T.C. Memo. 2004-46
UNITED STATES TAX COURT
ESTATE OF LEA K. HILLGREN, DECEASED, MARK HILLGREN, EXECUTOR,
Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 13394-01. Filed March 3, 2004.
Paul Frederic Marx, for petitioner.
Thomas J. Fernandez, Hieu C. Nguyen, Edwin Herrera, for
respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
COHEN, Judge: Respondent determined a deficiency of
$1,269,498 in the Federal estate tax of the estate of Lea K.
Hillgren (decedent), Mark Hillgren, executor, and an accuracy-
related penalty under section 6662(a) of $247,691. After
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concessions by the parties, the issues for decision are:
(1) Whether an entity entitled “The Lea K. Hillgren Partnership,
A California Limited Partnership” (LKHP or partnership) is a
partnership that should be disregarded under section 2036(a) in
valuing seven properties in which decedent had an interest;
(2) the effect of a Business Loan Agreement (BLA) between
decedent and her brother on the value of four properties in which
decedent had an interest. Respondent concedes that the estate is
not liable for the accuracy-related penalty under section 6662.
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect as of the date of decedent’s
death, and all Rule references are to the Tax Court Rules of
Practice and Procedure.
FINDINGS OF FACT
Some of the facts have been stipulated, and the stipulated
facts are incorporated in our findings by this reference. Lea K.
Hillgren (decedent) was a resident of California at the time of
her death. The executor of decedent’s estate, her brother, Mark
Hillgren (Hillgren), resided in California when the petition in
this case was filed.
Decedent’s Background
Decedent graduated from California State University with a
degree in restaurant and hotel management. She was a restaurant
manager for Hamburger Hamlet, attended cooking school in France,
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and was in the catering business at various times. In 1978 and
1979, decedent was a professional snow skier. Later in her life,
she was a golfer. During her life, decedent owned various
income-producing properties that she acquired through a
combination of purchase and inheritance from her grandfather.
Decedent did not marry and did not have any children.
Decedent was treated for mental illness beginning in 1984.
Decedent’s psychiatrist, Dr. Carolyn Hays (Hays), practiced
psychiatry in Beverly Hills, California. Hays began treating
decedent for depression in 1987 and treated her regularly
beginning in 1994.
Decedent’s boyfriend in 1996, Michael O’Brien (O’Brien), was
a golf professional at decedent’s golf club. O’Brien was
approximately 10 years younger than decedent. Around October
1996, decedent ended her relationship with O’Brien.
On October 31, 1996, decedent attempted to commit suicide by
intentional overdose of medications and alcohol and by carbon
monoxide poisoning. The attempt was unsuccessful because she was
discovered by a police officer. She was taken to Hoag Memorial
Hospital Presbyterian (Hoag hospital) in Newport Beach,
California, and was admitted for treatment for a week or two at
Cedars Sinai Medical Center (Cedars Sinai) in Los Angeles,
California. Decedent’s treating psychiatrist at Cedars Sinai and
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Hays changed decedent’s medication, prescribing a new
antidepressant for her.
After decedent’s suicide attempt, she tried to resume her
relationship with O’Brien. The relationship did not continue,
and O’Brien seemed to lose interest in decedent.
On March 21, 1997, decedent was admitted to Hoag hospital
for pain in her arm and neck. At the time, she was taking five
different medications. Decedent also suffered from a
degenerative disc disease of the cervical spine. On March 28,
1997, decedent received a cervical epidural steroid for her back
pain at Hoag hospital. On June 5, 1997, at the age of 41,
decedent committed suicide by carbon monoxide poisoning.
According to Hays, several factors possibly contributed to
decedent’s suicide, including the relationship with O’Brien; the
death of decedent’s cat; and a combination of prescription
medication that decedent was improperly taking.
Decedent was survived by her parents, Carl C. Hillgren and
Kay Schureman; by her brother, Hillgren; and by Hillgren’s
children, Sophia M. Hillgren and Carl R. Hillgren.
The Original Lea K. Hillgren Trust
On April 10, 1984, decedent established the Lea K. Hillgren
Trust (original trust). Under the original trust, decedent could
revoke or amend the trust, in whole or in part, during her
lifetime. Decedent and Hillgren were named as cotrustees of the
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original trust, and Hillgren was named as the beneficiary. The
“Schedule I” attached to the original trust specified the
property that was transferred to the trust and included shares of
stock in Sea Shell Properties, Limited (Sea Shell Limited), and
unspecified real estate partnership interests. On November 24,
1986, decedent executed a durable power of attorney, appointing
Hillgren as her agent.
Business Entities
Prior to 1988, decedent, as trustee of the original trust,
owned a California corporation, Sea Shell Limited. In December
1988, Sea Shell Limited dissolved, and all of its assets were
distributed to decedent as trustee of the original trust.
Decedent then conducted business as a sole proprietor under the
name Sea Shell Properties. (“Sea Shell” will be used to refer to
Sea Shell Properties and its predecessor and related entities
that were essentially controlled by decedent and bore names used
interchangeably in referring to decedent’s business activities.)
On December 12, 1997, after decedent’s death, Hillgren filed a
fictitious business name statement in California for Sea Shell
Limited, naming decedent as the registrant.
As of the date of decedent’s death, Hillgren had worked in
the real estate industry for 27 years. Prior to December 1986,
Hillgren established, merged, and dissolved various entities,
some with similar names, to conduct his real estate activities.
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In December 1986, one of Hillgren’s entities, Seaward Properties,
Limited, dissolved, and its assets were distributed to Seaward
Partners, a California general partnership owned 89 percent by
Hillgren and 11 percent by Carl C. Hillgren. (“Seaward” will be
used to refer to Seaward Partners and its predecessor and related
entities that were essentially controlled by Hillgren.) From
1987 through 1997, Hillgren held a general partnership interest
in two partnerships, LKHP and Seaward. Seaward also held general
partnership interests in three other partnerships. At the date
of decedent’s death, Hillgren had executed several certificates
of partnership.
Business Loan Agreement
Around April 1994, decedent and Hillgren entered into the
BLA, which was drafted by their attorney, Jeffrey Walsworth
(Walsworth). The BLA described a series of events occurring
between decedent, doing business as Sea Shell and referred to as
the “debtor”, and Hillgren, doing business as Seaward and
referred to as the “lender”. The BLA was signed by decedent and
Hillgren, but was undated. The term of the BLA was for 29 years.
The BLA was never recorded.
Several properties were the subject of the BLA. The BLA
discussed “Properties” (Orange County properties) as described in
exhibit “A” and the “University Industrial Park” (University
property) as described in exhibit “B”. The Orange County
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properties, however, were actually described in exhibit B,
whereas the University property was described in exhibit A,
because the exhibits were inadvertently switched when the BLA was
signed. The Orange County properties included properties on West
Collins Avenue (West Collins), North Main Street (North Main),
and North Enterprise Street (Enterprise) in Orange County,
California.
