T.C. Memo. 2011-95
UNITED STATES TAX COURT
ESTATE OF ELLEN D. FOSTER, DECEASED, ASHLEY BRADLEY AND TARA
SHAPIRO, CO-EXECUTORS, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 16839-08. Filed April 28, 2011.
D. Douglas Metcalf, George L. Paul, and Hope E. Leibsohn,
for petitioners.
Christopher J. Sheldon and Shad M. Brown, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
COHEN, Judge: Respondent determined a deficiency in the
Federal estate tax of the Estate of Ellen D. Foster (the estate)
of $4,749,722. By amended answer, respondent asserts an
increased deficiency of $14,637,722.
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After concessions, the issues for decision are: (1) Whether
the estate is entitled to discount the value of certain assets in
the gross estate; (2) the value of claims held by the estate; and
(3) whether the estate is entitled to deduct its actual
litigation expenses for those claims.
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for 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. Ellen
Foster (decedent) resided in Arizona at the time of her death.
Ashley Bradley and Tara Shapiro (coexecutors) were appointed
coexecutors of the estate, and they also resided in Arizona at
the time the petition was filed.
Decedent’s husband, Thomas S. Foster (Mr. Foster), founded
Foster & Gallagher, Inc. (F&G), in 1951. F&G was in the mail-
order horticulture business and relied heavily on a sweepstakes
program as part of its direct mail advertising.
In 1991, Mr. Foster and F&G entered into a stock restriction
agreement (SRA) which required F&G, upon the deaths of decedent
and Mr. Foster, to purchase all of the F&G stock held by Mr.
Foster’s family group (family group). To ensure that F&G had the
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money to do so, the SRA required F&G to maintain life insurance
on the joint lives of decedent and Mr. Foster, payable after both
had died. F&G accordingly purchased and maintained $50 million
of paid-up life insurance (the life insurance). The SRA
prohibited F&G from borrowing against the cash surrender value of
or otherwise encumbering the life insurance and gave decedent or
Mr. Foster the right to purchase the life insurance if the family
group disposed of its F&G stock. Kavanagh, Scully, Sudow, White
& Frederick, P.C. (Kavanagh), represented both Mr. Foster and F&G
in the negotiation and drafting of the SRA.
In 1995, Mr. Foster and several other shareholders of F&G
decided to sell the majority of their stock to F&G’s employee
stock ownership plan (ESOP). In order to finance the ESOP’s
purchase of that stock (ESOP transaction), F&G borrowed
approximately $70 million on an unsecured basis (the ESOP loans)
from four institutional lenders (ESOP transaction lenders) and
lent the proceeds to the ESOP. In connection with the ESOP
transaction, F&G hired U.S. Trust Company, N.A. (U.S. Trust), as
the ESOP’s new trustee, and Mr. Foster agreed to indemnify U.S.
Trust against any loss arising from any misrepresentation or
breach of duty committed by Mr. Foster. On December 20, 1995,
the ESOP purchased 3,589,743 shares of F&G common stock at $19.50
per share. Mr. Foster received $33,120,789 for the 1,698,502 F&G
shares that he sold. Mr. Foster transferred the stock sale
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proceeds along with his remaining F&G stock to the Thomas S.
Foster Revocable Trust (Foster Trust).
Mr. Foster died on July 11, 1996. Upon his death, the
Foster Trust was divided into three trusts: Marital Trusts #1,
#2, and #3 (collectively, the Marital Trusts). Decedent was the
sole income beneficiary of the Marital Trusts during her life and
could withdraw any part of the principal of Marital Trust #3 at
any time. The trust instrument appointed Northern Trust Company
(Northern Trust) and decedent cotrustees of the Marital Trusts
and gave them the discretion to invade the principal for
decedent’s benefit.
In 1998, F&G began experiencing financial trouble on account
of negative publicity surrounding sweepstakes advertising
strategies such as the one F&G employed. F&G’s revenues and
earnings steadily declined, causing F&G to be in violation of the
financial covenants of the ESOP loans. Because the ESOP loans
were unsecured, the ESOP transaction lenders (which included
Northern Trust) sought to restructure the loans to gain a
security interest in F&G’s assets.
In February 1999, Northern Trust, as co-trustee of the
Marital Trusts, waived the SRA’s restrictions and allowed F&G to
borrow against the cash surrender value of the life insurance.
In September 1999, Northern Trust again waived the SRA
prohibition against encumbrance and assigned itself the life
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insurance as collateral for the ESOP loans. F&G also demanded
that decedent lend F&G approximately $6.8 million (the Founder’s
Loan). In order to make the Founder’s Loan, decedent borrowed
$6.8 million from Northern Trust, securing the loan with over $12
million worth of assets that she withdrew from Marital Trust #3.
