Cook v. Commissioner of I.R.S.

• Decision Date: 13 November 2003
• Docket Number: No. 02-61011.,02-61011.
• Citation: 349 F.3d 850
• Parties: Gladys J. COOK, Estate of Gladys J. Cook, Deceased, Verna Lee Steele, Executrix, Petitioner-Appellant, v. COMMISSIONER OF THE INTERNAL REVENUE SERVICE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Fifth Circuit

349 F.3d 850

Gladys J. COOK, Estate of Gladys J. Cook, Deceased, Verna Lee Steele, Executrix, Petitioner-Appellant, v. COMMISSIONER OF THE INTERNAL REVENUE SERVICE, Respondent-Appellee.

No. 02-61011.

United States Court of Appeals, Fifth Circuit.

November 13, 2003.

John W. Porter (argued), Stephanie Loomis-Price, Baker Botts, Houston, TX, Robert Allen Helms, Edwin Walker Arenson, Arenson & Spears, Austin, TX, for Petitioner-Appellant.

Annette Marie Wietecha, Jonathan S. Cohen (argued), U.S. Dept. of Justice, Tax Div., Washington, DC, for Respondent-Appellee.

Appeal from a Decision of the United States Tax Court.

Before DAVIS, SMITH and DUHÉ, Circuit Judges.

DUHÉ, Circuit Judge:

Appellants ask this Court to reverse the Tax Court's conclusion that a non-transferrable lottery prize payable in seventeen annual installments is a private annuity that must be valued, for estate tax purposes, in accordance with 26 U.S.C. § 7520. Because we conclude that the prize is properly characterized a private annuity, and that non-marketability does not render the valuation of the prize under § 7520 and the regulations unreasonable, we affirm.

FACTUAL AND PROCEDURAL HISTORY

Gladys Cook and her sister-in-law Myrtle Newby had a longstanding informal agreement under which they jointly purchased Texas lottery tickets and shared the winnings. On July 8, 1995, Cook bought a winning ticket valued at $17 million, payable in 20 annual installments. The initial payment of $858,648 was made July 10, 1995, and the remaining payments of $853,000 each would be made on July 15th of the next 19 years. Texas law prohibited the assignment, other than by court order, of the right to receive the lottery payments; neither could the prize be collected in a lump sum.

On July 12, 1995, Cook and Newby converted their informal partnership to a formal limited partnership, MG Partners, Limited ("MG Partners" or the "partnership"), and each assigned her interest in the lottery winnings to the partnership.¹ In exchange, each received a 48% limited partnership interest and a 2% general partnership interest.

Cook died November 6, 1995. The partnership's assets on that date, the valuation date for estate tax purposes, were $391,717 in cash and the right to receive 19 annual lottery payments of $853,000 each. The parties stipulated that, because of the prohibition on transfer of the lottery prize, no market for the right to lottery payments existed in Texas at the time of Cook's death.

Cook's executor hired a valuation expert, Peter Phalon. Phalon valued the partnership's right to lottery payments at $4,575,000, using a discounted cash flow method and including a discount for non-marketability. He valued the Estate's interest in the partnership at $1,529,749, which amount the Estate included on its tax return.

The Commissioner assessed a deficiency based on the value of the partnership interest. Rejecting the expert valuation relied on by the Estate, the Commissioner valued the partnership's right to the lottery payments using 26 U.S.C. § 7520 and the accompanying regulations (the "annuity tables"), which govern the valuation of private annuities. The value under the annuity tables was $8,557,850. The Commissioner then valued the Estate's partnership interest, discounted for lack of control, restrictions in the partnership agreement, and lack of a ready market, at $3,222,919, yielding a deficiency in the tax paid by the Estate of $873,554.

The Estate petitioned the Tax Court for a redetermination of the deficiency, contending that the Commissioner erred in using the annuity tables to value the lottery prize held by the partnership. The Estate procured a second expert valuation, and the Commissioner procured its own expert in the event that the annuity tables were held not to apply.² Foregoing trial under Tax Court Rule 122, the parties stipulated that the only remaining disputed issue was whether the lottery prize must be valued according to the annuity tables for purposes of valuing the partnership interest.³ The parties stipulated to alternate values for the partnership interest, agreeing that if the prize must be valued under the annuity tables, the value of the partnership interest was $2,908,605; if not, it was $2,237,140.

