Or, A Credible Appraisal Saves the Day

Fans of Sherlock Holmes will recognize his encomium to his nemesis, Prof. Moriarity: “Is he not the celebrated author of The Dynamics of an Asteroid, a book which ascends to such rarefied heights of pure mathematics that it is said that there was no man in the scientific press capable of criticizing it?”

I could say the same about Judge Morrison’s decision in Estate of Natale B. Giustina, Deceased, Laraway Michael Giustina, Executor, 2011 T.C. Memo. 141, filed 6/22/11. But here the object of the rarefied heights of pure mathematics is not found in outer space, but rather in a forest in Oregon. The late Nat, through a revocable trust everyone agrees should be disregarded for estate tax purposes, owned a 41.128% interest in a limited partnership; the partnership’s business was lumbering over 47,000 acres of Oregon timberland. The issue was valuing Nat’s interest at date of death. Laraway was the executor, and claimed around $12 million; IRS said $33 million.

Judge Morrison carefully unpacks the trust instrument and the limited partnership agreement. Who can break up the property, how can they break it up, and if they break it up what would a sale yield? Judge Morrison finds a sale would yield more present value dollars than continuing lumbering operations, finding the probability of the sale sufficiently high to justify a valuation taking that probability into account.

Judge Morrison also evaluates the expert appraisers’ testimony, both IRS’ and Laraway’s, and mixes and matches their methodologies and results to come in at $27 million, apparently discounting IRS’ expert’s value by 20%, and increasing Laraway’s expert’s value by 56%, ascending to the “rarefied heights of pure mathematics” that inspired Sherlock’s breathless praise.

Unhappily for Laraway, the estate is therefore in the Section 6662 substantial-understatement-because-of-estate-tax-undervaluation 20% penalty zone, as his number is more than 50% below what Judge Morrison finds.

Judge Morrison does admit that all the mathematical juggling, impressive as it is, still has a basic flaw. He quotes Repetti: “The entire valuation process is a boundless subjective inquiry: To value an asset the court has to make guesses or assumptions about the future. These inquiries require speculation about the composition of management * * *

Repetti, “Minority Discounts: The Alchemy in Estate and Gift Taxation”, 50 Tax L. Rev. 415, 445 (1995).” 2011 T.C. Memo. 141, at p. 21.

The difficulty does not deter Judge Morrison.

Now Laraway is looking at $2 million plus of penalty on top of a $15 million deficiency. But help is on the way. Says Judge Morrison: “However, no penalty is imposed with respect to an underpayment if there was reasonable cause for the underpayment and the taxpayer acted in good faith. Sec. 6664(c)(1). Whether an underpayment of tax is made in good faith and due to reasonable cause will depend upon the facts and circumstances of each case. Sec. 1.6664-4(b)(1), Income Tax Regs. In determining whether a taxpayer acted reasonably and in good faith with regard to the valuation of property, factors to be considered include: (1) the methodology and assumptions underlying the appraisal; (2) the appraised value; (3) the circumstances under which the appraisal was obtained; and (4) the appraiser’s relationship to the taxpayer. Id. Although the IRS bears the burden of production under section 7491(c) that the section 6662 penalty is appropriate, the taxpayer bears the burden of proof in demonstrating reasonable cause. See Higbee v. Commissioner, 116 T.C. 438, 446-448 (2001).” 2011 T.C. Memo. 141, at p. 29.

To prepare the Form 706, Laraway hired a lawyer, who hired an asset appraisal company, which produced an appraisal. Rather than unpacking yet another appraisal, Judge Morrison finds that, although he does not agree with the appraisal company’s results and finds their methodology deficient, their methodology and result were sufficiently credible to let Laraway rely in good faith on their number. So no penalty.

Takeaway for fiduciaries- Have a third party professional choose an appraiser with decent credentials, and rely in good faith.

To my readers–I was down in Virginia at the National Society of Tax Professionals’ summer school, so I missed a day or two of postings. I’m catching up. And for any who didn’t get the word, the new Registered Preparers Office at IRS is taking over the examination functions formerly carried on by OPR at Treasury. OPR will be strictly rulemaking and enforcement. A more energetic enforcement is coming: beware!