T.C. Memo. 1997-188
UNITED STATES TAX COURT
ESTATE OF BONNIE I. BARGE, DECEASED,
C. RICHARD BARGE, EXECUTOR, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 230-92. Filed April 23, 1997.
At issue is the valuation of a 25-percent
undivided interest in timberland that was the subject
of gifts made by donor. R determined a deficiency in
Federal gift tax based on her valuation of the
interest. Held: Value of interest determined by
discounting partition award to present value.
Harris H. Barnes III and John V. Eskrigge, for petitioner.
Robert W. West, for respondent.
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MEMORANDUM FINDINGS OF FACT AND OPINION
HALPERN, Judge: Respondent determined deficiencies in
Bonnie I. Barge’s Federal gift tax for 1987 and 1988 in the
amounts of $5,547,988 and $4,000, respectively. Respondent also
determined an addition to tax under section 6660 in the amount of
$1,664,396 for 1987. Respondent has since conceded that no
addition to tax under section 6660 is due. We accept that
concession. The only issue remaining for decision is the value
of a 25-percent interest in certain timberland that was the
subject of gifts made by Bonnie I. Barge in 1987. Respondent’s
determination of a deficiency in gift tax liability for 1988 is a
consequence of her determination with respect to 1987, and it
requires no separate analysis from us.
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the taxable periods in
issue, and all Rule references are to the Tax Court Rules of
Practice and Procedure.
FINDINGS OF FACT
Some facts have been stipulated and are so found. The
stipulation of facts filed by the parties with accompanying
exhibits is incorporated herein by this reference. Bonnie I.
Barge filed the petition in this case on January 3, 1992. At
that time, she resided in Macon, Mississippi. Subsequently, she
died, and we ordered that Estate of Bonnie I. Barge, C. Richard
Barge, Executor, be substituted as petitioner.
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The Partnership
In 1941, Bonnie I. Barge (decedent) and her husband, C.A.
Barge, formed a general partnership, eventually known as the C.A.
Barge Lumber Co. (the partnership), for the purpose of carrying
on a lumber business. In that same year, decedent and C.A. Barge
purchased approximately 60,000 acres of timberland in Winston and
Noxubee Counties, Mississippi (the timberland). They acquired
the timberland as tenants in common, and each owned an undivided
one-half interest. The partnership operated the timberland as a
business for timber growth, harvesting, and sale on behalf of
decedent and C.A. Barge.
Decedent and C.A. Barge had three children (the children):
Richard, Betty, and Charlene. In 1959, C.A. Barge died. He
devised his one-half interest in the timberland one-half to
decedent and one-half to the children, in equal shares (so that
each child received an 8.33-percent undivided interest in the
timberland). After the death of C.A. Barge, decedent owned a
75-percent undivided interest in the timberland.
Decedent's Gifts
In 1976, decedent gave a 25-percent undivided interest in
the timberland to the children in equal shares. After the 1976
gift, decedent owned an undivided 50-percent interest in the
timberland, and each of the children owned an undivided interest
of 16.67 percent.
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Because of purchases and sales, in 1987, the timberland
totaled approximately 44,972 acres. On or about February 6,
1987, decedent gave an undivided 25-percent interest (the
undivided interest) in the timberland to separate trusts
established for the benefit of her 10 grandchildren (the 1987
gifts).
Partnership's Management Philosophy
Two management philosophies exist in the timber industry:
That which produces a majority of pulpwood, known as plantation
stand or even age management (pulpwood management), and that
which produces a majority of saw timber, known as natural stand
or uneven age management (saw timber management). The objective
of saw timber management is to allow trees to grow to maturity,
which can take as long as 50 years, for use as lumber and poles.
Each tree to be harvested is specially selected and marked.
Pulpwood management, used by those who grow pulpwood for use by
paper companies, involves clear-cutting a certain number of acres
on a shorter rotation, before the trees reach their maturity.
Consequently, pulpwood management, which harvests younger trees,
accelerates the cash-flow from a given stand of timber. Saw
timber management, on the other hand, reduces current cash-flow
by postponing the harvests and sales until later years, when the
trees reach maturity. The risk of loss to trees on account of
pests, disease, and other factors increases, however, as they
age.
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The partnership’s management objective was the production of
large, mature trees for use as saw timber and poles, in line with
the saw timber management philosophy. The management philosophy
adopted by the partnership did not maximize the current income
and profit from the timberland. Operating the timberland under
the pulpwood management philosophy would have greatly increased
the cash-flow available from the timberland.