The BLA provided that, in exchange for the consideration
given by Hillgren, decedent encumbered the Orange County
properties as collateral for the fulfillment of decedent’s
obligations to Hillgren. Hillgren also had the sole right and
discretion to determine if and when any of the Orange County
properties should be sold for up to 29 years after the date of
the BLA. As stated in the BLA, Hillgren would also provide
$1 million, if necessary, to maintain decedent’s financial
obligations in the University property. Decedent granted to
Hillgren a 25-percent interest in “all net cash sales/refinance
proceeds” (25-percent lender interest) from the University
property. The 25-percent lender interest was defined in the BLA
as any cash proceeds available from refinancing or cash from a
sale of the property, after payment of all preexisting debts.
The BLA appointed Hillgren as decedent’s “attorney-in-fact” for
the duration of the contract. Pursuant to the BLA, decedent paid
delinquent property taxes.
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1. Purchase of the University Property
The University property was a multitenant industrial park
located in Tempe, Arizona. In December 1985, the University
property was acquired by Hillgren and decedent from the Huettner
Limited Partnership (Huettner). Hillgren signed the purchase
agreement as the “buyer” of the property. The University
property was purchased for $3,831,800 with cash of $319,194.78,
assumption of the existing mortgage of $1,518,432.05 (Safeco
loan), and assumption of a second mortgage previously carried by
Huettner of $1,966,567.95 (Huettner loan). The loans on the
property were nonrecourse.
Under the warranty deed for the property, Sea Shell and
Seaward each held title to 50 percent of the property. On
December 23, 1985, a promissory note for the Huettner loan made
Sea Shell and Seaward jointly and severally liable on the debt.
Hillgren signed the promissory note as president and secretary of
Seaward and as vice president of Sea Shell. On July 1, 1986,
Seaward executed a quitclaim deed where it relinquished its
interest in the University property to Sea Shell. The quitclaim
deed on the University property was not recorded until May 23,
1994.
2. Financing of the University Property
The BLA recited that Hillgren had assisted decedent in her
acquisition of the University property by lending her $485,000.
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In 1986, decedent suffered a “negative cashflow exclusive of
depreciation” exceeding $115,000 on the University property.
After 1986, decedent continued to incur a negative cashflow on
the property. In 1987, due to the financial problems associated
with the University property, Hillgren “facilitated” a loan of
$400,000 from Louis Puccio to decedent (Puccio loan). On
April 27, 1988, in his capacity as trustee of the original trust,
Hillgren signed a promissory note between Louis Puccio and Sea
Shell. The promissory note was secured by a deed of trust on the
North Main property. According to the BLA, by 1988, decedent
owed $285,000 to Hillgren and $400,000 on the Puccio loan. From
1988 through 1993, decedent continued to incur a negative
cashflow on the property, she did not pay the Puccio loan, and
she continued to be indebted to Hillgren.
The BLA recited that, as of 1994, decedent owed $1.3 million
on a first trust deed (Safeco loan) and $1.5 million on a second
trust deed (Huettner loan), both secured by the property, in
addition to the Puccio loan and her remaining debt of $150,000 to
Hillgren. In August 1994, the Huettner loan and the Puccio loan
were to become due and payable, but decedent was unable to pay
the loans because of her negative cashflow on the property. The
BLA provided that Hillgren assist decedent in obtaining an
extension of the Puccio loan and that Hillgren became a guarantor
of the loan. On May 11, 1994, Hillgren executed a Forbearance
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and Guaranty Agreement on the Puccio loan, extending the
collection of the principal of the loan until January 1, 2001.
Hillgren also placed his assets as collateral on the Puccio loan.
Hillgren assisted decedent in obtaining a forbearance and
extension on other loans as well, including the Huettner loan.
On May 1, 1994, the terms of the Huettner loan were modified,
reducing the amount of the loan to $1,481,567.95. To secure the
payment of the modified loan, Sea Shell and Seaward executed a
second in priority deed on the “Arizona Property” and a deed of
trust on the North Main property, in favor of Huettner. (It is
unclear from the exhibit whether the “Arizona Property” referred
to is the same as the University property or is another property
owned by Nordica Properties (Nordica), a California general
partnership, also owned by decedent and Hillgren, which owned
properties in Phoenix, Arizona.) On April 15, 1994, Hillgren and
Carl C. Hillgren modified the Safeco loan by becoming guarantors
of the loan, reducing the interest rate and extending the
maturity date.
3. Refinancing of the University Property
On May 20, 1999, the University property was refinanced by
LKHP when a new first mortgage in the amount of $2.5 million was
obtained from Baltimore Life Insurance Co. As a result of the
refinancing, the net cash proceeds totaled $369,329. Hillgren
did not receive a distribution of loan proceeds during the
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refinancing in accordance with his 25-percent lender interest in
proceeds from refinancing as provided by the BLA. In 2001,
however, in his capacity as general partner of LKHP, Hillgren
paid himself $92,332, representing 25 percent of the net loan
proceeds from the 1999 refinancing of the University property.
The Amended Trust
On January 29, 1997, the original trust was amended and
restated (amended trust). Decedent and Hillgren were named as
cotrustees of the amended trust. Whereas Hillgren was the
beneficiary of the original trust, Hillgren and his two children
were the beneficiaries of the amended trust. The amended trust
provided for payment of the estate’s expenses and taxes after
decedent’s death.
The amended trust was funded by the items listed in
“Schedule A”. Schedule A included: The Orange County
properties, the University property, a partnership interest in
Nordica, decedent’s personal residence, three other properties
(Crescent Bay, Railroad, and Manzanita), and several additional
assets including bank accounts. Also on January 29, 1997,
decedent executed a will, naming Hillgren and his children as the
sole beneficiaries of decedent’s estate.
Loans Between Decedent and Hillgren
Over a number of years, decedent and Hillgren engaged in
several loan transactions. When one sibling needed money, the
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other would lend money. In 1994, Hillgren was paying decedent
10-1/2 percent interest whereas decedent was paying Hillgren
8-1/2 percent. Separate loan accounts were maintained for loans
between decedent (doing business as LKHP, the amended trust, or
Sea Shell) and Hillgren (doing business as Seaward). One account
tracked the amounts borrowed by decedent from Hillgren, and
another account tracked the amounts borrowed by Hillgren from
decedent. The balances in the two accounts were reported
separately in the general ledger and financial statements of LKHP
and the amended trust. Sea Shell’s balance sheets for 1987
through 1994 did not reflect accrued interest on the loans
between decedent and Hillgren, nor was interest included in the
balances of these loans when computing the net asset value of
LKHP as reported on decedent’s estate tax return. The accrued
interest on the loans from Seaward to Sea Shell was not paid
until December 1997, and the accrued interest on the loans from
Sea Shell to Seaward was not paid until 1998.
In December 1993, decedent sold a house, and the proceeds
were disbursed to Seaward as the $20,000 remaining principal on a
loan and $265,000 as a new loan to Seaward. At the time that the
BLA was signed, if the balances in the accounts were netted,
Seaward owed more money to Sea Shell than Sea Shell owed to
Seaward.
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The Partnership
1. Formation of LKHP
Decedent and Hillgren formed LKHP with an effective date of
January 1, 1997. The term of the partnership was set for
29 years. Walsworth represented both decedent and Hillgren in
the formation of the partnership. Decedent held a 99.95-percent
capital interest and a 75-percent profit interest in LKHP.