Kavanagh represented and advised both decedent and F&G in
connection with all three of these transactions (the 1999
transactions).
As a result of F&G’s borrowing on the cash surrender value
of the life insurance, the life insurance ceased to be self-
funding. F&G filed for bankruptcy on July 2, 2001, and the life
insurance ultimately lapsed when F&G failed to pay the premiums.
On April 6, 2001, just before F&G’s bankruptcy filing,
beneficiaries of the ESOP (the ESOP plaintiffs) filed suit (the
Keach lawsuit) in the U.S. District Court for the Central
District of Illinois alleging breaches of fiduciary duty
committed by U.S. Trust and Mr. Foster (with decedent named as a
defendant as executrix of Mr. Foster’s estate) in connection with
the ESOP transaction. The ESOP plaintiffs also sought
restitution against decedent and Northern Trust as cotrustees of
the Marital Trusts and requested the imposition of a constructive
trust over the assets held by decedent as executrix of Mr.
Foster’s estate and co-trustee of the Marital Trusts. Kavanagh
represented decedent in the Keach lawsuit as well.
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To avoid potential liability to the ESOP plaintiffs for
distributions from the Marital Trusts, Northern Trust
unilaterally froze decedent’s right to withdraw the principal of
Marital Trust #3. However, despite the freeze, some of the
assets of Marital Trust #3 were sold at undiscounted prices.
On March 5, 2003, the District Court granted summary
judgment to decedent as executrix of Mr. Foster’s estate because
his estate was closed and therefore no judgment could be enforced
against her in that capacity. The District Court did leave open
the possibility that the ESOP plaintiffs could proceed with their
restitution claim against decedent as co-trustee of the Foster
Trust if the ESOP plaintiffs could establish that Mr. Foster had
committed a breach of fiduciary duty. However, on February 12,
2004, the District Court entered an order finding, among other
things, that Mr. Foster and U.S. Trust had committed no such
breach. The District Court entered a judgment on March 8, 2004,
and an amended judgment on April 23, 2004, in favor of all of the
defendants.
On April 9, 2004, the ESOP plaintiffs appealed to the Court
of Appeals for the Seventh Circuit. Decedent died on May 15,
2004, while that appeal was pending. On September 27, 2004,
coexecutors, as successor cotrustees of the Marital Trusts,
entered into a settlement agreement whereby the ESOP plaintiffs
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released their claims against the estate. On August 17, 2005,
the Court of Appeals affirmed the District Court’s judgment.
Shortly after decedent’s death, coexecutors met with
Kavanagh and Northern Trust on May 27, 2004, to discuss the
administration of the estate. Coexecutors were not informed of
the existence and lapse of the life insurance.
On June 4, 2004, upon being appointed coexecutors of
decedent’s estate, coexecutors hired the law firm Lewis and Roca,
LLP (L&R), to handle the probate of the estate. During the
course of administering the estate, coexecutors came to believe
that the work Kavanagh had done in planning decedent’s estate and
in representing decedent in the Keach lawsuit had been deficient.
By September 22, 2004, L&R had identified and begun investigating
potential claims against Kavanagh. By October 2004, coexecutors
had stopped paying Kavanagh’s legal fees. On November 12, 2004,
L&R discovered that the life insurance had lapsed during F&G’s
bankruptcy.
On June 13, 2005, Kavanagh filed a claim against the estate
for unpaid legal fees in the Superior Court of Arizona, Maricopa
County.
In July 2005, L&R began investigating the circumstances
surrounding the lapse of the life insurance, including Northern
Trust’s involvement. However, L&R quickly determined that a
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claim against Northern Trust would not be viable when on August
4, 2005, the attorney for the trustee of F&G’s bankruptcy estate
informed George Paul (Paul), an L&R attorney and coexecutors’
counsel in this case, that Northern Trust had decided against
reinstating or transferring the life insurance because the tax
consequences of doing so would be “detrimental and uneconomical”.
On the basis of that information, L&R concluded that a claim
against Northern Trust would be unsuccessful because Northern
Trust had a justifiable reason for allowing the life insurance to
lapse.
On August 12, 2005, a Form 706, United States Estate (and
Generation-Skipping Transfer) Tax Return, was filed on behalf of
the estate. On Schedule F, Other Miscellaneous Property Not
Reportable Under Any Other Schedule, of the return, the estate
reported:
THE DECEDENT WAS PREDECEASED BY HER SPOUSE, THOMAS S.
FOSTER. UPON MR. FOSTER’S DEATH ON JULY 11, 1996,
THREE MARITAL TRUSTS WERE FORMED UNDER THE THOMAS S.
FOSTER REVOCABLE TRUST DATED APRIL 15, 1994 * * *.