Decedent's 1987 Gift Tax Return and Respondent’s Notice of
Deficiency
Decedent reported the 1987 gifts on a U.S. Gift (and
Generation Skipping Transfer) Tax Return, Form 709, for 1987.
She reported the value of the 1987 gifts to be $2,450,002. In
her notice of deficiency for 1987, respondent explained that she
had determined the value of the undivided interest to be
$12,847,252.
Fair Market Value of the 44,972 Acres
As of the date of the 1987 gifts, the fair market value of
the fee simple ownership of the timberland, including land and
timber, was $40 million.
Fair Market Value of the Undivided Interest
The fair market value of the undivided interest was
$7,404,649 on February 6, 1987.
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OPINION
I. Introduction
This case involves the value of certain gifts made in 1987
(the 1987 gifts) by Bonnie I. Barge (decedent) in trust for the
benefit of her 10 grandchildren. The 1987 gifts were of portions
of a 25-percent undivided interest in certain timberland (the
timberland). The parties agree that the question for decision by
the Court is the fair market value of the 25-percent undivided
interest in the timberland (the undivided interest) as of
February 6, 1987. Petitioner argues that the fair market value
of the undivided interest in February 1987 was between $4,200,000
and $4,888,600 and on February 6, 1987, it was $4,750,000.
Respondent argues that the fair market value of the undivided
interest on February 6, 1987, was at least $8,413,050. The
parties have stipulated that, as of the date of the 1987 gifts,
the fair market value of the timberland was $40 million.
The standard for determining fair market value for purposes
of the gift tax is the price at which the property would change
hands between a willing buyer and seller, neither being under any
compulsion to buy or sell, and both having knowledge of relevant
facts. Sec. 25.2512-1, Gift Tax Regs. Valuation is an issue of
fact, and petitioner bears the burden of proof. Rule 142(a). We
have found that the fair market value of the undivided interest
was $7,404,649 on February 6, 1987. We will explain our reasons
for making that finding.
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II. Valuation of the Gift
In part, to support their respective valuations, the parties
have relied on the testimony of experts. We have considered that
testimony and, in part, have relied on it in reaching our own
conclusion.
A. Method of Valuation
Based on expert testimony, petitioner requests that we value
the undivided interest in one of two ways: (1) apply a discount
(50 percent) to 25 percent of the value of the timberland
($40 million) to take into account various problems relating to
the ownership of an undivided fractional interest, or (2) use an
income capitalization approach. Because of the possibility that,
by way of an action for partition, the undivided interest could,
in a reasonable amount of time, be liquidated or turned into a
fee interest in some portion of the timberland, we believe that a
capitalization approach is a reasonable way to arrive at a value
for the undivided interest. At the end of the partition period,
a hypothetical owner of the undivided interest would receive
either cash payment or a fee interest in certain acreage (a
payment in kind). During the pendency of the action, she would
(as will be shown) receive certain cash payments. We believe
that we can value all of those payments and determine an
appropriate discount rate. With such data, we can determine a
present value for the undivided interest. But cf. Harwood v.
Commissioner, 82 T.C. 239, 265 (1984) (declining to accept an
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income capitalization approach to value limited partnership
interests in a family partnership engaged in the forest products
business), affd. without published opinion 786 F.2d 1174 (9th
Cir. 1986).
Petitioner’s expert, Thomas J. Ebner (Ebner), a forest
consultant, relied heavily on an income capitalization approach.
Petitioner’s expert, Richard H. Pinkowski, Jr. (Pinkowski), a
registered forester, considered an income capitalization
approach, among other approaches. Respondent’s expert, Earl
Flowers (Flowers), a registered forester, did not rely on an
income capitalization approach and relied exclusively on a market
comparison approach. Nevertheless, on brief, respondent argues
that the value of the undivided interest is to be determined by
considering the present value of the benefit to be received on
partition.
We do not find Pinkowski's income capitalization analysis
persuasive. He had little experience with that type of analysis,
and he merely applied an income capitalization methodology that
he obtained from a journal article. Moreover, he projected
future income based only on past income from one year, 1987, a
year which produced abnormally high income due to the Barges’
excessive harvesting, which was done in order to raise cash to
pay gift taxes.