Decedent gave Hillgren a .05-percent capital interest and a
25-percent profit interest in the partnership. The term “profit
interest” was defined in the partnership agreement as “a
partnership interest other than a capital interest * * * which
will give rise to a partnership capital account * * * only if and
when there is future economic income” (25-percent profit
interest). The partnership agreement also provided Hillgren with
25 percent of the amount, if any, by which the partnership
profits from operations in any year exceeded profits from
operations realized by decedent in 1996 from the properties
transferred (25-percent operational interest). The 25-percent
operational interest was compensation to Hillgren for time spent
in the management of LKHP. Decedent made no other gifts of
partnership interests.
Decedent contributed seven properties (the LKHP properties)
to LKHP, as described in exhibit B to the partnership agreement.
Hillgren did not contribute any property to LKHP. The seven LKHP
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properties that were contributed to the partnership at its
formation included the three Orange County properties and the
University property that were already the subject of the BLA and
that were used to fund the amended trust. In addition, the other
three properties that were contributed were the Crescent Bay,
Railroad, and Manzanita properties in California that also
previously were used to fund the amended trust. After the
initial contributions were made, no additional property was
transferred to the partnership.
Decedent did not deed or transfer title to the seven LKHP
properties to the partnership. The partnership agreement
provided that title to any property that was contributed by a
limited partner, and was deemed to be owned by the partnership,
would remain in the name of the limited partner for the benefit
of the partnership. The leases that encumbered the LKHP
properties were not formally assigned to LKHP prior to decedent’s
death. The leases remained in the name of decedent, or in the
name of Sea Shell, after LKHP was formed. The title remained in
the name of decedent or Sea Shell in order to hide the change of
ownership from the general public and from the tenants of the
properties. Under the partnership agreement, Hillgren could
conduct partnership business without disclosing the existence of
the partnership. The partnership was designed generally to be
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invisible to the public and to persons with whom decedent and
Hillgren did business.
On May 27, 1997, decedent executed seven quitclaim deeds,
transferring her interest in the LKHP properties to the amended
trust. The deeds were unrecorded at the time of her death. Also
on May 27, 1997, decedent assigned her partnership interest to
the amended trust.
2. Operation of LKHP
The partnership agreement provided that the general partner
need not open a bank account in the name of the partnership, but
could instead maintain the existing bank account that was used by
Sea Shell and the amended trust. As a result, LKHP did not have
a dedicated bank account during decedent’s lifetime. Decedent
held a bank account at Wells Fargo Bank (Wells Fargo) that
operated under the name of the amended trust, doing business as
Sea Shell. The Wells Fargo account was used for operation of
LKHP.
LKHP’s financial statement dated June 5, 1997, and its
general ledger from January 1 through June 30, 1997, included
decedent’s residence, the mortgage on her residence, and the
mortgage and property tax payments that were made on the
residence. Decedent’s residence and the expenses attributed to
the residence were removed from the ledger in a journal entry by
an adjustment dated January 1, 1997. The adjusted journal entry
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was not posted until after decedent’s death. It was the practice
of decedent and Hillgren to post the opening entries on their
accounting books anywhere from 6 to 8 months after the start of
the year. As a result, the opening entries for LKHP were not
made until after decedent’s death. Also, the balance sheets,
ledgers, and check registers that represented the financial
information of LKHP were actually maintained under the name of
Sea Shell.
After the formation of LKHP, leases were executed on the
LKHP properties in the name of Sea Shell. Also after the
formation, all contracts that were entered into for maintenance
and improvement of the LKHP properties, as well as all bills that
were received, were in names other than that of LKHP. On
March 12, 1997, a check was issued under the name of Sea Shell to
pay property taxes for various properties including Manzanita and
Enterprise. On May 22, 1998, Sea Shell also paid for landlord’s
insurance on the Manzanita property.
After the formation of LKHP, Nordica completed refinancing
of its properties. During the loan application process, it was
represented to a mortgage broker, Walker Mortgage, and a lender,
Homesteader’s Life Co., that decedent owned and controlled all of
the LKHP properties. No mention was made to either the mortgage
broker or the lender that the properties were restricted by the
BLA or that they were owned by LKHP. The disclosure was not made
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to the lender because it might have caused the refinancing to
fail.
There were no recorded minutes of any meetings of partners
of LKHP. On May 13, 1999, after decedent’s death, a certificate
of limited partnership was filed for LKHP with the California
Secretary of State.
3. LKHP Distributions
The partnership agreement provided for distributions of cash
at the sole discretion of Hillgren, as the general partner. From
January 1 through June 5, 1997, decedent received distributions
totaling $99,363. Hillgren did not receive any distributions
during this period. The distributions that were received by
decedent during 1997 were made specifically to enable decedent to
pay her living expenses, and she was dependent on the cashflow of
the partnership to cover her personal expenses.
LKHP also paid the costs of the estate. On March 5, 1998,
distributions in the amounts of $135,000 and $80,000 were made
from the partnership to the amended trust. The distributions
were applied to pay installments of decedent’s estate taxes due
to the Internal Revenue Service (IRS) and to the California State
Treasurer. From 1998 until 2002, distributions were consistently
made from LKHP to the amended trust to continue payment of
decedent’s estate taxes to the IRS and to the California
Franchise Tax Board.
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4. Management of the LKHP Properties
MSL Properties, Inc. (MSL), is a property management company
in Orange, California, with the same business address as
Hillgren. Debra Gates (Gates) is the president and registered
agent of MSL. Gates and decedent met in 1984 and became friends.
Decedent appointed Gates as an alternate under decedent’s durable
power of attorney for health care.
Since MSL was incorporated in 1986, MSL continuously managed
properties that were owned by Hillgren family entities. MSL had
approximately 12 clients in addition to LKHP, all of which were
related entities of the Hillgren family. The related entities
included, among others, the amended trust, Carl C. Hillgren,
Hillgren, Hillgren’s children, the Mark Hillgren Children’s
Trust, and Seaward. The duties that were performed by MSL
included property management, general office functions, and
bookkeeping. Gates worked with decedent in managing the
properties, and decedent would set parameters for Gates’s
responsibilities.
Prior to the formation of LKHP, MSL managed the seven LKHP
properties. In 1997, MSL continued to manage the LKHP properties
after the formation of LKHP. Gates understood that LKHP was to
continue using the Wells Fargo bank account, used previously by
Sea Shell and the amended trust, after the partnership commenced.
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To perform its bookkeeping duties, MSL gave each client an
individual company number in order to keep their books. The LKHP
properties were managed under “company number 50" prior to the
formation of LKHP. From January 1 through June 30, 1997, the
LKHP properties continued to be managed for LKHP under company
number 50. After formation of the partnership, the books
remained the same as before. Gates planned to make journal
adjustments for the partnership for “year-end tax return
purposes”.
5. LKHP’s Federal Tax Returns
For 1997, LKHP filed a Form 1065, U.S. Partnership Return of
Income (1997 return). The 1997 return reported no ordinary
income to LKHP. On LKHP’s Schedule K, Partners’ Shares of
Income, Credits, Deductions, etc., the partnership reported net
income from real estate activities of $93,304, depreciation of
$1,011, and distributions of $100,601. On LKHP’s Schedule K-1,
Partner’s Share of Income, Credits, Deductions, etc., filed for
the amended trust, as a partner, the partnership reported income
from rental activities of $93,257, depreciation of $1,010, and
distributions of $100,601. The amended trust was allocated a
99.95-percent interest in LKHP. The Schedule K-1 filed for
Hillgren reported income from rental activities of $47 and
depreciation of $1. The schedule of activities that was filed
with the 1997 return reported rental real estate income or loss
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associated with the seven LKHP properties as allocated to both
the amended trust and Hillgren, as reported on their respective
Schedules K-1. The partnership also filed a statement with the
1997 return notifying the IRS that it intended to file an amended
return.