UNDER INTERNAL REVENUE CODE SECTION * * * [2056(b)(7)],
THE ASSETS OF ALL THREE MARITAL TRUSTS ARE INCLUDIBLE
IN THE ESTATE OF THE DECEDENT. * * *
The estate reported the following as assets of Marital Trust
#1 at the values set forth below:
Cash $12,862
Publicly traded securities 972,722
Accrued dividend on securities 969
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The estate reported the following as assets of Marital Trust
#2 at the values set forth below:
Cash $362,418
Publicly traded bonds 33,891,338
Accrued interest on bonds 515,367
Federal home loan bond 1,000,000
Shares of Foster & Gallagher, Inc. - 0 -
The estate reported the following as assets of Marital Trust
#3 at the values set forth below:
Cash $781,814
Publicly traded bonds 5,122,019
Accrued interest on bonds 73,645
Publicly traded securities 6,784,708
Accrued dividend on securities 6,190
Partnership interests in real estate funds 1,086,000
Shares of Foster & Gallagher, Inc. - 0 -
The estate also listed on Schedule F a “LIABILITY RELATED TO
LITIGATION AGAINST THOMAS S. FOSTER MARITAL TRUST” for each of
the Marital Trusts. The estate reported the value of these
“liabilities” as negative $286,100 for Marital Trust #1, negative
$10,373,046 for Marital Trust #2 and negative $4,017,769 for
Marital Trust #3 (collectively, the Marital Trust discount) based
on an appraisal performed by Lynton Kotzin (Kotzin), vice
president of Ringel Kotzin Valuation Services, on July 22, 2005.
Kotzin’s appraisal report (which was attached to the return)
determined a 29-percent Marital Trust discount attributable
solely to the hazards of litigation presented by the Keach
lawsuit. The estate did not report any potential claims against
Kavanagh or Northern Trust as assets of the estate.
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By August 30, 2005, the only claim against Northern Trust
being investigated by L&R was for negligently managing the
Marital Trusts. Paul, however, believed this claim to be “weak
and speculative.” He concluded that “Unless something jumps out
at us, it does not appear to be as economical an investment as
the * * * [claims] against Kavanagh.”
On September 6, 2005, coexecutors, individually and as
coexecutors of the estate, filed a counterclaim against Kavanagh
alleging that it had committed legal malpractice while drafting
decedent’s will and breach of fiduciary duty while representing
decedent in the Keach lawsuit. Coexecutors obtained a subpoena
for Northern Trust’s records of its administration of the Marital
Trusts and its loans to F&G and to decedent.
In October 2005, Robert McKirgan (McKirgan) joined the L&R
team investigating the estate’s claims against Kavanagh and
Northern Trust. McKirgan reexamined the encumbrance of the life
insurance but believed the estate did not have a viable claim
against Northern Trust because: (1) There were not enough facts
about what Northern Trust had or had not done; (2) decedent
apparently knew about and gave her informed consent to the
encumbrance of the life insurance; and (3) Mr. Foster had waived
Northern Trust’s conflict of interest by allowing Northern Trust
to remain successor co-trustee of the Marital Trusts after it had
become a creditor of F&G.
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L&R was finally able to assemble the estate’s claims against
Northern Trust when on November 16, 2005, Northern Trust produced
a memorandum (the memorandum) which L&R believed suggested that
Northern Trust had been concerned only with justifying the
encumbrance of the life insurance and had ignored its duty to
investigate the merits of the transaction and advise decedent as
to what rights she was surrendering. The memorandum also helped
L&R identify which of the documents that were already in the
estate’s possession were essential to proving the estate’s
claims.
On July 28, 2006, coexecutors met with Kavanagh and Northern
Trust to present the estate’s claims against them regarding the
1999 transactions. At this point, the claims were based on the
theory that Northern Trust and Kavanagh failed to advise decedent
to obtain independent legal and financial advice for the 1999
transactions. On August 23, 2006, coexecutors offered to settle
the estate’s claims against Northern Trust and Kavanagh
concerning the 1999 transactions for $19 million. On September
28, 2006, Northern Trust rejected coexecutors’ offer and claimed
it would be entitled to attorney’s fees because the estate’s
claims were “completely without merit”.
On October 27, 2006, coexecutors filed an amended
counterclaim which sought joinder of Northern Trust as an
additional defendant. In the amended counterclaim, coexecutors
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alleged, among other things, that Northern Trust had breached its
fiduciary duty as trustee of the Marital Trusts when it (1)
engaged in self-dealing by allowing decedent to give up her
rights to the life insurance in order to improve its position
from unsecured to secured creditor of F&G (the Life Insurance
Claim) and (2) facilitated decedent’s withdrawal of assets from
Marital Trust #3 to overcollateralize the loan it made to
decedent in connection with the Founder’s Loan (the Founder’s
Loan Claim). The estate sought compensatory damages, punitive
damages, emotional distress damages, disgorgement of Northern
Trust’s and Kavanagh’s fees, prejudgment interest, reimbursement
of costs, and reasonable legal fees.
