July, 2006 | Issue 5
A team of valuation experts helped Arthur Temple win a $7 million refund of Federal gift tax and interest payments. The case, Temple v. United States, 2006 U. S. Dist. LEXIS 16171 (March 10, 2006), revolved around a battle between Temple and the IRS over the appropriate valuation discounts to be applied in valuing four limited liability entities owned by members of the Temple family.
In 1997 and 1998, Mr. Temple and his wife gave to their children and grandchildren gifts totaling over $34 million, made up of their interests in four separate investment entities. The four entities were Ladera Land, Ltd. (“Ladera”), which owned a ranch in Texas, Boggy Slough West, LLC (“Boggy Slough”), which owned a vineyard in California, Temple Interests, L. P. (“Temple Interests”) and Temple Partners, L. P. (“Temple Partners”), the latter two of which owned stocks in publicly-traded companies.
The IRS audited the gift tax returns, increased the value of the gifts, and assessed additional gift tax. The Temples paid the assessments and filed for a refund. The parties ended up in US District Court for the Eastern District of Texas.
The Discount Arguments
The Taxpayer and the IRS were in general agreement as to the net asset values of each of the entities. The disagreement was over the size of the discounts to apply. The parties’ experts deployed various arguments supporting their opinions of the appropriate valuation discounts that should be used to reflect the lack of control and lack of marketability of these interests. The Taxpayer also argued that he was entitled to an additional discount owing to the built-in capital gains tax liability arising from the low tax basis of the properties in the entities.
In the case of the Landera interests, the Court settled on a total discount of 38%, reflecting lack of control and lack of marketability.
The Boggy Slough interest was the most interesting of the properties from a valuation standpoint. The Court ended up at a 60% valuation discount, larger even than what the Taxpayer had asked for. The reason was that Boggy Slough was a California LLC. California law permits partnership dissolution to take the form of a distribution of real property in kind. (Boggy Slough’s assets were primarily a tract of real property.) The Court concluded that the distribution of the real property would be in the form of undivided interests to the members as tenants in common.
The Taxpayer presented a real estate expert who testified that the Boggy Slough property could be partitioned no more than one time because of zoning limitations, topography, and the varying values of parts of the land in question. Boggy Slough could only be divided into two tracts because of local zoning provisions. The expert could not determine a partitioning approach, by either value or area, that would allow Boggy Slough to stay within the zoning restrictions. Because of these difficulties, the Court concluded that, by a preponderance of the evidence, the Boggy Slough interest should be subjected to a 60% discount.
The two Temple LPs that held marketable securities ended up being awarded overall discounts ranging from 15 to 21%, representing both lack of control and lack of marketability.
Built-in Capital Gains
The Taxpayer brought up the issue of built-in capital gains taxes with respect to all four of the entities, arguing that a prospective buyer would insist on an additional discount to reflect the low tax basis of the assets in the partnerships. The Court rejected this on the grounds that IRS Code Sec. 754 allows a general partner to elect to increase a buyer’s basis in partnership assets to equal the basis in the acquired partnership interest, thus sparing the buyer the built-in gain. The Court was confident that a hypothetical willing buyer and willing seller would resolve the Sec. 754 issue before completing the transaction, making a built-in capital gains discount inapplicable.
At the end of the day, the Taxpayer went home with a $7 million refund as a result of pursuing this claim. Not a bad outcome.