For 1997, LKHP filed an additional Form 1065 as an amended
return (1997 first amended return). The 1997 first amended
return made an election to adjust the basis in the LKHP
properties under section 754. The Schedule K and Schedules K-1
remained the same as in the original return.
Also for 1997, LKHP filed an additional Form 1065 as an
amended return (1997 second amended return). The 1997 second
amended return was filed to correct the allocation of partnership
income as 75 percent to the amended trust and 25 percent to
Hillgren. The Schedules K-1 for the amended trust, and for
Hillgren, were adjusted for this change, showing that the amended
trust held a 99.0027-percent capital interest and a 75-percent
profit interest and that Hillgren held a .9973-percent capital
interest and a 25-percent profit interest. As a result, the net
income from real estate and the depreciation on the Schedules K-1
were reallocated accordingly. The reported distribution of
$100,601 to the amended trust remained allocated to the amended
trust on the Schedule K-1.
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For 1998, LKHP filed a Form 1065 (1998 return) with attached
Schedule K reporting net income of $389,124 and distributions of
$423,500. The 1998 return’s Schedule K-1 for the amended trust
reported allocations of $388,929 of income in accordance with the
99.95-percent profit interest and the entire amount of the
distribution. Hillgren’s Schedule K-1 reported $195 in income
and no distribution. Also for 1998, LKHP filed an amended
Form 1065 (1998 amended return). The 1998 amended return reduced
the net income to $320,369 and reported guaranteed payments to
partners of $68,755. The distribution remained unchanged.
Similar to the 1997 second amended return, the 1998 amended
return reported a corrected allocation of the 25-percent profit
interest to Hillgren. The income that was reported on the
Schedules K-1 was reallocated accordingly, but the amount of the
distribution to the amended trust remained the same.
For 1999, LKHP filed a Form 1065 and an amended Form 1065 to
report again the corrected allocation of the profits interest and
to report guaranteed payments to partners. For 2000 and 2001,
LKHP filed Forms 1065 with the correct allocation of the profits
interest, and no amended returns were filed.
Estate Tax Return
On August 28, 1998, the estate filed decedent’s Form 706,
United States Estate (and Generation-Skipping Transfer) Tax
Return (estate tax return). The estate provided financial
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statements and a summary of liabilities to Higgins, Marcus &
Lovett, Inc., who prepared the appraisal (Higgins appraisal) of
decedent’s interest in LKHP. The Higgins appraisal was filed
with the estate tax return.
The Higgins appraisal was conducted on behalf of the estate
by Thomas E. Higgins (T. Higgins), an Accredited Senior Appraiser
of the American Society of Appraisers, and by Mark C. Higgins
(M. Higgins), an Accredited Member of the American Society of
Appraisers. Both T. Higgins and M. Higgins specialize in the
business valuation discipline. The appraisal was dated June 22,
1998, but valued the partnership interest as of June 5, 1997.
The estate’s attorney, Richard Albrecht (Albrecht), instructed
the appraisers to value the interest as a limited partnership
interest. The Higgins appraisal reported that the fair market
value of decedent’s 99.95-percent limited partnership interest in
LKHP on June 5, 1997, was $2,266,000, after discounts for lack of
marketability and for lack of control. On the estate tax return,
decedent’s gross estate was reported as $2,543,378. On
February 3, 1999, respondent commenced an examination of the
estate tax return.
Examination
On February 4, 1999, the IRS sent an audit letter to Maurice
Polner, the accountant for the estate. On May 23, 2001, Hillgren
responded to questions that were posed by IRS estate tax attorney
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Jay Goldenberg (Goldenberg). Hillgren answered questions
regarding the BLA, LKHP, the appraisal of decedent’s interest in
LKHP, and a mortgage.
In response to questions regarding the BLA, Hillgren told
Goldenberg that he did not know when the BLA was signed and that
Walsworth drafted the agreement. Hillgren also told Goldenberg
that he complied with the requirements in the BLA to extend the
Huettner and Safeco loans. Hillgren stated that the only
document that encumbered the properties that were subject to the
BLA was the agreement itself. Hillgren stated that he took over
management control of the properties subject to the BLA but that
he also controlled the day-to-day management of decedent’s other
properties not subject to the BLA.
In response to questions that were posed by Goldenberg
regarding LKHP, Hillgren explained the purpose of forming the
partnership as “Lea suffered from depression. She did not have a
husband. She was dating a young guy. He was worried about his
motives and she was worried too. The Partnership served as an
asset protection.” Hillgren gave the same answer in response to
questions as to why they formed the partnership when Hillgren was
already managing decedent’s properties under the BLA. Hillgren
also stated that his rights under the BLA were senior to the
partnership agreement and that he gave his consent for the
transfer of the properties to LKHP.
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On August 24, 2001, a notice of deficiency was sent to the
estate. The notice increased the value of decedent’s interest in
LKHP. The notice determined decedent’s 99.95-percent interest in
LKHP to be valued at $4,526,740 based upon the undiscounted
values of the LKHP properties. The notice determined a
deficiency in the estate tax of $1,269,498. The increased
values, as determined in the notice, were not supported by
independent appraisals because LKHP was not recognized as a valid
partnership entity.
Value of the LKHP Properties as Agreed by the Parties
The parties have stipulated the undiscounted values of
decedent’s interest in the seven LKHP properties as follows:
Property Value
West Collins $1,285,000
Enterprise 1,093,787
North Main 975,000
University property 1,074,131
Manzanita 2,261
Crescent Bay 265,176
Railroad 115,711
Total $4,811,066
OPINION
Burden of Proof
Generally, under section 7491(a), in any court proceeding,
if a taxpayer introduces credible evidence with respect to any
factual issue, the burden of proof is shifted to respondent. The
burden shifts, however, only when the taxpayer has maintained all
records and has cooperated with reasonable requests by respondent
- 25 -
for witnesses, information, documents, meetings, and interviews.
Sec. 7491(a)(2)(B); see Higbee v. Commissioner, 116 T.C. 438,
440-441 (2001).
The parties dispute whether the burden shifts to respondent
in this case. The estate argues that respondent has the burden
of proof because the estate has satisfied all of the conditions
under section 7491. The estate contends that it responded by
fully cooperating with respondent’s requests for witness
interviews and by responding to numerous requests for information
and documents during audit. Respondent, however, argues that the
estate did not comply with the substantiation and record-keeping
requirement under section 7491(a)(2)(A) and that the estate did
not cooperate as required under section 7491(a)(2)(B).
Respondent also argues that the estate failed to introduce
credible evidence, stating, instead, that the estate has
introduced “evidence that is internally contradictory and
inconsistent, and not worthy of belief.”
We agree with respondent that the estate’s evidence was
sometimes inconsistent and that Hillgren had made inaccurate and
misleading representations prior to trial. There is no evidence,
however, that the testimony at trial was false or implausible.
