Rule 144 -- Valuation at Death

Rule 144 -- Valuation at Death

News story posted in Field Service Advice on 3 February 1999| comments
audience: National Publication | last updated: 18 May 2011
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Summary

In a recently-released 1992 Field Service Advice memorandum, the IRS and case rulings present inconsistent positions for valuing Rule 144 stock at death.

PGDC SUMMARY:

In a recently-released 1992 Field Service Advice, basing its position on the Code and a series of cases on this matter, the Service held that when valuing Rule 144 stock at the time of death for estate tax purposes, any restrictions that existed prior to death should not be taken into account.

POINTS TO PONDER:

The IRS' valuation approach is consistent with the Tax Court case of Estate of Charles K. McClatchy v. Commissioner (106 TC 206, 1996), where the court held that "at the instant of death, the securities law restrictions no longer applied." However, the Ninth Circuit reversed the decision in McClatchy in 1998 and held that since the "value of the estate is determined by the interest of the decedent at the time of death," the stock should be valued with the restrictions present prior to death. Additionally, "the increase in the stock's value was occasioned, not by death, but by transfer to a non-affiliate estate; death alone did not alter the value [of the stock]." The IRS may be right on this one!

FULL TEXT:

INTERNAL REVENUE SERVICE
MEMORANDUM
CC:TI-N-4
FS:P&SI

date: September 1, 1992
to: District Counsel, * * * CC:* * *
from: Assistant Chief Counsel, Field Service CC:FS
subject: * * *
TL-N-9407-92
Rogers/Miscavich
section 2031

This is response to your request for field service advice dated July 17, 1992.

Issue

In the instant case, where the decedent's death altered the value of the stock, should the valuation take into account the decedent's death. 2031-0300.

Conclusion

The value at death should give effect to the change that accompanies the decedent's death; i.e., the stock should be valued without the restrictions.

Facts

The facts as presented by the taxpayers and in which you concur are as follows. The decedent, * * * died * * * At the time of his death he owned * * * shares of * * * stock of * * * The shares were unregistered and their sale was restricted for federal securities law purposes. Restricted securities can only be sold under the following circumstances: (1) after the securities are formally registered with the Securities and Exchange Commission; (2) in a private resale to a purchaser who would also be subject to resale restrictions; or (3) pursuant to an exemption from the securities law restrictions.

The decedent was considered an "affiliate" for securities law purposes at the time of his death and therefore was subject to stringent volume limitations, disclosure and other requirements if he were to dispose of the shares pursuant to SEC Rule 144. However, the estate was not an affiliate and could sell the shares pursuant to SEC Rule 144(k) without regard to such restrictions. The decedent's prior holding period in the stocks was attributed to the estate so that the estate could sell the shares pursuant to SEC Rule 144(k) immediately.

Discussion

I.R.C. section 2001(a) provides, "A tax is hereby imposed on the transfer of the taxable estate of every decedent who is a citizen or resident of the United States." This tax is an excise tax laid upon the right of the decedent to transmit his property at death and is measured by the value of that property which is transmitted at death. Edwards v. Slocum, 264 U.S. 61 (1924); New York Trust Co. v. Eisner, 256 U.S. 345 (1921); Estate of Chenoweth v. Commissioner, 88 T.C. 1577 (1987).

Section 2031(a) provides: "The value of the gross estate of the decedent shall be determined by including to the extent provided for in this part, the value at the time of his death of all property, real or personal, tangible or intangible, wherever situated."

Section 2033 in turn provides: "The value of the gross estate shall include the value of all property to the extent of the interest therein of the decedent at the time of his death."

Property includible in a decedent's gross estate is generally included at its fair market value on the date of the decedent's death. Treas. Reg. section 20.2031 - 1(b); Estate of Titus v. Commissioner, T.C. Memo. 1989 - 466. Fair market value is "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 to sell and both having reasonable knowledge of relevant facts." Treas. Reg. section 20.2031 - 1(b); United States v. Cartwright, 411 U.S. 546, 551 (1973).