In 2007, coexecutors, Kavanagh, and Northern Trust engaged
in court-ordered mediation. Northern Trust offered to settle the
case for $250,000, but coexecutors rejected that offer.
On or about January 29, 2007, the estate’s tax return was
selected for examination. On May 24, 2007, coexecutors informed
the Internal Revenue Service (IRS) of a potential additional
asset of the estate. The asset, consisting of the claims held by
the estate against Kavanagh and Northern Trust, was appraised on
September 25, 2007, by Philip M. Schwab (Schwab), senior vice
president of FMV Valuation & Financial Advisory Services. L&R
provided the IRS with Schwab’s appraisal report on September 27,
2007.
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On March 28, 2008, coexecutors settled the estate’s claims
against Kavanagh for approximately $850,000 (Kavanagh’s $1
million insurance limit minus litigation costs of approximately
$150,000).
On April 24, 2008, the IRS sent the estate a notice of
deficiency determining a deficiency of $4,749,722. The notice
stated:
The * * * [Marital Trust discount has] been disallowed
as the amounts are not “sums certain” and “legally
enforceable” at death. Estate of Van Horne v.
Commissioner, 83-2 USTC (CCH) 13,548, [720] F.2d 1114,
1116 (9th Cir. 1983) and Propstra v. United States, 680
F.2d 1248, 1254 (9th Cir. 1982).
Alternatively, the * * * [Marital Trust discount has]
been disallowed as vague and uncertain estimates that
are not ascertainable with reasonable certainty. IRC
§ 2053(a)(3) and Treas. Reg. § 20.2053-1(b)(3).
The notice did not determine a deficiency with respect to the
estate’s claims against Kavanagh and Northern Trust or disallow
attorney’s fees claimed to date as deductions with respect to
administering the estate. On July 8, 2008, a timely petition was
filed.
In April 2008, coexecutors filed a motion to compel in the
State court action which led to the production of hundreds of
documents that Northern Trust had claimed were privileged. L&R
believed these documents suggested that Northern Trust’s legal
department had concealed from its own trust department the fact
that Northern Trust’s lending department had deliberately
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disregarded Northern Trust’s conflict of interest arising from
its roles as co-trustee of the Marital Trusts and creditor of F&G
and decedent.
The trial of the estate’s claims against Northern Trust
began on October 22, 2008. On October 24, 2008, coexecutors
settled the estate’s claims against Northern Trust for $17
million plus the return of previously withheld trust funds.
On July 21, 2009, respondent filed an amended answer
asserting an increased deficiency of $14,637,722 attributable to
the estate’s claims against Kavanagh and Northern Trust, which
respondent valued in the amended answer at $20.6 million. No
adjustments were requested regarding attorney’s fees claimed as
deductions.
OPINION
The valuation issues in this case, as discussed below, are
to be decided as of the date of decedent’s death, May 15, 2004.
Differences between the parties focus in large part on the
reasonableness of the valuation positions of the parties in
appraising likely resolutions of litigation after the date of
death. Before discussing the applicable legal principles, it is
useful, therefore, to repeat the chronology of events relevant to
the valuation issues. The important dates are:
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Regarding Keach Lawsuit
Mar. 5, 2003 Summary judgment in favor of decedent as
executrix of Mr. Foster’s estate
Feb. 12, 2004 District Court finding in favor of defendants
Mar. 8, 2004 Judgment in favor of defendants
Apr. 9, 2004 Appeal filed
Sept. 27, 2004 Release of claims against the estate
Aug. 17, 2005 District Court judgment affirmed
Regarding Claims Held by the Estate
Sept. 22, 2004 Decedent’s counsel investigated and
identified potential claims against Kavanagh
June 13, 2005 Kavanaugh suit for unpaid legal fees filed
Aug. 12, 2005 Estate tax return filed without mention of
claim against Kavanagh or Northern Trust
Sept. 6, 2005 Counterclaim for malpractice and breach of
fiduciary duty against Kavanagh
Oct. 27, 2006 Amended counterclaim sought joinder of
Northern Trust as a defendant
Mar. 28, 2008 Kavanagh agreed to pay approximately $850,000
in settlement of estate’s claims
Oct. 24, 2008 Northern Trust agreed to pay $17 million in
settlement of estate’s claim and to return
withheld trust funds
As a general rule, the Internal Revenue Code imposes a
Federal tax “on the transfer of the taxable estate of every
decedent who is a citizen or resident of the United States.”
Sec. 2001(a). The taxable estate, in turn, is defined as “the
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value of the gross estate”, less applicable deductions. Sec.