The Tax Court held that it was bound under a previous Tax Court case, Gribauskas v. Commissioner, 116 T.C. 142, 2001 WL 227025 (2001), to value the lottery payments using the annuity tables. Gribauskas, which has since been reversed by the Second Circuit,⁴ held that a lottery prize is a private annuity that must be valued under the annuity tables. The Estate appeals, asserting that the Tax Court erred in valuing the lottery prize rather than the partnership, and alternatively, in determining that the annuity tables do not assign an unreasonable value to the lottery prize.

DISCUSSION

A. Standard of review

We review the Tax Court's factual findings for clear error, see, e.g. McIngvale v. Comm'r, 936 F.2d 833, 836 (5th Cir.1991), and its conclusions of law de novo. See American Home Assurance Co. v. Unitramp Ltd., 146 F.3d 311, 313 (5th Cir.1998). Mathematical computation of fair market value is a factual issue; however, determination of which is the proper valuation method is a question of law. Estate of Dunn v. Comm'r, 301 F.3d 339, 348 (5th Cir.2002).

B. The asset to be valued

The Estate challenges the Tax Court's conclusion that ownership of the prize by the partnership, rather than outright by Mrs. Cook, made no difference to the question of its value. The Estate contends that the Tax Court's error is evident in its statement that it saw "no difference between a right to receive lottery payments that is owned by a partnership in which decedent owned an interest and an identical right to receive lottery payments that was owned directly by decedent. In both instances, the asset must be given a value in order to determine the tax consequences to the Estate." The Estate argues that Mrs. Cook's partnership interest, rather than the lottery prize itself, is the asset that must be valued. We do not agree, however, that the Tax Court was asked to value the partnership. The stipulations clearly frame the issue in terms of whether the lottery prize owned by the partnership must be valued under the annuity tables.⁵

The Estate asserts that the asset-based approach is not the only way to value the partnership interest, but if a lottery prize must always be valued using the annuity tables, other valuation methods will become unavailable when a partnership owns a lottery prize or other private annuity. Because the law allows more than one method of valuation, in the Estate's estimation, it would be error to reach a conclusion that forces the use of only one method.

We disagree with the Estate's characterization of the valuation methods as mutually exclusive in application. The value of the partnership's assets is but one component in the valuation analysis. As illustrated in Dunn v. Commissioner, 301 F.3d 339 (5th Cir.2002), valuation of a closely-held business interest may involve a balance between income-based and asset-based valuation, depending on what feature of the interest best reflects its desirability to a willing buyer, its assets or the income stream it produces. Stated another way, valuation of an entity's assets need not be the end of the valuation process. There was indeed a value assigned to the company's assets in Dunn, although in that case we determined that the asset-based value was secondary to the income-based value in accurately capturing the value of the entity. Dunn, 301 F.3d 339, 357 (assigning weights of 85% to the value of the company's income stream and 15% to that of its assets). Here, however, the parties have stipulated to alternate values of the partnership interest, depending upon whether the annuity tables apply to the prize or do not apply; therefore, the balance (value of partnership interest) has been agreed upon. Our holding does not mandate application of one method or the other to the partnership; rather, it bears only on the proper method of valuing the lottery prize.

C. Valuation of the lottery prize

The Internal Revenue Code taxes the "transfer of the taxable estate," 26 U.S.C. § 2001(a), defined as the value of the gross estate less applicable deductions, 26 U.S.C. § 2051. The gross estate comprises "all property, real or personal, tangible or intangible." 26 U.S.C. § 2031(a). 26 U.S.C. § 2033 requires inclusion in the gross estate of all property to the extent of the decedent's interest.

Treasury Regulations § 20.2031-1(b) governs valuation generally, providing that "the value of every item of property includible in a decedent's gross estate under sections 2031 through 2044 is its fair market value at the time of decedent's death." Fair market value is defined 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 sell and both having reasonable knowledge of relevant facts...." Id.

In the case of a private annuity, fair market value is determined not under the general willing-buyer-willing-seller test, but under the method prescribed by 26 U.S.C. § 7520 and the accompanying regulations. In general, the value of a private annuity is determined by a factor composed of an interest rate component and a mortality component. When the annuity is for a term of years rather than an interest for life, the mortality component is equal to the term of years. The interest rate component is determined using a rounded interest rate equal to 120 percent of the Federal midterm rate in effect for the month in which the valuation date falls. 26 U.S.C. § 7520; Treas. Reg. § 20.7520-1(b).

Thus, for the property interests subject to § 7520 and the accompanying regulations, the sometimes wide variation produced by experts' fair market valuation methods gives way to certainty provided by the valuation tables....