The Tax Court gives new meaning to the phrase “lengthy opinion,” when it issued its 114 page decision a few days ago regarding the valuation of parcels of land in Estate of Shirley C. Giovacchini v. Commissioner, T.C. Memo. 2013-27 (Jan. 24, 2013). To save you the trouble of weeding through Judge Robert A. Wherry Jr.’s detailed analysis, here’s the bottom line: The values of the parcels in question were higher than those reported on the gift and estate tax returns, but lower than those determined in the Internal Revenue Service’s notice of deficiencies. And, because the court determined that the undervaluations were due to reasonable cause, Internal Revenue Code Section 6662 accuracy-related penalties didn’t apply. If you want to learn about the nitty gritty, however, read on.
A Pioneering Start
Decedent Shirley C. Giovacchini and her husband, Roy, were from a line of pioneering Nevada families that settled in the west in the mid-1800s. In 1929, Shirley’s father and grandfather (the Trimmers) bought High Meadows, land that covered about 2,350 to 2,500 acres near Lake Tahoe, Calif. Some of the land was extremely mountainous and hard to survey. In 1968, the Trimmers executed a deed conveying High Meadows to Shirley and Roy. Shirley and Roy’s family used the land to ride horses, cut firewood and Christmas trees and raise cattle.
In 1971, the Trimmers contracted with the County of El Dorado, agreeing to limit the use and development of High Meadows in accordance with the Williamson Act, a California land conservation law. In exchange for limiting use and development to agricultural and “compatible” uses, the Trimmers received favorable property tax treatment.
In 1986, The Trust for Public Land appraised High Meadows because it was interested in buying the property. The appraisal, prepared for the U.S. Forest Service (USFS), valued about 2,356 acres of High Meadows at $3.8 million. In 1991, the appraisal was updated to $4.1 million. After Roy died in 1997, the appraisal was again updated to $5.375 million, reflecting the value of High Meadows as of the date of Roy’s death. On the estate tax return, Roy’s estate listed the value of High Meadows as $3.837 million for land and $743,750 for timber.
In April 1998, the American Land Conservancy (ALC) expressed an interest in acquiring High Meadows. Later that month, Shirley and her family met with USFS to discuss its own interest in buying High Meadows.
The Family Trust
In 1999, Shirley transferred ownership of High Meadows to herself and her daughter, Lisa, as co-trustees of the Giovacchini Family 1989 Trust (the trust). In mid-2000, the trust sold a 50 percent interest in High Meadows for $2.5 million to High Meadows Six, LLC (HM6), controlled by Lisa, her two sisters and their spouses. The parties didn’t perform any appraisal to reach the sale price of $2.5 million.
In October 2001, the trust, HM6 and ALC entered into a purchase agreement, stating that the trust and HM6 would sell about 1,730 acres to ALC, with the understanding that ALC would sell the acres to a public agency, to preserve High Meadows in its present condition and use it for public space and recreation. The purchase price would be 95 percent of the fair market value (FMV) as determined in an appraisal. The purchase agreement also contained a series of conditions to ALC’s obligation to buy the land. At the time of the signing, ALC didn’t have a public agency ready to buy High Meadows.
ALC’s appraiser valued 1,790 acres at $25 million as of October 2001 and issued a report in November 2001, noting a continuous use of a right of way and an access road. ALC then hired a second real estate appraiser to review the first appraisal. The second appraiser expressed concerns about the first appraiser’s report, including issues about access to the property. Shirley died on Oct. 8, 2001, prior to the sale to ALC; Lisa was appointed executor of Shirley’s estate.
In 2002, ALC contacted USFS about working together to buy High Meadows. USFS contacted ALC’s first appraiser to value the land in conformity with the Uniform Appraisal Standards for Federal Land Acquisitions and the Uniform Standards of Professional Appraisal Practice (USPAP). At the end of 2002, the first appraiser issued a second report, valuing about 1,789 acres at $29.5 million. Two members of the USFS, however, didn’t take into consideration several factors that appraisers are directed to consider by USPAP. Moreover, the USFS didn’t take into consideration the first (October 2001) appraisal of $25 million, stating that it only took into consideration the second appraisal (of $29.5 million). The ALC likewise didn’t consider the October 2001 appraisal.
Closing the Sale
The trust, HM6 and ALC amended the purchase agreement four times. On Jan. 14, 2003, the ALC and the Department of Agriculture entered into a contract for sale of ALC’s interest in High Meadows (1,790 acres) for $29.5 million. After they closed the deal, Shirley’s estate kept its share of the $29.5 million and an undivided 50 percent interest in the remaining 566 acres of High Meadows.
