Baty v. Commissioner (U.S. Tax Court Docket No. 12216-21) involves a valuation controversy in the context of funding a grantor retained annuity trust (GRAT). Daniel Baty funded a GRAT with shares of a publicly traded company (Company) while serving as Company’s Chairman of the Board and amid negotiations between Company and other third parties regarding Company’s potential merger/acquisition. Negotiations regarding the merger began in the first half of 2013, and Daniel participated in them. Daniel funded a 2-year GRAT using shares in Company on Jan. 14, 2014 and valued the contribution to the GRAT based on the mean of the high and low public share price of Company’s shares on the date of contribution (that is, the methodology espoused in Treasury Regulations Section 25.2512-2(b)). The terms of the GRAT represented the annuity payments as a percentage of the initial value of the asset contributed (that is, the annuity payments were “self-adjusting”).
A merger agreement between Company and a competitor was ultimately reached, with the terms of the deal finalized weeks later in mid-February 2014, and the deal was publicly announced on Feb. 20, 2014. The merger wasn’t completed until July 31, 2014, after the parties worked through shareholder approval, regulatory approval, third party consents and other hurdles.
The Internal Revenue Service assessed a tax deficiency premised on the notion that the contribution to the GRAT shouldn’t have been valued based on the mean of the high and low share price on date of contribution but rather on the trading price when the merger actually took place (more than six months later). Because of the facts at hand and the gross underpayment in the annuity payments, Daniel was liable for an intentional undervaluation (and couldn’t avail himself of provisions relating to incorrect valuations and the adjustment clause in the GRAT as to the annuity payments), was subject to gift tax on the full value of the transfer to the GRAT (due to the annuity failing to be a “qualified annuity” under Internal Revenue Code Section 2702) and was subject to penalties. In Chief Counsel Advice 201939002, the IRS Chief Counsel responded to the facts of the case by formally opining that a pending merger must be taken into account in valuing shares of a publicly traded company for gift tax purposes (citing Treas.Regs. Section 25.2512-2(e)).
Ultimately, Daniel filed a motion for summary judgment in favor of using the mean high and low trading price of Company stock for valuation purposes, and the government conceded to Daniel prior to issuance of a decision on the motion. In his motion, Daniel argued: (1) that the valuation methodology was well established for cases involving publicly traded stock in the gift tax context and specifically cited cases that noted that public stock prices reflected potential merger negotiations, (2) events taking place subsequent to a gift can’t be used to value the gift in hindsight, (3) the “hypothetical willing buyer” that’s used as the touchstone for gift tax valuation wouldn’t have known about the merger negotiations, (4) Treas. Regs. Section 25.2512-2(e) is inapplicable, (5) the merger wasn’t “practically certain” to occur, as was the case in the “anticipatory assignment of income” cases cited in CCA 201939002, and (6) the IRS’ proposed valuation methodology is unworkable.