Respondent often objected to the estate’s proposed findings of
fact on the ground that they are “biased and self-serving”. This
obvious comment is insufficient, without more, to contradict the
- 26 -
estate’s testimony. It is unnecessary, however, to prolong our
discussion of burden of proof. We decide the issues based on the
preponderance of the evidence.
Section 2036
We must decide whether the existence of LKHP will be
recognized for estate tax purposes. Respondent argues that the
value of the properties that were transferred to LKHP is
includable in decedent’s gross estate under section 2036(a). The
estate argues, however, that LKHP was a valid partnership, formed
under California law and created as a premarital asset protection
device.
Under section 2036(a), a decedent’s gross estate includes
the value of property interests transferred by the decedent
during his or her lifetime if the decedent retained for life the
possession or enjoyment of the property, or the right to the
income from the property, or the right to designate the persons
who would possess or enjoy the property or the income from the
property. The general purpose of section 2036(a) is to include
in a decedent’s gross estate transfers of property that are
“essentially testamentary in nature”. Estate of Ray v. United
States, 762 F.2d 1361, 1362 (9th Cir. 1985) (quoting United
States v. Estate of Grace, 395 U.S. 316, 320 (1969)). An asset
transferred by a decedent during his or her lifetime is included
in his or her gross estate unless he or she “absolutely,
- 27 -
unequivocally, irrevocably, and without possible reservations,
parts with all of his title and all of his possession and all of
his enjoyment of the transferred property.” Commissioner v.
Estate of Church, 335 U.S. 632, 645 (1949).
Under section 2036(a), a transferor retains the enjoyment of
the property transferred if there is an express or implied
agreement at the time of the transfer that the transferor will
retain the present economic benefits of the property, even if the
retained right is not legally enforceable. See Estate of
Reichardt v. Commissioner, 114 T.C. 144, 151 (2000); sec.
20.2036-1(a), Estate Tax Regs. In deciding whether there was an
implied agreement, the Court considers all of the facts and
circumstances surrounding the transfer and the subsequent use of
the property. See Estate of Reichardt v. Commissioner, supra at
151. Where the decedent conveys all or nearly all of his or her
assets to a trust or partnership, this may suggest an implied
agreement that the decedent can continue to use the assets. See
id. at 153. Section 2036 applies not only if a transferor
retains possession or enjoyment of property but also if a
transferor retains the right to income from the property. See
sec. 2036(a)(1); Estate of Reichardt v. Commissioner, supra at
153. Moreover, if a decedent’s relationship to the assets
transferred to a partnership remains the same after the transfer
as it was before the transfer, the value of the assets may be
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included in the decedent’s gross estate. See sec. 2036(a)(1);
Estate of Reichardt v. Commissioner, supra at 152.
Section 2036(a) does not apply if the transfer of property
was part of a bona fide sale in exchange for full and adequate
consideration. A bona fide sale is an arm’s-length business
transaction between a willing buyer and a willing seller. Estate
of Reichardt v. Commissioner, supra at 155.
The estate argues that there was no agreement, express or
implied, that decedent would retain the possession, control, or
enjoyment of, or the right to the income from, the partnership.
The estate contends that, because the partnership was in
existence for only 5 months at the time of decedent’s death,
there was not enough time to establish a pattern of history or
behavior from which respondent could imply an agreement.
Respondent contends that, shortly after decedent’s initial
suicide attempt, decedent executed her will, the amended trust,
and the LKHP agreement, thereby transferring substantially all of
her assets. Respondent argues that the practical effect of the
partnership was minimal because decedent continued to be the sole
economic beneficiary of the property that was contributed to the
partnership.
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1. Formation of LKHP as a Premarital Asset Protection
Device
The estate contends that the creation of LKHP was motivated
by legitimate business concerns and for premarital asset
protection. The estate further contends that decedent and
Hillgren negotiated the terms of the partnership agreement at
arm’s length under “adverse economic interests”.
First, with respect to the claim that the partnership served
as a premarital asset protection device, respondent notes that
decedent and her boyfriend broke up before her initial suicide
attempt and that it was unclear from the record whether they were
intending to get married. Respondent also notes that the estate
made inconsistent representations during discovery and during
trial as to whether decedent’s boyfriend was even aware of the
partnership. Respondent further argues that, as a premarital
asset protection device, the partnership agreement would fail
because decedent had the right to transfer her interest to a
spouse and had the power to approve a transfer to her spouse.
There is nothing in the language of the LKHP agreement
stating the reasoning behind the formation of the partnership.
The estate’s claim that the partnership served to protect
decedent’s assets from an impending marriage to O’Brien is
unsupported by the record. Title to the properties remained
solely in decedent’s name, potentially within the reach of a
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spouse. There is no evidence that O’Brien knew of the existence
of LKHP. The partnership was intended to be largely invisible.
Goldenberg testified that, during the examination of the
case, the estate did not mention that the partnership agreement
was intended as a “premarital tool”. The estate told Goldenberg
that the partnership served as an asset protection vehicle.
Goldenberg further testified that, if he had known of the
premarital reason for the partnership agreement, he would have
identified O’Brien to interview him. We are therefore not
persuaded by the testimony that LKHP was formed to provide
premarital asset protection.
Second, with respect to the estate’s claim that the
partnership was formed as a result of arm’s-length negotiations,
we are not persuaded that decedent and Hillgren acted at arm’s
length. The estate contends that Hillgren made a significant
contribution to the partnership, to wit, the services that he was
to provide to the partnership as a general partner with a
25-percent profit interest. The estate argues that decedent and
Hillgren bargained over what his profit interest would be in the
partnership. The estate claims that the negotiation between
decedent and Hillgren distinguishes this case from that of Estate
of Harper v. Commissioner, T.C. Memo. 2002-121, where the
decedent stood on both sides of the transaction. The record,
however, indicates that Hillgren was not only a general partner
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in the partnership but was also cotrustee of the amended trust
and a “lender” to decedent regarding the same properties that
were transferred to the partnership. At various times, Hillgren
signed his name on documents as trustee of both the original and
amended trusts, as vice president of Sea Shell, as an officer of
Seaward, and as general partner of LKHP. As a result, Hillgren
stood on every side of the transaction. The same lawyer
represented decedent and Hillgren with respect to the formation
of the partnership. In addition, the estate provided no
corroboration of the negotiation between decedent and Hillgren
regarding Hillgren’s interest. Hillgren ignored the terms of the
partnership agreement as it suited him. Further, because the
management functions did not change and were still performed by
MSL after the formation of the partnership, it is hard to believe
that Hillgren contributed sufficient services at the formation of
the partnership to warrant his 25-percent profits interest.
(This case is further indistinguishable from Estate of Harper v.
Commissioner, supra, as discussed below because of the
commingling of funds, the “egregious” disregard for the
partnership form, and the existence of post mortem accounting
manipulations.)
2. How Formation of LKHP Failed To Alter Decedent’s
Interest
In this case, neither decedent’s interest in the properties
that were transferred to the partnership nor legal title changed
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once the partnership was established. MSL provided the day-to-
day management services for the properties both before and after
the creation of the partnership. The tenants of the LKHP
properties were unaware of the supposed change in ownership.
