Opinion ID: 25542
Heading Depth: 2
Heading Rank: 1

Heading: Valuation of the Timber Property

Text: The value of the Johnco stock for estate tax purposes depended principally on the fair market value of the Timber Property at the date of Helen’s death. The concept of fair market value represents the price that a willing buyer would pay a willing seller, if both have reasonable knowledge of the facts and neither is under compulsion. Estate of Bright v. United States, 658 F.2d 999, 1005 (5th Cir. 1981). The buyer and seller are hypothetical, 2 This value reflects a capital gains tax discount of $872,920. 9 not actual persons, and each is a rational economic actor, that is, each seeks to maximize his advantage in the context of the market that exists at the date of valuation. Estate of Newhouse v. Comm’r, 94 T.C. 193, 217 (1990). Valuation is a question of fact that may be reversed only for clear error by this court. Although the parties stipulated to a fair market value of $6 million for the Timber Property, they disagreed whether in valuing Johnco stock, the Estate was entitled to a discount because of the substantial capital gains that would be recognized as timber is harvested and sold. In Johnco’s hands, the Timber Property had appreciated enormously since its original purchase, and its basis for tax purposes was $217,850. Any sale of Johnco stock would transfer the Timber Property with the built-in capital gains liability. The estate’s valuation experts opined that the only sound economic strategy for a hypothetical purchaser of Johnco would be to liquidate the Timber Property immediately and pay off the 34% capital gains tax. The Commissioner’s expert opined, however, that, in part due to creative alternative tax strategies to offset the built-in tax liability, no discount should be recognized. The Tax Court found neither side’s argument fully persuasive. Contrary to the Commissioner’s view, the court concluded that some discount for built-in capital gains should be acknowledged based on its recent decision in Estate of Davis v. Comm’r, 110 T.C. 530 (1998). Estate of Davis held that in 10 determining the fair market value of closely held stock after repeal of the General Utilities doctrine, 3 built-in capital gains discounts are not precluded and are appropriate in some circumstances. Id. at 547. The Tax Court also rejected the Estate’s valuation of Johnco stock, which it viewed as having been incorrectly derived from Johnco’s income rather than its assets. The Tax Court found that the Johnco stock is properly valued under Revenue Ruling 59-60, 1959-1 C.B. 237, according to the fair market value of its assets. The IRS has typically applied an asset approach when a closely held corporation functions as a holding company, and earnings are relatively low in comparison to the fair market value of the underlying assets. See Estate of Davis, 110 T.C. at 536-37. Finally, the Tax Court rejected the Estate’s methodology that contemplated immediate liquidation of the Timber Property rather than, as the government’s forestry expert testified, its sound cultivation and continued management. The court then crafted its own valuation. It accepted the parties’ $6 million figure as the net asset value for the Timber Property, while estimating a net present value of the capital gains tax liability that will be incurred as the timber is cut. The court used assumptions furnished by the estate, i.e. a 10% annual growth/harvest rate of the timber; a 4% annual inflation rate in the value of the harvest; a 34% capital gains tax rate; and 3 Gen. Utils. and Operating Co. v. Helvering, 296 U.S. 200, (1935). 11 a 20% discount rate. According to the court’s method, it would take nine years to pay off the built-in capital gains liability. Consequently, the present value of the liability, and the reduction of the fair market value, is approximately $870,000. This deduction is less than half that sought by the Estate, which sought full deduction of the built-in $1.9 million capital gain liability if the Timber Property were to be liquidated immediately. Although the Tax Court was not required to credit the valuation testimony of either party, its calculations must be tied to the record and to sound and consistent economic principle. Unfortunately, the court deviated from several criteria of fair market value analysis and thus clearly erred in assessing Johnco’s stock value. First, the court should not have assumed the existence of a strategic buyer of the Timber Property, a buyer that most probably would continue to operate it for timber production. Fair market value analysis depends instead on a hypothetical rather than an actual buyer. See Treas. Reg. § 20.2031-1(b); Estate of Bright, 658 F.2d at 1006; LeFrak v. Comm’r, 66 TCM (CCH) 1297, 1299 (1993). While it may well be true that the Timber Property’s best use is for sustainable yield timber production, this does not mean that the first, or economically rational, purchaser of Johnco stock would so operate or lease the property. That purchaser would have to take into account the consequences of the unavoidable, substantial built-in tax liability on the property. Relatedly, the court’s misplaced emphasis on a purchaser 12 engaged in long-run timber production led to its peremptory denial of a full discount for the accrued capital gains liability. The hypothetical willing buyer/willing seller test substitutes evidence of the actual owner’s or purchaser’s intent with the most economically rational analysis of a sale. See Eisenberg v. Comm’r, 155 F.3d 50 (2nd Cir. 1998) (vacating and remanding Tax Court decision because a tax liability upon liquidation or sale for built-in capital gains was not too speculative, and such potential liability should be taken into account in valuing the stock even though no liquidation or sale of the corporation or its assets was planned at the time of valuation. If the evidence did not support an economic case for the buyer of Johnco’s stock to engage in longterm timber production, then the Tax Court’s discount of the capital gains liability over nine years of further production was erroneous. Such was the case here. Recognizing the uncertainties inherent in the acquisition, the Estate’s experts arrived at substantial discount rates for any hypothetical investment in the property. The Tax Court recognized that the discount rate represents the rate of return necessary to attract capital based on an asset’s overall investment characteristics. Moreover, the court did not quarrel with the finding of a 20% annual discount rate, and it applied that rate to the stream of future capital gain taxes. Nevertheless, the court simultaneously recognized that no more than a 14% gross annual rate of return would be received from the 13 ongoing production of timber. A reasonable hypothetical investor who required a 20% rate of return on Johnco stock would not accept the Timber Property’s modest 14% return. Instead, the investor would liquidate Johnco quickly and reinvest the proceeds. “Courts may not permit the positing of transactions which are unlikely and plainly contrary to the economic interest of a hypothetical buyer.” Estate of Smith v. Comm’r, 198 F.3d 515, 529 (5th Cir. 1999), citing Eisenberg, 155 F.3d at 57. The Tax Court’s internally inconsistent assumptions, that a hypothetical purchaser of Johnco stock would engage in long-range timber production even though the Timber Property’s annual rate of return is substantially lower than the investor’s required return, fatally flawed its decision to discount the future flow of capital gains taxes. Whether the record supports other estimates of the value of Johnco stock is unclear. Because the Tax Court clearly erred in its approach to the discount of capital gains taxes on the Timber Property, this issue must be remanded for further consideration.