestead rights are not dower, curtesy, or an interest created in lieu thereof. See Interpretive Commentary following Tex. Const, art. 16, sec. 50. We are in no way persuaded by the analogy respondent seeks to draw.⁴

Respondent contends that the direct reference to homestead property in section 20.2033-l(b), Estate Tax Regs., clearly signifies that the homestead property is includable at full value. But the purpose of that reference is to assure that, although State law may exempt it from probate or State tax, the property is still includable in the gross estate. This is made clear by the words "Property subject to homestead or other exemptions under local law.” However, the fact that property is included in gross estate, although exempt under local law, has no bearing on determining the value at which the interest is to be included.

The language of respondent’s own regulations concerning dower and curtesy differs from that dealing with homestead property. Section 20.2034-1, Estate Tax Regs., reads as follows:

Thus, the full value of property is included in the decedent’s gross estate, without deduction of such an interest of the surviving husband or wife, and without regard to when such an interest arose. [Emphasis supplied.]

Section 20.2033-l(b), Estate Tax Regs., on the other hand, simply states that "Property subject to homestead or other exemptions under local law is included in the gross estate.” Respondent’s attempt to read the explicit language of section 20.2034-1 into section 20.2033-l(b), Estate Tax Regs., must therefore be rejected. We note in passing that the language of both sections of his regulations has remained substantially unchanged since 1937. See arts. 13⁵ and 14,⁶ Estate Tax Regs. 80 (1937).

In this case, the decedent did not possess a full total interest subject to her unrestricted control. Once the property was characterized as the homestead, decedent could not sell it without joinder of her spouse (Tex. Fam. Code Ann. tit. 1, sec. 5.01 (Vernon); see, e.g., Farmers & Merchants National Bank of Nocona v. Williams, 133 Tex. 554, 129 S.W.2d 268 (1939)), nor could she dispose of the entire homestead property by will without its being subject to the rights of her surviving spouse. Thus, at all times, decedent could convey only an interest subject to the homestead rights of her husband. Once the property became homestead property, it was no longer subject to decedent’s free and unrestricted dominion.

The fair market value of property subject to restrictions is generally recognized to be less than that of the same property unrestricted. Thus, restrictions on shares in a corporation (see sec. 20.2031-2(f) and (h), Estate Tax Regs., and sec. 25.2512-2(f), Gift Tax Regs.) and restrictions on sales of interests in an unincorporated business (see sec. 20.2031-3, Estate Tax Regs., and sec. 25.2512-3, Gift Tax Regs.) affect fair market value adversely. See Wilson v. Bowers, 57 F.2d 682 (2d Cir. 1932); Estate of Littick v. Commissioner, 31 T.C. 181 (1958); and Estate of Weil v. Commissioner, 22 T.C. 1267 (1954) (restrictive agreement affects estate tax valuation); Estate of Piper v. Commissioner, 72 T.C. 1062 (1979); and Bolles v. Commissioner, 69 T.C. 342 (1977) (restrictions under Federal securities laws affect fair market value); Worcester County Trust Co. v. Commissioner, 134 F.2d 578 (1st Cir. 1943); Krauss v. United States, 140 F.2d 510 (5th Cir. 1944); and Estate of Reynolds v. Commissioner, supra (restriction such as right of first refusal affects fair market value); Spitzer v. Commissioner, 153 F.2d 967 (8th Cir. 1946), and Kline v. Commissioner, 130 F.2d 742 (3d Cir. 1942) (restrictive agreement affects gift tax valuation).

Because of the restrictive nature of common ownership of property, the fair market value of an undivided fractional interest is often less than the full aliquot share of the value of the entire property. See Stewart v. Commissioner, 31 B.T.A. 201, 203-206 (1934); Estate of Companari v. Commissioner, 5 T.C. 488, 492-493 (1945); Estate of Henry v. Commissioner, 4 T.C. 423, 446-447 (1944); Estate of Fawcett v. Commissioner, 64 T.C. 889, 898-901 (1975).⁷ Similarly, the fair market value of a minority interest in a business is ordinarily less than the proportionate share of the value of the entire business. See Estate of Bischoff v. Commissioner, 69 T.C. 32, 48-50 (1977); Estate of Leyman v. Commissioner, 40 T.C. 100, 119 (1963), modified on other grounds 344 F.2d 763 (6th Cir. 1965); opinion of Court of Appeals vacated per curiam 383 U.S. 832 (1966); Estate of de Guebriant v. Commissioner, 14 T.C. 611, 619 (1950), revd. on another issue sub nom. Claflin v. Commissioner, 186 F.2d 307 (2d Cir. 1951). Consistent with these principles, it is well established that because of the difficulties related to and the restrictions associated with selling large blocks of stock, valuation may be reduced to take into account a "blockage discount.” See sec. 20.2031-2(e), Estate Táx Regs.; sec. 25.2512-2(e), Gift Tax Regs.; Helvering v. Maytag, 125 F.2d 55 (8th Cir. 1942), cert. denied 316 U.S. 689 (1942); Standish v. Commissioner, 8 T.C. 1204 (1947). Also see Rushton v. Commissioner, 498 F.2d 88 (5th Cir. 1974); Estate of Smith v. Commissioner, 57 T.C. 650 (1972), affd. 510 F.2d 479 (2d Cir. 1975).