2051. Section 2031(a) specifies that the gross estate comprises
“all property, real or personal, tangible or intangible, wherever
situated”, to the extent provided in sections 2033 through 2045.
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.’” Estate of Newhouse v.
Commissioner, 94 T.C. 193, 217 (1990) (quoting sec. 20.2031-1(b),
Estate Tax Regs.). The determination of fair market value is a
question of fact. Id.
I. Value of Marital Trusts
As a preliminary matter, the parties disagree as to whether
the burden of proof has been shifted to respondent under section
7491(a). The burden of proof is relevant only when there is
equal evidence on both sides: “In a case where the standard of
proof is preponderance of the evidence and the preponderance of
the evidence favors one party, we may decide the case on the
weight of the evidence and not on an allocation of the burden of
proof.” Knudsen v. Commissioner, 131 T.C. 185, 185-189 (2008).
The parties agree on the unencumbered values of the assets
of the Marital Trusts. The parties disagree as to whether the
estate is entitled to a Marital Trust discount consisting of (1)
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a discount for the hazards of litigation and (2) discounts for
lack of marketability and lack of control attributable to the
freeze imposed by Northern Trust. For purposes of trial,
coexecutors hired David M. Eckstein (Eckstein), managing director
of FMV Valuation & Financial Advisory Services, to reappraise the
Marital Trust discount. Eckstein determined the impaired value
of the Marital Trusts to be $34,200,000 based on (1) a 12.9- to
17.2-percent discount for the hazards of litigation presented by
the Keach lawsuit followed by (2) discounts of 4 percent for lack
of control and 15 to 20 percent for lack of marketability
attributable to the freeze imposed by Northern Trust. Thus,
coexecutors now claim a Marital Trust discount of approximately
32.4 percent.
A. Hazards of Litigation
The estate contends that it is entitled to discount the
values of the assets of the Marital Trusts because the ESOP
plaintiffs sought to impose a constructive trust over those
assets. The estate cites cases which it argues held that
litigation (or the threat of litigation) concerning an asset in
the gross estate justified discounting the value of the asset for
estate tax purposes: Am. Natl. Bank & Trust Co. v. United
States, 594 F.2d 1141 (7th Cir. 1979), Estate of Newhouse v.
Commissioner, supra at 218, Estate of Curry v. Commissioner, 74
T.C. 540 (1980), Estate of Sharp v. Commissioner, T.C. Memo.
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1994-636, Estate of Lennon v. Commissioner, T.C. Memo. 1991-360,
Estate of Henderson v. Commissioner, T.C. Memo. 1989-79, Estate
of Crossmore v. Commissioner, T.C. Memo. 1988-494, and Estate of
Cobb v. Commissioner, T.C. Memo. 1982-571.
The cited cases are distinguishable, however, because they
involved litigation that could have affected the rights of a
purchaser of the asset that was the subject of the litigation. A
willing buyer in such a situation would have refused to pay full
fair market value in light of the possibility that the buyer’s
rights in the asset could have subsequently been impaired.
In contrast, a willing buyer would not have insisted on a
discount on the assets of the Marital Trusts because the Keach
lawsuit could not have affected a buyer’s rights. See Estate of
Kahn v. Commissioner, 125 T.C. 227, 241 (2005). Moreover, the
District Court entered its amended judgment in decedent’s favor
on April 23, 2004. “Upon a final judgment or decree, a party
must seek a stay of judgment pending appeal to protect its
interest in the underlying property.” Duncan v. Farm Credit Bank
of St. Louis, 940 F.2d 1099, 1102 (7th Cir. 1991). The ESOP
plaintiffs did not do so. While rule 62(a) of the Federal Rules
of Civil Procedure as in effect at the relevant time provides for
an automatic 10-day stay of the judgment, that automatic stay
expired before decedent’s death. Since the ESOP plaintiffs did
not thereafter seek a stay under rule 62(d) of the Federal Rules
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of Civil Procedure, the assets of the Marital Trusts could have
been transferred at decedent’s death free and clear of the ESOP
plaintiffs’ claim for a constructive trust.
The estate contends alternatively, that if the Keach lawsuit
is not an impairment to the value of the estate under sections
2031 and 2033, then the Keach lawsuit instead constitutes a claim
against the estate entitling the estate to a deduction under
section 2053.