The fair market value of shares of a publicly traded corporation is ordinarily deemed to be the mean between the highest and lowest quoted selling prices on the valuation date. Treas. Reg. section 20.2031-2(b)(1). However, the stock at issue may have a different fair market value if the shares held by the decedent were substantially different from the shares being traded on the open market. Estate of Brownell v. Commissioner, T.C. Memo. 1982-632, 44 T.C.M. (CCH) 1550, 1553.

In Brownell, the Tax Court examined the value of shares of a publicly traded corporation. The estate argued that the shares were restricted securities while the Service contended that the shares were not restricted because the decedent and the estate were not "control" persons for purposes of the federal securities law. Citing prior law, the court recognized that "the value of restricted stock that may be sold only through a private offering to persons who take the stock subject to the same restriction is significantly lower than the value of unrestricted stock." Brownell, 44 T.C.M. at 1553. The court found that the estate met its burden of proof and established that the estate was a control person on the applicable valuation date. Therefore a substantial discount was applied to the publicly traded selling prices in determining the value of the stock for estate tax purposes.

However, in the instant case, the parties agree that while the decedent was an affiliate for securities law purposes, the estate was not. Therefore, while there were severe limitations on the decedent's ability to dispose of the stock, the shares were freely transferable by the estate. Thus, the law enunciated in Brownell is not applicable in this case because the stock can be freely transferred and does not have to be sold in a private offering to persons who must take it subject to the same restrictions.

There is no prior case law that addresses this exact issue. However, as the estate recognized when it attempted to distinguish the case, the Fifth Circuit addressed an analogous issue in United States v. Land, 303 F.2d 170 (5th Cir.), cert. denied, 371 U.S. 862 (1962).

In Land, the decedent and his son were members of a family partnership. The partnership agreement provided that if any partner wished to withdraw from the partnership during his lifetime the other partners would have the option of purchasing his interest at two- thirds its calculated value. At the death of a partner, the surviving partners become entitled to purchase his interest at its full value; if they did not do so, the partnership would be dissolved and its assets liquidated and distributed.

The estate reported the decedent's partnership interest at two-thirds of its fair market value on the theory that value is determined before death and that the restriction controlled the valuation for federal estate tax purposes. The district court agreed.

The Fifth Circuit did a thorough, frequently cited analysis of this area. It concluded that "a restriction on the value of a partnership interest that expires at the decedent's death cannot affect the valuation of the interest for estate tax purposes." Land, 303 F. 2d at 171. The analysis in Land is applicable in the instant case as well.

In Land, the Fifth Circuit opined:

"Brief as is the instant of death, the court must pinpoint its valuation at that instant___the moment of truth, when the ownership of the decedent ends and the ownership of the successors begins. It is a fallacy, therefore, to argue value before - or - after death on the notion that valuation must be determined by the value either of the interest that ceases or of the interest that begins. Instead, the valuation is determined by the interest that passes, and the value of the interest before or after death is pertinent only as it serves to indicate the value at death. In the usual case death brings no change in the value of property. It is only in the few cases where death alters value, as well as ownership, that it is necessary to determine whether the value at the time of death reflects the change caused by death, for example, loss of services of a valuable partner to a small business. (Emphasis in the original.) An examination of several instances where the value of a decedent's property differs after death from its value during his life indicates that whether the subsequent value is increased or reduced, the valuation at death uniformly gives full effect to the change that accompanies the death. Land, 303 F. 2d at 172."

The Fifth Circuit further stated:

"Underlying the determination in these instances that the valuation of property passing at death reflects the changes wrought by death is a basic economic fact: value looks ahead. To find the fair market value of a property interest at the decedent's death we put ourselves in the position of a potential purchaser of the interest at that time. Such a person would not be influenced in his calculations by past risks that had failed to materialize or by restrictions that had ended. Death tolls the bell for risks, contingencies, or restrictions which exist only during the life of the decedent. A potential buyer focuses on the value the property has in the present or will have in the future. He attributes full value to any right that vests or matures at death, and he reduces his valuation to account for any risk or deprivation that death brings into effect, such as the effect of the death on the brains of a small, close corporation. These are factors that would effect his enjoyment of the property should he purchase it, and on which he bases his valuation. The sense of the situation suggests that we follow suit. Land, 303 F. 2d at 173."