Thus, restrictions have consistently played a role in determining fair market value. As provided in section 20.2031-l(b), Estate Tax Regs., all the relevant facts and elements of value must be considered. In the case at bar, the Texas constitution and Texas statutes have specifically provided for restrictions, and, consistent with the dictates of accepted rules of valuation, we cannot disregard those restrictions.

Accordingly, we hold that the fair market value of the property in controversy, and the amount thus includable in the gross estate of decedent, was $92,233.73. Estate of Hinds v. Commissioner, supra, will no longer be followed and is expressly overruled.

Decision will be entered under Rule 155.

Reviewed by the Court.

Sterrett, J., dissents.

* By order of the Chief Judge dated Sept. 12, 1980, this case was reassigned from Judge Herbert L. Chabot to Judge Sheldon V. Ekman.

1 Petitioner alternatively contends that even if Estate of Hinds v. Commissioner, 11 T.C. 314 (1948), was correctly decided, the facts of the present case are not governed by the clear language and holding of Hinds. In light of our conclusion herein, we need not consider this contention.

2 Fortunately, the parties, by stipulation, have spared us the task of ascertaining the value of those rights.

3 The Court of Appeals for the Fifth Circuit in a comprehensive opinion has recently held that a Texas homestead interest is a "property right in the nature of an estate in land.” United States v Rogers, 649 F.2d 1117 (5th Cir. 1981).

The interest differs from a life estate- in that if the surviving spouse ceases to use the property as a homestead, his homestead rights are terminated. In addition, the right to live on the property for life cannot be sold or conveyed but rather is personal to the surviving spouse. Williamson v. Kelley, 444 S.W.2d 311 (Tex. Civ. App. 1969). A life estate, on the other hand, can be sold or conveyed and is only terminated on the death of the life tenant.

4Compare sec. 2034 with sec. 2043(b) (and) sec. 2053(e) wherein Congress used "dower or curtesy, or of a statutory estate created in lieu of dower or curtesy, or of other marital rights in the decedent’s property.” (Emphasis supplied.)

5 Art. 2, Regs. 70 (1926), for the first time provided that "homestead and other exemptions” are subject to tax, following enactment of sec. 302(b), Revenue Act of 1926, 44 Stat. 70. That statute eliminated the limitation of an earlier predecessor of sec. 2033, that, in order for the value of an interest to be included in his estate under that section, the interest of a decedent had to be "subject to the payment of charges against his estate and the expenses of its administration and * * * subject to distribution as part of his estate.”

Respondent, in his 1937 regulations, removed the reference to homestead from art. 2, Regs. 80 (1937) (the predecessor of Estate Tax Regs. sec. 20.0-2) and placed it in art. 13, Regs. 80 (1937) (the predecessor of sec. 20.2033-l(b), Estate Tax Regs.) in its present form.

6 The words "full value” have consistently been included in respondent’s regulations for property subject to dower and curtesy rights since 1919 (see art. 21, Regs. 37 (1919); art. 21, Regs. 37 (1921); art. 16, Regs. 63 (1922); art. 14, Regs. 68 (1924); art. 14, Regs. 70 (1926); art. 14, Regs. 70 (1929); art. 14, Regs. 80 (1934); art. 14, Regs. 80 (1937); sec. 81.14, Regs. 105 (1942); sec. 20.2034-1, Estate Tax Regs. (1959)) but have never appeared in his regulations for property subject to homestead rights (see art. 2, Regs. 70 (1926); art. 2, Regs. 70 (1929); art. 2, Regs. 80 (1934); art. 13, Regs. 80 (1937); sec. 81.13, Regs. 105 (1942); sec. 20.2033-l(b), Estate Tax Regs. (1959).

7 In Estate of Fawcett v. Commissioner, 64 T.C. 889, 900 (1975), we stated that in determining the fair market value of an undivided interest, a discount factor "should be considered to reflect the possible legal and other problems that would arise when such an interest is sold.”

4 In his reply brief, respondent stated, "Respondent does not assert that I.R.C. sec. 2034 applies to the instant case, except by analogy.” Respondent’s Reply Brief at 7. However, respondent’s, argument by analogy clearly asserts the applicability of sec. 2034. In his opening brief, respondent stated, "It would be manifestly unfair for taxpayers such as petitioner to escape [sec. 2034’s] application merely because an interest is characterized as homestead rather than dower or curtesy, when the reason for the allowance of such interests and the effect of both are virtually the same.” Respondent’s Brief at 13.