Section 2053(a) allows a deduction for claims against the
estate that are allowable by the laws of the jurisdiction under
which the estate is administered. Section 20.2053-1(b)(3),
Estate Tax Regs., as in effect for the date of death of decedent
provided:
An item may be entered on the return for deduction
though its exact amount is not then known, provided it
is ascertainable with reasonable certainty, and will be
paid. No deduction may be taken upon the basis of a
vague or uncertain estimate. * * *
Section 20.2053-4, Estate Tax Regs., provided:
The amounts that may be deducted as claims against a
decedent’s estate are such only as represent personal
obligations of the decedent existing at the time of his
death, whether or not then matured, and interest
thereon which had accrued at the time of death. * * *
Only claims enforceable against the decedent’s estate
may be deducted. * * *
Our decision in this case is appealable to the Court of
Appeals for the Ninth Circuit, and thus respondent relies on
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Propstra v. United States, 680 F.2d 1248, 1253 (9th Cir. 1982)
(stating that “The law is clear that post-death events are
relevant when computing the deduction to be taken for disputed or
contingent claims” (citing section 20.2053-1(b)(3), Estate Tax
Regs.)), and Estate of Van Horne v. Commissioner, 78 T.C. 728,
735 (1982) (in which we concluded that we consider postdeath
events in cases where the decedent’s creditor has only a
potential, unmatured, contingent, or contested claim that
requires further action before it becomes a fixed obligation of
the estate, but not where a claim is valid and fully enforceable
on the date of death), affd. 720 F.2d 1114 (9th Cir. 1983). See
Golsen v. Commissioner, 54 T.C. 742 (1970), affd. 445 F.2d 985
(10th Cir. 1971); see also Estate of Shapiro v. United States,
634 F.3d 1055 (9th Cir. 2011); Marshall Naify Revocable Trust v.
United States, 106 AFTR 2d 2010-6236, 2010-2 USTC par. 60,603
(N.D. Cal. 2010) (discussing the precedential weight of Propstra)
on appeal (9th Cir., Oct. 19, 2010). Respondent describes the
combined effect of those cases as holding “in the case of a
contingent claim, which is not certain and enforceable at the
decedent’s death, post-death events (such as a subsequent
settlement) should be taken into account.” The estate discounts
the Propstra rationale as dicta.
In Estate of Saunders v. Commissioner, 136 T.C. ___ (2011)
(slip op. at 20-23), we observed that courts appear to disagree
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on the extent to which events subsequent to the date of death may
be considered in determining the deductibility of a claim under
section 2053: the Courts of Appeals for the Eighth and Ninth
Circuits have directed that postdeath events be considered
whereas the Courts of Appeals for the Fifth and Tenth Circuits
have directed that postdeath events should not be considered.
See Estate of McMorris v. Commissioner, 243 F.3d 1254 (10th Cir.
2001), revg. T.C. Memo. 1999-82; Estate of Smith v. Commissioner,
198 F.3d 515 (5th Cir. 1999), revg. on this issue 108 T.C. 412
(1997); Estate of Sachs v. Commissioner, 856 F.2d 1158, 1160-1163
(8th Cir. 1988), affg. in part and revg. in part 88 T.C. 769
(1987); Propstra v. United States, supra. We declined to attempt
to reconcile these cases and did not consider the effect of a
post-death settlement of a claim against the taxpayer-estate
because we instead found that the value of the claim was not
ascertainable with reasonable certainty on the valuation date.
The taxpayer-estate had suggested several values for the claim,
and we considered the great differences in valuations to be a
prima facie indication of the lack of reasonable certainty. We
noted that the estate’s experts did not and could not reasonably
opine that any of the suggested amounts would be paid, as
required by the applicable regulation. We concluded that stating
and supporting a value is not equivalent to ascertaining a value
with reasonable certainty.
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Here, respondent alternatively determined in the notice of
deficiency that the value of the Marital Trust discount was not
ascertainable with reasonable certainty, and the estate has also
suggested inconsistent values that indicate a lack of reasonable
certainty. Kotzin, in the appraisal report included with the
return, determined a 29-percent discount for the hazards of
litigation presented by the Keach lawsuit. In the appraisal
report prepared for the trial of this case, however, Eckstein
determined only a 12.9- to 17.2-percent discount. The estate’s
experts thus differed on the effect of the Keach lawsuit by up to
$8.1 million. In addition, Kotzin altogether failed to evaluate
the lack of marketability and lack of control purportedly created
by the freeze. The sharp discrepancy in their figures evidences
a lack of reasonable certainty in the values they suggested.
Like the taxpayer’s experts in Estate of Saunders v.
Commissioner, supra, neither Kotzin nor Eckstein opined or could
reasonably opine that the amounts they suggested would be paid by
the estate. Indeed, at the date of death the Keach lawsuit had
been decided in favor of the defendants, although an appeal was
pending. The estate has therefore failed to establish the value
of the Marital Trust discount with reasonable certainty, as
required by the applicable regulation.
Thus, the estate is not entitled to a discount or a section
2053 deduction in connection with the Keach lawsuit.