Gift and Estate Tax Returns
Shirley’s 2000 gift tax return reported gifts of $754,564, $664,564 of which were claimed to be taxable (relating to a 43 percent interest in a limited partnership). Shirley reported gift tax of $216,689; applied $216,689 of her available unified credit to the tax due; and paid zero tax. She didn’t report the trust’s sale of its 50 percent interest in High Meadows to HM6, having been told by an advisor that the transaction was for FMV and, therefore, not a gift.
Shirley’s estate Form 706 reported the value of the estate’s interest in High Meadows as $3,235,117 ($2.8 million for land, $453,000 for timber). The value was based on the 1997 appraisal, not the updated appraisal made in October 2001 (during which time the appraiser was aware of ongoing negotiations regarding a sale of High Meadows, but had never seen the purchase agreement).
In October 2005, the IRS issued two separate notices of deficiency to Shirley’s estate. One notice was for a gift tax deficiency of $3,784,333 relating to Shirley’s 2000 gift tax return; the other notice was for an estate tax deficiency of $9,818,040. The IRS sought IRC Section 6662 penalties of $722,573 for the gift tax deficiency and $2,817,294 for the estate tax deficiency.
The IRS argued that the sale to HM6 of the 50 percent interest in High Meadows for $2.5 million was a part sale and a part gift in the amount of $6,958,375. The IRS also argued that the estate held a 50 percent interest in approximately 2,356 acres of High Meadows, not 1,789 acres reported on the estate tax return and therefore, the estate’s interest was worth $16.059 million in October 2001, significantly more than the $3,252,117 reported on the return.
The Court Speaks (and speaks, and speaks)
In its lengthy opinion, the court first discussed the concept of FMV, noting that its definition and the USFS’s definition differ. The USFS didn’t consider facts acknowledged by the USPAP to be highly relevant in making a determination of FMV. The court stated, “Thus, all facts that would affect purchase price in a hypothetical sale and which should and would have been considered by a willing seller and a willing buyer aware of all relevant facts were not in fact considered.”
After a review of the burden of proof, the general rules of gift and estate tax and all of the parties’ experts’ testimony and appraisals, the Tax Court reduced its mission to one sentence: “The ultimate question that we are called upon to answer is deceptively simple: How much was High Meadows worth on June 27, 2000 (for gift tax purposes), and on October 8, 2001 (for estate tax purposes)?” The estate argued that the High Meadows was worth $7.4 million as of June 27, 2000 and $8 million as of Oct. 8, 2001. The IRS argued that High Meadows was worth $25.185 million as of June 27, 2000 and $36.280 million as of Oct. 8, 2001.
What’s It Really Worth?
The court noted that the IRS relied almost exclusively on the January 2003 sale of a large part of High Meadows to ALC/USFS, while the estate disregarded the sale completely. The court sided with the IRS and refused to disregard the sale, as it’s “undoubtedly some evidence of High Meadows’ values for estate and gift tax purposes.” Although the sale occurred after the tax returns were filed for the years in question, the court noted that a subsequent event (like the sale) is still relevant when it involves a sale of the property itself, within a reasonable time of the relevant valuation date. The court noted that the sale of most of High Meadows to ALC/USFS, two months after the date of the gift and approximately 16 months after Shirley’s death, was reasonably close to both relevant valuation dates. Moreover, in disagreeing with the estate, the court, found that although some changes did occur to High Meadows between the relevant valuation dates and the January 2003 ALC/USFS sale, these changes weren’t sufficient to eliminate the sale’s probative value. Indeed, the “the January 2003 sale to ALC/USFS is the only truly comparable sale worthy of consideration,” said the court.
The court also considered other factors that would negatively affect the valuation of High Meadows, including the Williamson Act, which restricted the property’s use to “agricultural and compatible uses” and limited construction on the property to one house. The court determined that a buyer would be able to construct one, single-family residence of any size (even a “trophy home”) on the property. The court also considered access issues related to High Meadows. After an extensive review of analogous access cases regarding risks that property owners must accept and deal with if they lack a deeded easement and must cross USFS property to reach their land, the court concluded that a trophy home would require an access easement for individuals, supplies, utilities and emergency services.