Decedent continued to use Sea Shell’s bank account for the
partnership income, contracts and leases that were executed after
the formation of the partnership remained under Sea Shell’s name,
and bills remained in Sea Shell’s name. Representations were
made to third parties, including to a mortgage broker and a
lender during the Nordica refinancing, that decedent owned and
remained in control of the LKHP properties.
Hays also testified that decedent did not expect that the
partnership would change the relationship between decedent and
Hillgren or change decedent’s role in the management
responsibility for her property. Moreover, Hillgren told
Goldenberg during the examination that he took over management
control of the properties subject to the BLA and that he also
controlled the day-to-day functions of decedent’s other
properties. This arrangement did not change as a result of the
partnership agreement.
Respondent notes an apparent initial intent to transfer
decedent’s personal residence as shown in the partnership’s
financial statements, which were adjusted after decedent’s death.
The later adjustment was an attempt to reverse the initial
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commingling of funds between the partnership and decedent. See,
e.g., Estate of Reichardt v. Commissioner, 114 T.C. at 155.
Gates testified that she tracked the financial statements and
kept the accounting books for the partnership exactly as she had
for Sea Shell. No changes were made until after decedent’s
death. This testimony does not explain how the personal
residence was not a partnership asset. Instead, it demonstrates
the estate’s complete disregard for the formalities of financial
statements.
Based on the record as a whole, we reject the estate’s
claims that the partnership agreement changed any real
relationship between Hillgren and decedent or that it changed
decedent’s interest in the properties.
3. Distributions From LKHP
The estate admits that decedent received all of the income
distributed from the partnership in the 5 months preceding her
death. The estate further admits that decedent was dependent on
the cashflow from the partnership for her living expenses. The
estate claims that, presumably, Hillgren would have received cash
distributions as well if decedent had remained alive through the
end of the year. In addition, the estate claims that there was
no history of disproportionate distributions because the 5 months
of partnership distributions was too short to create a pattern.
Respondent argues that there was an implied agreement, as
- 34 -
demonstrated by the record, relating to the funding, operations,
and distributions of the partnership so that decedent retained
the right to the income of the partnership.
During 1997, decedent received $99,363 in distributions from
the partnership, and Hillgren received no distributions. When
questioned by the estate’s counsel, Hillgren described the
situation surrounding the disproportionate distributions as
follows:
Q Would you tell us about those cash distributions?
Were they disproportionate, and if so, why?
A To date, to her date of death, they were, in fact,
disproportionate. I took no distributions. She took
all of them.
Q And why did you distribute entirely to her, and
nothing to you?
A Well, in that I had a 25 percent--it was a
calculated number, and we didn’t have--obviously, the
books--we were only five months into the or six months
into the accounting year. We had no information as to
what my 25 percent would be.
Q Why didn’t you then withhold distributions to
either of you until those numbers could be calculated?
A Well, the distributions were discretionary on my
part. If we had erred, and distributed too much, for
example, it would have just gone against he--or would
gone into my--added to my capital account. So it would
have worked out in the end eventually, if we had made
that mistake, and overdistributed.
Q Well, let’s see if I understand it. Why did you
distribute anything to her?
A All of the--all of her income producing assets
were in the partnership. So her--that’s what she
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needed to live on. She wanted the income, or those
monies for living expenses * * *.
Hillgren’s explanation only underscores the intention to use
the partnership assets to support decedent. Further, it is not
apparent from the record that Hillgren would ever have received a
distribution from LKHP. Overall, the record shows that the
partnership distributions were intended to provide decedent with
her living expenses, further demonstrating that her relationship
to the LKHP properties remained the same after formation of the
partnership and that LKHP should be disregarded for estate tax
purposes.
4. Formality of the LKHP Agreement
Hillgren did not file a certificate of limited partnership
until respondent began examination of the estate’s return.
Striking features of LKHP were the lack of formality surrounding
the partnership, the intention of the parties to keep the
agreement largely invisible, the apparent disregard of the
agreement as situations arose, and the restatements of the
financial affairs by Hillgren and representatives of the estate.
Hillgren and Albrecht took advantage of apparent
inconsistencies in the partnership agreement regarding Hillgren’s
interest when reporting Hillgren’s interest on the estate tax
return and on the partnership tax returns. On the estate tax
return, the estate reported that Hillgren had a 25-percent profit
interest to increase the discount on the estate tax. On the
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other hand, on the partnership tax return, Hillgren reported a
.05-percent profit interest so more income from the partnership
could bypass him and go to the trust that provided for his
children. The discrepancy was not fixed until after the
examination of the estate tax return had begun. Hillgren then
caused amended partnership tax returns to be filed for 1997,
1998, and 1999.
During trial, Albrecht was questioned by respondent as to
why he took inconsistent positions on the estate tax return and
on the partnership return regarding Hillgren’s interest in the
partnership. Albrecht testified that, because decedent had died
and because the amended trust provided for disposition of her
estate to Hillgren’s children, the estate could essentially
disregard the provisions of the partnership agreement by
interpreting Hillgren’s partnership interest in a way that would
benefit his children and beneficiaries of decedent’s estate. The
income not allocated to Hillgren would not flow through the
partnership or subject him to income tax on the distributions and
ultimately would not pass through Hillgren’s estate.
Hillgren testified regarding the discrepancy on the returns
as follows:
Q Now, you heard counsel for respondent in his
opening statement mention the fact that in the 1997 tax
return for the partnership, your sister’s profit
interest was shown at 99.95 percent and yours was shown
at either zero, or .05 percent, instead of 25/75. Why
was that?
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A That was based on a misinterpretation of the
agreement by Rick Albrecht.
* * * * * * *
A He (Albrecht) advised me that he thought the
agreement could be read either way, that it was
confused.
Q Either way being what?
A With 25 percent of profits, and 25 percent of the
increased profits as one way. The other way was just
25 percent of increased profits.
Q But you knew better, didn’t you?
A Well, I had negotiated better, yes.
Q What did you know it to be?
A Well, that there was 25 percent, both 25 percents
apply. The 25 percent of operational profits, and the
25 percent of increased profits.
Q So that when Mr. Albrecht told you that in his
opinion it could be interpreted differently, why didn’t
you object?
A Well, he pointed out that the difference basically
goes--the 25 percent of operation profits would go to
my children. There’s an estate tax benefit in
interpreting it that way.
Q And so you accepted that?
A Yes, that was his advice at the time, and I
accepted it.
Hillgren further testified during cross-examination by
respondent’s counsel as follows:
Q Now, let’s talk about your meeting with
Mr. Albrecht. I think we said--I think you testified
in direct examination that when Mr. Albrecht told you
of his interpretation of the agreement, that there was
a conflict, and that the agreement was susceptible of
- 38 -
an interpretation whereby your profits interest was
limited to what the Section 3.4 provision said, i.e.,
25 of any post-‘96 increases, did you agree with that
interpretation?
A That was not how I had understood the document to
be, but he told me that that--it could be interpreted
that way, and that the benefits of using that
interpretation would be because basically that
25 percent would belong to my children, it would be
beneficial.
Q If Lea were still alive, and Mr. Albrecht had told
you that that was his interpretation, what would have
been your response?
A Oh, absolutely not. I mean, that would be
cheating money from Lea.
Q That would be what?