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B. Lack of Marketability and Control
The estate contends that it is entitled to lack of
marketability and lack of control discounts on the assets of the
Marital Trusts on account of the freeze placed on Marital Trust
#3 by Northern Trust.
We agree with respondent, however, that the estate is not
entitled to discounts on the assets of the Marital Trusts. There
is no basis for discounts on the assets of Marital Trusts #1 and
#2 because the freeze was imposed only on Marital Trust #3.
Furthermore, the estate is not entitled to discounts on the
assets of Marital Trust #3 because the restrictions applied only
to decedent, not the underlying assets of the trust themselves.
When determining the value of a trust for estate tax purposes, we
determine the value of the underlying assets in a hypothetical
sale to a willing buyer. Estate of Kahn v. Commissioner, 125
T.C. 227 (2005); see also Rev. Rul. 2008-35, 2008-2 C.B. 116.
That the freeze may have prevented decedent from selling any of
the assets of Marital Trust #3 does not affect the value of those
assets; we must assume that such a sale would take place even if
it could not actually occur. Shackleford v. United States, 262
F.3d 1028 (9th Cir. 2001); Bank of Cal., N.A. v. Commissioner,
133 F.2d 428, 433 (9th Cir. 1943), affg. in part and revg. in
part Estate of Barneson v. Commissioner, a Memorandum Opinion of
the Board of Tax Appeals dated May 27, 1941. Moreover, the
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“freeze” was loosely enforced, and trust assets were in fact sold
at undiscounted prices. Thus, no discount is appropriate because
once a hypothetical buyer purchased the assets, he or she would
be unaffected by the freeze and would be able to resell the
assets at an undiscounted price.
Accordingly, the estate is not entitled to a discount for
lack of marketability or for lack of control.
II. Claims Held by the Estate
The estate held choses in action consisting of its claims
against Northern Trust and Kavanagh. The estate concedes it
improperly failed to report the choses in action as assets of the
estate but disputes respondent’s valuations.
Section 2031(a) provides that the value of a decedent’s
gross estate shall include “the value at the time of his death of
all property, real or personal, tangible or intangible, wherever
situated.” For purposes of determining the value of the gross
estate, the term “property” encompasses choses in action. See
generally Estate of Curry v. Commissioner, 74 T.C. at 545-546.
The contingent nature of a claim bears on the question of its
value, not on its includability in the value of the gross estate.
Id.
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
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credible evidence in the record. See Estate of Jones v.
Commissioner, 116 T.C. 121, 131 (2001). We are not bound by the
expert opinions, and we may determine a value based on our own
examination of the record. It is the responsibility of the
parties to instruct the experts on 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. In the context of valuation cases, we have observed
that experts may lose their usefulness and credibility when they
merely become advocates for the position argued by a party. See,
e.g., Laureys v. Commissioner, 92 T.C. 101, 129 (1989).
Respondent did not raise the issue of choses in action in
the notice of deficiency. Respondent raised it as a new matter
in the amended answer. Accordingly, respondent bears the burden
of proof on this issue. See Rule 142(a).
Respondent provided evidence as to the value of the claims
against Northern Trust but failed to provide any evidence of the
value of the claims against Kavanagh. Respondent submitted the
expert reports and testimony of Mark L. Mitchell (Mitchell) and
Mark E. House (House) regarding the value of the Life Insurance
Claim and the Founder’s Loan Claim. Mitchell’s report explicitly
states that “No analysis is provided of claims against Kavanagh
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or others.” Respondent therefore has failed to carry his burden
of proof as to any claims against Kavanagh.
Respondent relies on the reports of House and Mitchell and
Mitchell’s conclusion that the fair market value of the Life
Insurance Claim was $4,600,000 and the fair market value of the
Founders Loan Claim was $500,000, for a total valuation of the
claims against Northern Trust of $5,100,000 as of the date of
death. These values, however, rise or fall on House’s position
that a hypothetical purchaser of the claims would have
knowledge of all relevant facts that are reasonably
known. And these facts were reasonably known. And
yes, I mean I appreciate the fact that these guys put
together a huge jigsaw puzzle. But all of those pieces
were known even if they didn’t understand the legal
theories on how to put them together.
In his report, he assumes that the hypothetical purchaser would
have knowledge of all of the facts in Northern Trust’s files,
including specifically those discovered by the estate’s counsel
after time-consuming and contested discovery. We agree with the
estate’s characterization of respondent’s theory:
that any fact known or document possessed by any of the
relevant witnesses on date of death -- even if in the
possession of concealing parties like Northern Trust or
* * * [Kavanagh] -- should be imputed to hypothetical
actors on date of death. In essence, they become
omniscient of all relevant material.