The estate primarily relied on two lines of cases to support its proposition that the stock must be valued at the moment before death. The first line of cases involved minority interest discounts for fractional interests (e.g., Bright/Propstra). These cases will be discussed later. The estate also relied heavily on Estate of Maddock v. Commission, 16 T.C. 324 (1951). In Maddock, the Service argued that the decedent's interest in a partnership was worth considerably more than the reported value because the reported value ignored good will. The Tax Court recognized that to determine whether a business had good will of any appreciable value one must look at the nature of the business and the circumstances surrounding its ownership and operation to determine whether any good will that it may have possessed could have survived transfer of all or a fractional part of the going business.

In Maddock, the court looked at the above factors and concluded that the partnership did not possess good will of substantial value. Maddock, 16 T.C. at 331. The court also held that, if there was good will, the decedent was unlikely to realize any value for such good will. The decedent had the right to demand a dissolution and liquidation of the business. However, good will cannot survive separate and apart from a going business. Further, no informed purchaser would have failed to recognize the depressive effect of the loss of the decedent's association with the business and of the other partner's right to open a competing business in the same locality using the same name and hiring the same salespeople and soliciting the old customers. Thus, the court concluded that the decedent could not have received more for his partnership interests during life than his estate received upon his death. Maddock, 16 T.C. at 331-32.

Based upon the foregoing, we do not believe that Maddock supports the estate's position. Maddock was based on the facts and circumstances of that particular case. It recognized that the decedent's death or withdrawal from the business would reduce or eliminate any good will, as would the dissolution of the partnership. Thus, Maddock actually supports the rationale that the value of stock in a corporation may need to be reduced because of the decedent's death to reflect the loss of good will. Thus, as in Land, the value could change as the result of the decedent's death.

The estate also contends that under the rationale of Bright v. United States, 658 F. 2d 999 (5th Cir. 1981) and Propstra v. United States, 680 F. 2d 1248 (9th Cir. 1982), the value of the shares must reflect the restrictions. In both Bright and Propstra, the courts were called upon the determine the value of a decedent's interest in community property. The courts determined that the willing buyer and willing seller were hypothetical third persons. Such a criteria provides an objective standard to determine the value. Both courts also recognized that "the estate tax is a tax on the privilege of transferring property upon one's death, the property to be valued for estate tax purposes is that which the decedent actually transfers at his death rather than the interest held by the decedent before death or that held by the legatee after death." Propstra, 680 F. 2d at 1250; Bright, 658 F. 2d at 1001.

State law determines what property is transferred at death. Propstra, 680 F.2d at 1251. In Bright and in Propstra, experts testified and the court held that the value of an undivided fractional interest in real property would be less than a proportionate share of the fair market value of the whole. Both courts rejected the government's unity of ownership argument. The court in Propstra, relying on Bright, stated that:

"The relationship between Mr. and Mrs. Bright and their stock is an irrelevant, before death fact. Thus, it is clean that the 'willing seller' cannot be identified with Mrs. Bright. . . .

Similarly, . . . [because] valuation is not determined by the value of the interest in the hands of the legatee, . . . the 'willing seller' cannot be identified with Mr. Bright as executor or as trustee of the testamentary trust. Propstra, 680 F. 2d at 1252, citing Bright, 658 F. 2d at 1006."

Thus, Bright and Propstra are in conformity with Land. It is not the value before death or after death but the value at the moment of death that is important. In Bright and Propstra, the decedent's death did not cause any right that vested at death or account for any risk or deprivation that death brings into effect. Therefore, the hypothetical willing seller acceded only to the interest that the decedent transferred at death under state law. Both cases are among those usual cases where death brings no change in the value of property. See Land, 303 F. 2d at 172.