Ebner’s report and testimony, on the other hand, did
influence our analysis. He determined a future income stream
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based upon the cash-flow of the years 1983 through 1986. Using
the partnership's tax returns and income and expense statements,
he first calculated that an average cash-flow applicable to a
25-percent interest was $341,000 a year. He then concluded that,
because the partners received distributions of only 86 percent of
that cash-flow, a purchaser of a 25-percent interest would
receive $293,000 a year. He thought that a private investor (as
opposed to a forest products company or an institutional
investor) would be the most likely purchaser of the undivided
interest. He concluded that a private investor would capitalize
the estimated $293,000 annual cash-flow at 10 percent and add the
unrealized gain on the buildup of inventory resulting from the
Barges’ saw timber management policies to make a maximum offer of
$3,340,000.
Ebner did not consider that a potential purchaser
unsatisfied with the Barges’ saw timber management philosophy
could force a partition of the property and, thus, escape the
Barge management philosophy. Petitioner agrees that Mississippi
law provides for partition of real property. See Miss. Code Ann.
sec. 11-21-3 (Supp. 1996). If the timberland were partitioned, a
purchaser would pay an amount equal to the present value of
(1) the cash-flow expected under Barge management for the period
until partition (minus the costs of partition, which would be
divided equally over the partition period), and (2) the value of
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the interest on partition (which, if she received a payment in
kind, would not be subject to the Barge management philosophy).
Accordingly, in order to determine the price that the purchaser
would pay, we must figure (1) the length of the partition process
and its costs, (2) the proper interest rate a buyer would demand,
and (3) the value of a 25-percent fee simple after partition.
B. What a Purchaser Would Pay
1. Partition
In partition suits, Mississippi courts tend to favor
equitable partition-in-kind over an outright sale of the entire
property. Shaw v. Shaw, 603 So.2d 287, 290 (Miss. 1992).
Petitioner's expert, William C. Smith, Jr. (Smith), was of the
opinion that a contested partition would take from 2 to 5 years
to resolve at a total cost of about $1,150,000 to $1,500,000,
which would be borne equally by the parties. Members of the
Barge family testified that they would resist any attempt to
partition the timberland. We are not convinced that such
resistance would be undertaken just for the sake of delay, since
it would not be cost free. Resistance might be mounted to obtain
an advantageous partition, however. We judge that a partition
action would take 4 years, and that the party initiating such
action would bear one-half of total partition costs of
$1,325,000.
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2. Discount Rate
Respondent argues that a capitalization rate of 9 to
10 percent is applicable in this case. In support of that
argument, she points to Ebner’s testimony and to the testimony of
her own expert, Flowers. Petitioner argues for a discount rate
of 14 percent:
the rate of return which a potential investor would
require from the type of investment involved herein is
considered a minimum of 10% exclusive of investment
risks. The evidence in this case clearly indicates
that there are many risks inherent with the ownership
of this type property. Therefore, it is reasonable for
the court to accept 14% as a required rate of return on
this type of investment. * * *
Petitioner points only to the expert testimony of Pinkowski to
support a rate of return of 14 percent. We do not find Pinkowski
particularly helpful with respect to the capitalization approach.
Petitioner has failed to prove that a discount rate of greater
than 10 percent is appropriate. We shall use 10 percent.
3. Value of Interest After Partition
The parties have stipulated that the timberland had a fair
market value of $40 million as of the date of the 1987 gifts.
Respondent argues, however, that because of the Barges’ saw
timber management philosophy, the value of the timberland would
increase during the period of any action to partition. We think
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that that is correct. Petitioner’s expert, Ebner, was of the
opinion that the increase would be $363,000 a year. We reach a
figure close to that and conclude that the timberland would be
worth $41 million at the end of a 4-year partition period.
Accordingly, we believe that the partition award to a 25-percent
owner of the timberland at the end of a 4-year partition action
would be worth $10,250,000
III. Fair Market Value
Accordingly, using a 10-percent rate of return, a partition
period of 4 years, future income of $293,000 per year during the
partition period, partition costs of $662,500 (the purchaser’s
50-percent share of $1,325,000) allocated equally over the
partition period, and a value of $10,250,000 after partition, we
find that the fair market value of the 1987 gift to be $7,404,649
under the following calculation:
Year Income Partition Partition Total Present
Costs Payment Value
1 $293,000 - $165,625 + $0 $127,375 $115,795
2 293,000 - 165,625 + 0 127,375 105,268
3 293,000 - 165,625 + 0 127,375 95,699
4 293,000 - 165,625 + 10,250,000 10,377,375 7,087,887
Total $7,404,649
Decision will be entered
under Rule 155.