A That would be cheating her of money, of--
Q Cheating her, or cheating you?
A Well, it would be--yeah, I’m sorry, cheating me of
money.
* * * * * * *
Q So why did you go along with Mr. Albrecht’s
interpretation?
A He--well, first of all, Lea was dead, so it was
not an issue between she and I, it was basically an
issue between my children and I, and it would be
beneficial for my children to have that 25 percent, not
me.
The estate contends that Hillgren received “faulty legal
advice” that induced him to take advantage of an ambiguity in the
partnership agreement for a tax benefit. The estate further
contends that the faulty advice created the inconsistency between
the estate tax return and the partnership tax returns. Hillgren,
- 39 -
however, was sophisticated in real estate and business matters
and was aware that Albrecht was interpreting the partnership
agreement in a way that was incorrect. During trial, Hillgren
admitted that he knew better and that he had negotiated better,
yet he was willing to take the inconsistent positions on the
returns knowing that it would benefit his children and,
implicitly, that he would avoid or reduce tax on the
distributions.
Respondent also questioned why Albrecht instructed
M. Higgins to appraise the limited partnership interest as though
Hillgren had a 25-percent profit interest, although the
partnership tax returns were filed with a .05-percent interest.
Respondent’s questions related to a letter written by Albrecht to
Higgins, Marcus & Lovett, Inc., regarding how to appraise
Hillgren’s interest. Albrecht testified as follows:
Q You advised Mark Higgins to appraise the
partnership interest as though Mark Hillgren had a
25 percent profits interest in the partnership,
correct?
A Well, I don’t know if I did or not, or whether
I’m--
Q You can take a minute and look at the letter if
you need to.
A Well, I don’t know--I just don’t recall, I--this
letter is obviously written as a response to the report
that they had written and I would have to compare it to
the report to see what I actually recommended by this.
I--it’s obviously something that I had my office
type up, and I signed the letter, but I would have to
- 40 -
look at the report to compare it to what I was really
trying to accomplish here.
Albrecht’s explanation of his instructions was evasive at best
and further demonstrates the estate’s inconsistency with regard
to the partnership overall.
In addition, Hillgren and decedent had a history of
producing incorrect or incomplete financial records. Hillgren
and Gates both testified that Sea Shell’s balance sheets and
financial records had arbitrary and imperfect numbers. Hillgren
described financial statements that were produced by MSL in 1994
as follows:
They are strictly an arbitrary--they’re not based on
appraisal, they’re not based on cost, they’re not based
on anything other than an arbitrary--well, a
guesstimate, per foot value times the number of feet
for each location.
As the market collapsed in the early ‘90s, we did
not adjust these down. * * * [T]hey had been used for
external purposes.
Despite their inaccuracies, the balance sheets were used for
external purposes. They were provided to the lender during the
refinancing of the Nordica properties to show that decedent had
equity in the University property. For example, Sea Shell’s
balance sheet as of July 31, 1994, as provided to respondent
during the audit, represented that the value of the University
property was $4,287,500. The Safeco and Huettner loans were
shown on the balance sheet in the amounts of $1,260,419.03 and
$1,481,567.95, respectively. The balance sheet therefore
- 41 -
indicated that the University property had approximately
$1.5 million in equity. Hillgren represented in the BLA and
during trial, however, that the University property was
“underwater” because the debt exceeded the equity at the time
that Hillgren and decedent entered into the BLA.
5. Conclusion
The estate claims that decedent was “in excellent physical
health, on new antidepressant medication, and not contemplating
suicide” and that, therefore, the partnership was not an
alternate testamentary vehicle. The evidence contradicts this
claim. Shortly before her death, decedent attempted suicide, was
on various medications, was under the care of a psychiatrist, and
suffered from severe pain due to degenerative disc disease.
After her initial suicide attempt, LKHP was formed.
Decedent and Hillgren started many businesses over the years
and disregarded entities as they saw fit, making various
“situational representations”, i.e., statements about their
property ownership and values to support a then existing purpose,
without regard to accuracy. Even the stipulated facts contain
inconsistencies regarding entity names and dates of creation and
dissolution. The stipulations of the parties were often
contradicted by the documents that were provided by Hillgren.
Hillgren and the estate’s representatives continued to disregard
the LKHP agreement both prior to and after decedent’s death.
- 42 -
The value of the properties that were transferred to the
partnership is includable in decedent’s gross estate under
section 2036(a). The properties are included in the estate at
the fair market value on the date of decedent’s death, subject to
the effect of the BLA.
Valuation of the Properties
The parties have stipulated the undiscounted values of all
seven properties in which decedent had an interest. Three of the
properties, Manzanita, Crescent Bay, and Railroad, are not
subject to the BLA. The three properties will therefore be
included in the value of the estate at stipulated values of
$2,261, $265,176, and $115,711, respectively.
Property is included in the gross estate at its fair market
value, which 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 sell and both having reasonable
knowledge of relevant facts.” Sec. 20.2031-1(b), Estate Tax
Regs.; Estate of Newhouse v. Commissioner, 94 T.C. 193, 217
(1990). The determination of fair market value is a question of
fact. Estate of Newhouse v. Commissioner, supra at 217. During
trial, we received reports and testimony from expert witnesses.
We evaluate the opinions of the experts based on the
qualifications and reasoning of each expert and on all other
credible evidence in the record. See Estate of Jones v.
- 43 -
Commissioner, 116 T.C. 121, 131 (2001). We are not bound by the
expert opinions, and we may determine value based on our own
examination of the record. It is the responsibility of the
parties to instruct the experts of all the relevant facts that
might affect the valuation. Estate of Hall v. Commissioner, 92
T.C. 312, 338 (1989). If the parties fail to provide the experts
with complete information concerning material facts or reasonable
assumptions to be made, the reliability of the experts is
undermined. Prior to trial, respondent instructed his experts to
value the LKHP properties as if the BLA encumbered only the
University property. At the conclusion of testimony in this
case, the Court agreed with the estate’s contention that the
exhibits to the BLA were inadvertently switched and that the BLA
encumbered the Orange County properties as well as the University
property. The Court further concluded that the BLA did not
terminate at decedent’s death. Nonetheless, in the briefs,
respondent argues that the BLA should be disregarded, that the
BLA terminated at the death of decedent, that the exhibits to the
BLA were not mistakenly switched, and that the BLA encumbered
only the University property.
The estate contends that the BLA was: (1) A contract for
services provided by Hillgren who would facilitate the
forbearance and extensions of the Puccio, Huettner, and Safeco
loans; (2) a loan guaranty agreement where Hillgren agreed
- 44 -
personally to guarantee the Puccio and Safeco loans; (3) a loan
agreement where Hillgren extended a $1 million line of credit to
decedent; and (4) a security agreement encumbering the three
Orange County properties, giving Hillgren the authority, for
29 years, to determine whether to sell any of the four properties
subject to the BLA and to grant an irrevocable power of attorney
to Hillgren for the duration of the ownership of the properties.
Because Hillgren had performed under the agreement, he was
entitled to be compensated under it, regardless of the death of
decedent. We agree with the estate’s analysis.