Numerous cases have relied on the rationale in Land. Many of them can be cited in support of the contention that the value of the decedent's interest in the stock must give effect to the change that accompanied the decedent's death. In Provident National Bank v. United States, 581 F. 2d 1081 (3d Cir. 1978), the decedent owned common stock in a corporation. In his will, he directed his executor to exchange the common stock for preferred stock on the recapitalization of the corporation. The court held the value of the interest included in the gross estate was the value of the common stock subject to the testamentary directive to exchange it for preferred stock. The value was not the value of the common stock or the par value of the preferred stock. The court in Provident National Bank recognized that the value must be determined as of the time of the decedent's death. Thus, the value may be impacted by directives in the will - the value is not the value after the directives are implemented but the value at the time of death when the will becomes operative and the interest in property becomes subject to future directives.

In Bright and in Propstra, the courts held the decedent's interest in property would not be aggregated with other family member's interests for purposes of determining value. However, in Estate of McMullen v. Commissioner, T.C. Memo. 1988 - 500, the court relied on Land and held there should be no discount for fractional interests. In McMullen, property was left in trust with a directive to the trustee to sell the property and distribute the net proceeds to named persons. The court cited Land for the proposition that a potential purchaser would not be influenced in his calculations by past risks that had failed to materialize or by restrictions that had ended. The court held the decedent's undivided fractional interest in the trust was not entitled to a fractional interest discount because the trustee was directed to sell the entire trust corpus in fee simple. The value of the decedent's interest must take into account this direction.

Similarly, in Estate of Hull v. Commissioner, 38 T.C. 512 (1962), the court had to determine the value of insurance policies includible in a decedent's gross estate. Citing to Land, the Tax Court said "value looks ahead. To find the fair market value of a property interest at the decedent's death we put ourselves in the position of a potential purchaser of the interest at that time. A potential buyer focuses on the value the property has in the present or will have in the future." Therefore, the court concluded that a potential purchaser, at the instant of the decedent's death, would not limit the price he would pay therefore to the cash surrender value of the policies, knowing full well that as of that instant the decedent could not change the beneficiaries and the beneficiaries then held a ripened claim for the full face value. Hull, 38 T.C. at 529.

In Ahmanson Foundation v. United States, 674 F. 2d 761 (9th Cir. 1981), the decedent held a controlling interest in 600 shares of common stock in a revocable trust. The trust also held 99 nonvoting and 1 voting share of a shell corporation's stock. At the moment of decedent's death, the shell corporation became unconditionally entitled to the 600 shares of common stock. At that moment, a charity became entitled to the 99 nonvoting shares of the shell corporation. The decedent's son became entitled to the one voting shares of the shell corporation. In determining the value at the moment of death of the 600 shares of common stock and the 100 shares of the shell corporation, the court held it had to take into account any transformations of the property that are logically prior to its distribution to the beneficiaries. Ahmanson Foundation, 674 F. 2d at 767 - 68. The court concluded that the 100 shares of the shell corporation (which represented the value of the 600 shares of common stock) should be viewed in the hands of the testator and thus given a value equal to the price which the 600 shares of common stock would have in exchange between a willing buyer and a willing seller even though the value of the shell corporation before the decedent's death was zero. See also Estate of Curry v. United States, 706 F. 2d 1424 (7th Cir. 1983).

In light of the above authorities, the shares should be valued without the restrictions. Under a hypothetical willing seller standard, such as that espoused in Bright and in Propstra, the seller would be aware of the relevant fact that the shares were no longer subject to the restrictions at the moment of the decedent's death. Therefore, the hypothetical willing seller, attempting to maximize his profit, would insist that the full fair market value of the stock would be the value without restrictions.

Similarly, as noted in Land, the willing buyer would focus on the value the property has in the present or will have in the future. He would not be influenced by restrictions that had ended. Therefore, the willing buyer would pay the full fair market value of the stock without restrictions.

This document may include confidential information subject to the attorney - client and deliberative process privileges, and may also have been prepared in anticipation of litigation. This document should not be disclosed to anyone outside the Service, including the taxpayer involved, and its use within the Service should be limited to those with a need to review the document in relation to the subject matter or case discussed herein. This document also is tax information of the instant taxpayer which is subject to section 6103.

If you have any additional questions, please contact Helen Rogers at (202) 622-7860.

Daniel J. Wiles,
By: Harve M. Lewis
Acting Senior Technician
Reviewer, Passthroughs & Special Industries
(Field Service)

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