Using House’s analysis, Mitchell values the claims as they
ultimately were refined over 2 years after the date of death with
a 50-percent probability of success. Respondent’s experts,
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however, ignore the intervening expenditures of time and money
investigating those claims in order to reach that level of
knowledge and assume that it was all “knowable” on May 15, 2004,
over 2 years before the claims were actually discovered by the
estate’s counsel.
Respondent argues that Mitchell’s use of a 50-percent-
likelihood-of-success assumption in his calculations is
“conservative” and favors the estate because the estate’s expert
used a 75-percent likelihood of success in his calculations.
That percentage, however, was the final number in the analysis of
possible outcomes and assumed that the litigation had proceeded
beyond various stages during which it might have been abandoned
or concluded without any recovery to the estate.
The estate’s valuation expert, Schwab, relied entirely on
information provided by McKirgan and Paul. The estate’s expert
valued the potential claims that were reasonably known and under
consideration at the date of death, specifically: (1) “The
possibility of seeking damages from the misdiagnosis of * * *
[decedent’s] medical condition”, (2) “the possibility of pursuing
redress against the lack of a hedge or other financial instrument
protecting the wealth of * * * [decedent] and her family from
failure of * * * [F&G]” (Financial Hedge Claim), (3) “the
possibility that the Kavanaugh [sic] law firm may have submitted
excessive billings related to the Keach litigation”, and (4) “the
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investigation and correction of any accounting errors related to
M[r]s. Foster’s business partnership with Mel Regal”.
The estate’s expert concluded that only the “Financial Hedge
Claim” had a positive value, found to be $43,474 before a 25-
percent marketability discount, leading to a final value of
$33,000. If this relatively minimal value had been placed on the
claims by the estate’s lawyers as of the date of death, however,
we do not believe that they would have pursued the claims. On
the contrary, we believe that at the date of death the estate’s
lawyers, as evidenced by their pursuit of the claims against
Kavanagh within a reasonable time after decedent’s death, had
reason to believe that the claims had substantial value.
Therefore, we reject Schwab’s conclusion as a reasonable estimate
of the value at which the claims would have been relinquished by
the hypothetical seller to a hypothetical buyer.
We are left with the conviction that neither side’s experts
in this case have provided an objective and reliable conclusion
and that they have each have engaged in “an overzealous effort
* * * to infuse a talismanic precision into an issue which should
frankly be recognized as inherently imprecise”. Messing v.
Commissioner, 48 T.C. 502, 512 (1967).
Schwab’s calculations assume a 99-percent probability of
abandonment of the claim after a preliminary investigation and an
80-percent probability of abandonment after a comprehensive
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investigation. We believe that these assumptions are not
reasonable and that the estate would not have proceeded past the
preliminary investigation stage if the chances of a favorable
outcome were less than 10 percent and would not have proceeded
past the comprehensive investigation stage if the chances of a
favorable outcome were less than 50 percent. By the time
coexecutors filed the amended complaint on October 27, 2006,
Northern Trust had refused to pay anything in relation to the
estate’s claims and had claimed that it would be entitled to
attorney’s fees if the litigation were pursued. Nonetheless, the
estate decided to pursue the claim and to invest the additional
resources necessary. At this point, Schwab incorporates a 75-
percent probability of success in his analysis. On consideration
of the methodology used by both valuation experts and adjusting
Schwab’s calculations to reflect (1) a 10-percent probability of
a successful preliminary investigation (instead of 1 percent),
(2) a 50-percent probability of a successful comprehensive
investigation (instead of 20 percent), (3) a 39.5-percent lack of
marketability discount (as determined by Mitchell), and (4) zero
estimated litigation costs (since, as discussed below, the estate
has claimed the actual costs of litigating its claims against
Kavanagh and Northern Trust), we arrive at our conclusion that
the fair market value of the claims against Northern Trust at the
date of death was $930,000.
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III. The Estate’s Actual Litigation Expenses
Section 2053 allows a deduction from the value of the gross
estate for administration expenses. Sec. 2053(a)(2).
Administration expenses include attorney’s fees. Sec. 20.2053-
3(a), Estate Tax Regs.
Respondent does not dispute that the expenses actually
incurred by the estate in litigating the claims against Northern
Trust and Kavanagh qualify as administration expenses within the
meaning of section 2053 and the regulations thereunder.
Respondent argues only that the estate should not be entitled to
deduct these expenses if the estimated cost of that litigation
has already been factored into the valuation of the choses in
action. Because we have not done so, there is no disagreement as
to the estate’s entitlement to deduct these administration
expenses.
Accordingly, the estate is entitled to deduct its actual
litigation expenses under section 2053. We have considered all
of the parties’ contentions, arguments, requests, and statements.
To the extent not discussed herein, we conclude that they are
irrelevant, moot, or without merit.
To reflect the foregoing,
Decision will be entered
under Rule 155.