Respondent contends that the BLA was superseded by the LKHP
partnership agreement, and the estate argues that the subject
matter of each agreement was separate. We have decided that the
partnership agreement was not respected by decedent or Hillgren
and will be disregarded. The BLA, however, had apparent business
purposes. Moreover, a hypothetical buyer would not disregard or
ignore the BLA. See Estate of Newhouse v. Commissioner, supra at
231; Estate of Hall v. Commissioner, supra at 338-339. As a
result, we value the University property and the Orange County
properties subject to the effect of the BLA.
The Higgins appraisal attached to the estate tax return
assumed, based on Albrecht’s erroneous instructions, that
Hillgren held a 25-percent operational interest and a .05-percent
profit interest. The Higgins appraisal essentially used the
- 45 -
existence of the BLA as a factor in determining the discounts to
apply to decedent’s partnership interest.
Carsten Hoffman, senior vice president of FMV Opinions,
Inc., of Irvine, California, prepared three appraisals for the
estate during trial preparation. The Hoffman appraisal relied on
information that was provided by Hillgren and by the estate’s
representatives and relied on the property values that were used
in the Higgins appraisal. The first report, dated February 22,
2002, appraised the value on June 5, 1997, of the Orange County
and University properties as subject to the BLA (Hoffman
appraisal). The other two appraisals valued partnership
interests that are irrelevant at this point in our analysis.
The Hoffman appraisal determined that, because of the BLA,
an investor in the real estate lacked control of and
marketability of the investments in the real estate. The report
compared these restrictions to those based on limited partnership
interests in real estate holding partnerships. The report also
applied additional discounts for lack of voting rights. The
Hoffman appraisal made the assumption that the BLA was “fully
transferable to a third-party upon giving notice and that the
* * * [BLA] remains in full force and effect upon such transfer”.
The Hoffman appraisal took into consideration that the exhibits
to the BLA were transposed. In addition, the Hoffman appraisal
- 46 -
considered that a hypothetical willing buyer would know of the
existence of the BLA.
Raynor Klaris (Klaris) and John A. Thomson (Thomson) of
Klaris, Thomson & Schroeder, Inc., prepared two appraisal reports
for respondent (respondent’s appraisal). Klaris has been in the
appraisal business since 1961 and is a Senior Accredited Member
of the American Society of Appraisers with a specialty in
business valuations. Thomson has been an appraiser since 1976
and received his Accredited Senior Appraiser designation in
business valuations and intangible properties in 1982. Thomson
is also a real estate appraiser. Both of respondent’s appraisals
assumed that the BLA affected only the University property and
not the Orange County properties. As in Estate of Hall v.
Commissioner, supra, although respondent’s experts were
qualified, they were hindered in their valuation by respondent’s
incorrect instructions regarding the effect of the BLA.
1. The University Property
The parties agree that the undiscounted value of decedent’s
interest in the University property is $1,074,131. Based on the
terms of the BLA, Hillgren held a 25-percent lender interest in
the net proceeds from sale or refinancing of the University
property. The Hoffman appraisal therefore reduced the value of
the University property by 25 percent to represent Hillgren’s
interest. Respondent’s appraisal also reduced the value of the
- 47 -
University property representing the 25-percent lender interest.
As a result, the value of the University property becomes
$805,598, the value to which the parties agree. The issue then
becomes whether any additional discounts should be applied for
lack of marketability, lack of control, or lack of voting rights.
The Hoffman appraisal compared the University property to
real property limited partnerships (comparable partnerships) with
revenues less than $3 million and with debt to total adjusted
capital greater than 20 percent. The discounts of the comparable
partnerships ranged from 24.7 percent to 57.8 percent and had a
median of 41.5 percent. The Hoffman appraisal also compared the
University property to comparable partnerships with net asset
values less than $10 million and with debt to total adjusted
capital greater than 20 percent. The discounts that were applied
for the comparable partnerships ranged from 28.3 percent to
56.9 percent and had a median discount of 43.9 percent. The
Hoffman appraisal also compared the University property to
comparable partnerships based on performance as measured by
distributions. The discounts for the comparable partnerships
ranged from 24.7 percent to 62.3 percent and had a median of
42.4 percent. In each of the three comparisons, the Hoffman
appraisal concluded that the University property was a less
attractive investment than the comparable partnerships.
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Taking into account the comparable partnerships, as well as
other factors regarding the University property’s marketability,
the Hoffman appraisal applied a combined discount for lack of
control and lack of marketability of 50 percent. The Hoffman
appraisal also applied a 5-percent discount for lack of voting
rights. The Hoffman appraisal therefore applied a total combined
discount of 55 percent to the University property in addition to
the discount representing the 25-percent lender interest. The
significant discount that was applied to the University property
was due in part to the high level of debt on the property.
Respondent’s appraisal used a discounted net asset value
approach and reduced the value of the University property by a
10-percent minority interest discount and a 35-percent discount
for lack of marketability. The minority discount was determined
by comparing the University property to closed-end equity funds
and real estate investment trusts and by taking into
consideration the effect of the BLA. The lack of marketability
discount was determined by comparing six separate independent
studies of restricted stock transactions. The discounts that
were applied by respondent’s appraisal allowed for an overall
combined discount of 41.5 percent. The estate’s brief points out
that respondent’s appraisal contains incorrect assumptions about
cashflow and the effect of the BLA.
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The estate’s suggested 50-percent discount for lack of
control and lack of marketability would not reduce the value of
the properties below the value reported on the estate tax return.
The estate is not seeking to establish a value less than that
reported on the estate tax return. The Hoffman opinion on
discounts is reasonable and is not contradicted by reliable
evidence. Thus we adopt it. See, e.g., Estate of Hall v.
Commissioner, 92 T.C. at 342.
2. The Orange County Properties
The Hoffman appraisal used a similar analysis for the Orange
County properties as it used for the University property, looking
to discounts for comparable partnerships. Therefore, the Hoffman
appraisal applied a 35-percent combined discount for lack of
marketability and lack of control on the West Collins property, a
35-percent combined discount on the Enterprise property, and a
40-percent combined discount on the North Main property. The
Hoffman appraisal also used an additional 5-percent discount for
lack of voting rights on each of the three properties.
Respondent’s appraisal did not discount the three Orange
County properties based on the effect of the BLA. Thomson
testified that, had he assumed that the BLA also encumbered the
Orange County properties, the Orange County properties would also
be discounted but at a different discount than that determined
for the University property. Thomson estimated discounts of
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30 percent on West Collins, 35 percent on North Main, and
30 percent on Enterprise. Because the difference between the
parties’ discounts on the Orange County properties is
insubstantial, we accept the estate’s discounts of 35 percent,
40 percent, and 35 percent for West Collins, North Main, and
Enterprise, respectively.
The estate’s experts suggest an additional discount of
5 percent for lack of voting rights. Thomson testified that an
additional lack of voting rights discount would be appropriate
between 2.5 percent and 5 percent and thus did not disagree with
the estate’s experts. Thus, we accept the 5-percent discount for
lack of voting rights.
Conclusion
We conclude that the properties in which decedent had an
interest should be valued and discounted in accordance with this
opinion, but not reduced below the value reported on the estate
tax return.
We have considered all of the remaining arguments made by
both parties for a result contrary to that expressed herein, and,
to the extent not discussed above, they are irrelevant or without
merit. To reflect the foregoing and to give effect to the
stipulations by the parties,
Decision will be entered
under Rule 155.