In addition to Williamson Act and other restrictions, High Meadows had other issues that negatively impacted its value and would’ve been considered by a hypothetical willing private buyer. These issues included the fact that High Meadows was surrounded on all sides by USFS property and road/utility easements were neither sought nor granted; the Tahoe Regional Planning Agency hadn’t rendered land coverage determinations; there wasn’t an adjudication of water rights; and there was a contaminated site that needed to be remedied. Thus, the September 2002 appraisal of 1,789 acres of High Meadow at $29.5 million assumed “ideal conditions”—conditions that (although some were resolved by the time of the 2003 sale to ALC/USFS) were far from ideal. In fact, these conditions would have had a negative impact on the price that a hypothetical willing buyer, including one seeking to build a trophy home, would have paid. The court found that a hypothetical willing private buyer would have paid far less than $29.5 million for High Meadows.
Moreover, the court found it “disconcerting” that despite an intervening appraisal by a different, second appraiser, the original appraiser raised the FMV of 1,789 acres from $25 million (as of October 2001) to $29.5 million as of September 2002, approximately one year after Shirley’s death. In its zeal to acquire the property, the ALC/USPS ignored the intervening second appraisal; relied on the September 2002 report that valued the property at $29.5 million; and paid that amount.
The Court’s Valuation Adjustments
The court’s starting point to adjust the value of High Meadows was the purchase price paid by ALC/USFS in January 2003 for 1,790 acres—$29.5 million. The court adjusted the sales price to correct it for inflation; the time value of money; and increases in the market prices from the two relevant dates (June 2000—the gift tax date) and Oct. 8, 2001—the estate tax date) to the January 2003 sale to ALC/USFS. As such, it reduced the $29.5 million sales price by 9 percent to the Oct. 8, 2001 date of Shirley’s death and by 17 percent to the June 2000 HM6 sale date, to adjust for the roughly the 16 month and 31 month periods between the January 2003 sale to ALC/USFS and Shirley’s death, and the HM6 sale, respectively.
Noting critical legal access difficulties on June 2000 and Oct. 8, 2001 over USFS land regarding egress, ingress and utilities, the court further adjusted the $29.5 million ALC/USFS sales price by 20 percent. The court then applied an additional 11 percent discount to the value as of Oct. 8, 2001 and June 2000, making a purchase parcel size adjustment.
Bottom line: The court applied a 40 percent discount to the $29.5 million sales price as of Oct. 8, 2001 (9 percent + 20 percent + 11 percent) for 1,790 acres (and one development right), which resulted in a value of $17.7 million. It similarly applied a 48 percent discount to the $29.5 million sales price as of June 2000 (17 percent +20 percent + 11 percent) for of 1,790 acres, which resulted in a value of $15.34 million. The court next considered adding the total value of the 566 acres not sold to ALC/USFS, but it reduced the value of the 566 acres by a net 35 percent, due to the lack of development rights, among others. Thus, the court determined the total value for High Meadows on Oct. 8, 2001 to be $21,337,894 and as of June 2000 to be $18,492,841. It stated:
After reviewing and analyzing all relevant evidence in the record, and using our best judgment, the Court concludes: respondent, who has the burden of proof, has failed to establish that High Meadows, in its 2,356-acre entirety, was worth more than a rounded $21,300,000 [for estate tax purposes] as of October 8, 2001, and $18,500,000 as of June 27, 2000 [for gift tax purposes].
Penalties Don’t Apply
Although the court, in essence, “split the baby” by finding a valuation for both estate tax and gift tax purposes in between the estate’s claim and the IRS’ claim, it did take a stand and side with the estate on the issue of penalties. To impose Section 6662(a) accuracy-related penalties, there must be negligence or disregard of the rules and regulations, as well as any substantial estate or gift tax valuation understatement.
To determine whether the estate could avoid liability for a Section 6662(a) penalty by claiming it reasonably relied on a tax professional, the court applied the three-prong test originally articulated in Neonatology Associates, P.A. v. Comm’r, 115 T.C. 43, 99 (2000), aff’d 299 F.3d 221 (3d Cir. 2002): 1) the advisor was a competent professional who had sufficient expertise to justify reliance; 2) the taxpayer provided necessary and accurate information to the advisor; and 3) the taxpayer actually relied in good faith on the advisor’s judgment. Regarding the first prong, the court found that the estate did rely on professionals who were competent and had sufficient expertise to justify reliance. With regard to the second prong, the court was satisfied that the estate provided its advisors with the information they needed to accurately and appropriately advise the family as to High Meadows’ value. Finally, the court found the estate demonstrated in good faith they it relied on the advice of advisors. Thus, the court held that the estate demonstrated good faith for the underpayment and as such, wasn’t liable for accuracy-related penalties under Section 6662.