Accounting 815

Taxation of Transfers and Fiduciaries

Week 7: Fair Market Value

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Sixth Week Summary

1. Spousal transfers and terminable interests

Nature of the problem reviewed

A gift to spouse of a terminable interest

eg life estate w/ remainder over

if remainder is valued now, rest would escape tax

W's life estate not in H's estate
And not in W's estate: terminates at death

The 2056(b) response, and the relief rules

a terminable interest doesn’t qualify for marital deduction, unless

Spouse for life w/ spousal general power of appointment not a problem -- inclusion in spouse's estate, or gift if general power released

Elective QTIP: Spouse has all income annually, no one else has right to appoint: elect to include in spouse's estate

Irrevocable election due by due date of return

Flexibility: the Partial Q-Tip election:

2. Funding the marital deduction

Problem of bypass coordination

What words say how much in bypass and how much in marital?

Bypass amount changes ($600K.now $625 and increasing)
And some may have been used up by lifetime gifts

If a specific bequest of $$

inflexible

gain or loss on funding

eg: leave bypass "$600 K": sell property at g/loss to get the $600
Or transfer stock w/ date of death basis of $550 -- is "sale or exchange"

Pecuniary vs fractional formulas

fractional

1/2, 1/3 of estate to S
or "smallest fraction needed to reduce estate tax to 0"
if leave more, you're wasting the bypass and having assets pile up in potentially taxable estate of survivor

pecuniary

 $100K, $200K, or the "smallest amount needed to reduce estate tax to 0"

Next problem: postmortem appreciation

changes in value between date of death and date of distribution

Concern: would value at DoD. Then, after years of administration, give depreciated to spouse and appreciated to heirs. Appreciation would escape tax in either estate. Example:

  • Properties R and S. AB 600 each.

  • Now R FMV 900, S FMV 300.
  • Distribute R to bypass and S to spouse
  • The gain on R will escape tax in spouse's estate

If fractional, distribution is exchange of retained asset for share in non-retained asset:

 gain / loss recognized

If pecuniary: The IRS position: Rev. Proc. 64-19 (Para. 27,463)

No marital deduction (at all!) unless property used has FMV at least the amount of the bequest

or it fairly represents value changes since death

3.Valuation of estates

Non cash assets, in a non-market transfer

special problems w/ real estate and CHB's
even worse: contingent interests

Example:. Burnet v. Logan (1931)

mining royalty interest valued for estate purposes
ct kept ransaction open for Y tax: cost recovery 1st

Regs. say use "Fair Market Value"

 20.2031-1(b) and 25.2512-1

Willing buyer, willing seller.
Equal knowledge and no compulsion to deal
Not a forced sale, or sale outside the usual public market

Need to construct hypothetical transactions and FMV's

Temptation to taxpayer to gerrymander interests to keep FMV low
eg Freezes: Newhouse estate

instability of FMV's

even in "efficient markets"
eg. aggregate FMV of US corporate stock on 10/19/87
Eg. What was Oracle worth day it announced 3Q earnings?
  $20 bb in AM, $15 bb in afternoon

Value When?

gifts: date of transfer:

estates: date of death

or AVD six months later: if it decreases estate value and tax

The "veil of ignorance"

Generally, value based on DoD knowledge
  not hindsight at time of filing
eg. Ithaca Trust case para. 9007

AVD not applied to wasting assets

disregard changes due to mere lapse of time
eg. patent royalties decay over 17 yrs.

AVD and the "veil of ignorance": Hance (Para. 9019)

Facts: H dies 2/22. W gets life annuities. (include in H's estate)

2/22 annuity cost would be $122K
W actually dies 5/15: got $5K

Issue/Holding: not due to mere lapse of time: so can use AVD

more like a stock market collapse

4. TheValuation process. See 2031 and 2512 Regs.

Marketable securities: 2031-2(b); 2512-2(b)

mean hi lo on sales date

day weighted mean if sales before and after

use close for bonds if not have hi-lo

if no sales, use bid and asked: same day or weighted average

use later date if no earlier date

Mutual funds

use last quoted redemption price. Regs. 2031-8(b)

IRS lost in Supreme Court @ 1960 -- wanted to use the asked for load funds

"Blockage

if it would depress the market, consider what it would go for through an underwriter

note that IPO's tent to go up when brought to market (short term) why?

consider also premium due to possible control

Notes: 20.2031-4

presumed face:

consider rate, maturity, security and capacity to pay

Household effects: 2031-6:

room by room itemization of all over $100, or statement by executor based on dealer info

If articles over $3K, include appraisal

(note: these $$ may be de facto obsolete)

5. Valuation of Real estate

see IRS training manual handout

If already in the "highest and best" use, tend to use capitalized earnings

market comparables, depreciated replacement cost

6. Valuation of CHB's

General Considerations in business valuation

consider what events cause need to determine FMV without sale

  • estate tax or gift tax

  • bringing someone new into the biz: partner, employee
  • insurance for losses

extreme difficulty of accurate val of CHB w/o actual sale

unique owner (personal goodwill), choice of salary or profits, vicissitudes of small businesses, "specific assets", intangibles, historical acctg weaknesses

Rev. Rul 59-60: A grab-bag of techniques

Appraisal techniques

  Methods to arrive at range of values

Book value/ historical cost

very weak unless business quite new and assets fungible

Asset value

reproduction cost less wear and tear allowance
e.g. insurance loss appraisals
Note arbitrariness of depreciation

breakup value

creditor protection analysis: think like a bank loan officer

quick sale value, as opposed to cost of buying assets and putting business together

cash at 100%, AR at 70-90% of face, inventory at 30% - debt

Comparables – but what makes them comparable?

Capitalized earnings

what are "normal" earnings? what is the appropriate cap rate?
typical for real estate, and often for publicly traded
i.e where there is stability

Capital Asset Pricing Model

Return proportionate to riskyness of asset
brilliant math resting on arbitrary assumptions

Ratio rules of thumb

5x earnings for small retail biz
1/2 to 1 x gross for restaurant
1.05 x sales for tax/accounting practices
8x gross for rental realty

Do tax attributes matter?

Built-in gains or losses

Piper Estate case said no, but that was before 1986 repeal of general utilities. no clear case since

A lot of bad tax court logic here -- trapped by precedent

Allow attributes if sale imminent -- but they also affect depreciation

Estate of Cook (para. 11,025:): representative valuation case

7. Valuation of partial and fractional interests

Estate of Bright (Para. 11037)

The hypothetical "willing buyer" is a non-attributed party:

don't consider value to the actual recipient (but wouldn't a buyer take this "holdup" value into account, less transaction costs?

Does this mean that community property stock never gets an estate tax control premium?

Does it mean that a community property interest always gets a discount?

IRS has acquiesced in Bright

Courts are following Bright: re minority discount

Control premium and minority discounts

control is worth something

in public, as well as private transactions
Does the premium necessarily depress the value of the remaining shares?

California counterargument, based on Jones v. Ahmanson
  Is 80% of the stock really worth 80% of the company?
  You are buying a co-owner: potential trouble

Discounts (The key element in most valuation cases now)

Note presence in publicly traded, liquid investment co's

if there are only minority interests, is the sum of the parts less than the whole?

Is a transaction that breaks up control a "transfer" to the existing minority shareholders?

Chenoweth case

Buy-Sell Agreements

Business purpose: keep control in the family / founding group

Also for S-Corps: prevent transfer to void the election

May be ability to match an offer, or may be a fomula price

Formula may protect a dissident: shares otherwise unmarketable

Because of valuation effect manipulation, now covered by Sec. 2703

Build Date 3/10/98