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Ninth Circuit Rejects Valuation of Partnership Interest Based on Hypothetical Asset Sale. (Parker Tax Publishing December 27, 2014)

The Ninth Circuit rejected the Tax Court's valuation, based on a hypothetical sale of the partnership's assets, of a decedent's interest in a limited partnership. The court concluded that such a sale was based on imaginary scenarios that were not reasonably probable to occur. Est. of Giustina v. Comm'r, 2014 PTC 587 (9th Cir. 12/5/14).

Natale Giustina was the trustee of the N.B. Giustina Revocable Trust. The trust owned a 41.128 percent limited partner interest in Giustina Land & Timber Co. Limited Partnership. Giustina died in August of 2005, survived by his spouse and his three children. The limited partnership interest was subject to a buy-sell agreement which greatly restricted the ability of the estate or the heirs to sell the interest to anyone outside of a small family ownership group.

On the estate tax return, the value of his limited partner interest was reported to be $12,678,117. In April of 2009, the IRS issued a notice of deficiency determining the value of the limited partner interest to be $35,710,000, and assessed a multi-million dollar deficiency. The estate challenged the IRS' valuation in the Tax Court.

The Tax Court examined the methods employed by each party's expert witnesses. After ruling out several valuation methods as inappropriate, the court decided to give full weight to two methods: (1) the cashflow method and (2) the asset method. The cashflow method was based upon how much cash the partnership would be expected to earn if it had continued its ongoing forestry operations. The asset method was based upon the value of the partnership's assets if they were sold. Application of the asset method resulted in a valuation roughly 50% greater than the one determined by the cashflow method.

The Tax Court concluded that there was a 25 percent likelihood of liquidation of the partnership and therefore gave a 25 percent weight to the asset method valuation and a 75 percent weight to the cashflow method valuation. Applying these factors, the court arrived at a weighted valuation of the limited partnership interest of $27,454,115.

Dissatisfied with the Tax Court's valuation, the executor appealed to the Ninth Circuit, which reviewed the Tax Court's valuation for clear error.

Generally, the value of all property included in a decedent's gross estate is the property's fair market value on the date of the decedent's death (Code Sec. 2031(a)). The fair market value of any interest of a decedent in a business is the net amount that a willing buyer would pay for the interest to a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts (Reg. Sec. 20.2031-3).

Appraisers rely on several different approaches in valuing partnership interests including the cash flow method, based upon how much cash the partnership would be expected to earn if it had continued its ongoing operations, and the asset value method, based upon the value of the partnership's assets if they were sold.

The Ninth Circuit concluded that the Tax Court had clearly erred in assigning any weight to the asset method valuation methods. The Circuit Court noted that, although the Tax Court recognized that the owner of the limited interest could not unilaterally force liquidation, it had concluded that the owner of that interest could form a voting bloc with other limited partners to force liquidation. The Tax Court proceeded to assign a 25 percent probability to this occurrence and weighted its valuation accordingly.

The Ninth Circuit determined the Tax Court's conclusion was contrary to the evidence in the record. In order for liquidation to occur, the court noted, it must be assumed that (1) a hypothetical buyer would somehow obtain admission as a limited partner from the general partners, who had repeatedly emphasized the importance they placed upon continued operation of the partnership; (2) the buyer would then turn around and seek dissolution of the partnership or removal of the general partners who just approved his admission to the partnership; and (3) the buyer would manage to convince at least two other limited partners to go along, despite the fact that no limited partner ever asked or ever discussed the sale of an interest. Alternatively, the court said, for liquidation to be probable, it must be assumed that the existing limited partners, or their heirs or assigns, owning two-thirds of the partnership, would seek dissolution.

Referencing a similar situation in Estate of Simplot v. Commissioner, 249 F.3d 1191 (9th Cir. 2001), the Circuit Court stated the Tax Court had engaged in "imaginary scenarios as to who a purchaser might be, how long the purchaser would be willing to wait without any return on his investment, and what combinations the purchaser might be able to effect" with the existing partners. The court also applied Olson v. United States, 292 U.S. 246 (1934), which states that elements affecting value that depend upon events or combinations of occurrences which, while within the realm of possibility, are not shown to be reasonably probable, should be excluded from consideration when estimating market value.

The Ninth Circuit therefore concluded that it was clear error to assign any weight to a valuation based on a hypothetical sale of the partnership's assets, and remanded the case for recalculation of the estate's value based on the partnership's value as a going concern.

For a discussion of estate tax valuation, see Parker Tax ¶ 224,700. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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