United States Court of Appeals
Fifth Circuit
F I L E D
IN THE UNITED STATES COURT OF APPEALS
FOR THE FIFTH CIRCUIT July 11, 2005
_____________________
Charles R. Fulbruge III
No. 03-60855 Clerk
_____________________
Estate of JOHN L. BAIRD, Deceased,
Ellen B. Kirkland and J. Samuel
Baird, Co-Executors,
Petitioner - Appellant,
versus
COMMISSIONER OF INTERNAL REVENUE,
Respondent - Appellee.
*****************************************************************
Estate of SARAH W. BAIRD, Deceased,
Ellen B. Kirkland and J. Samuel
Baird, Co-Executors,
Petitioner-Appellant,
versus
COMMISSIONER OF INTERNAL REVENUE,
Respondent - Appellee.
_________________________________________________________________
Appeal from the Decision of the United States Tax Court
_________________________________________________________________
Before JOLLY and DAVIS, Circuit Judges, and ENGELHARDT, District
Judge.1
E. GRADY JOLLY, Circuit Judge:
The Tax Court held that the taxpayers, the estates of a
deceased husband and wife, were not entitled to an award of
administrative and litigation costs because the Commissioner of
1
District Judge of the Eastern District of Louisiana, sitting
by designation.
Internal Revenue (“IRS”) was substantially justified in taking the
position that the only discount allowable when valuing the
decedents’ non-controlling fractional interests in Louisiana
timberland was the cost of partitioning the property. The
taxpayers appeal, contending that the IRS did not meet its burden
of proving that its position was substantially justified. We
conclude that the Tax Court abused its discretion by finding that
the IRS’s position was substantially justified. Accordingly, we
REVERSE and REMAND for a determination of reasonable fees and
costs.
I
John L. Baird (“Mr. Baird”) died on December 18, 1994. His
estate included a 14/65 undivided interest in a Louisiana trust
that held 2,957 acres of timberland in 16 noncontiguous tracts in
Sabine Parish, Louisiana, ranging in size from one-half acre to
1,092 acres.2 Mr. Baird’s widow, Sarah W. Baird (“Mrs. Baird”),
died less than a year later, on November 2, 1995. Her estate
included a 17/65 interest in the same trust.
Mr. Baird’s estate filed its initial estate tax return on
March 18, 1996. His estate claimed a 25% fractionalization
2
The parties stipulated the fair market value of the undivided
fee interest in the 16 tracts at the date of Mr. Baird’s death and
at the date of Mrs. Baird’s death. The sole issue before the Tax
Court was the amount of discount to be applied because their
interests in the property were non-controlling, fractional
interests.
2
discount from the pro rata fair market value of his 14/65 interest
in the 16 tracts held by the trust.3
Mrs. Baird’s estate filed its initial estate tax return on
January 31, 1997. Her estate claimed a 50% fractionalization
discount from the pro rata fair market value of her 17/65 interest
in the 16 tracts held by the trust. On February 24, 1997, Mr.
Baird’s estate filed an amended estate tax return, and a claim for
a refund, using a 50% fractionalization discount for the 16 tracts.
The IRS issued notices of proposed adjustments on June 26,
1998, rejecting the estates’ claimed fractionalization discounts,
and setting forth the agency’s position that the only discount
should be the estimated costs of a hypothetical partition in kind.
That position was based on the report of an IRS forester, Robert
3
The standard for valuation of property in an estate is fair
market value, which is defined as “the price at which the property
would change hands between a willing buyer and a willing seller,
neither being under any compulsion to buy or to sell and both
having reasonable knowledge of relevant facts.” United States v.
Cartwright, 411 U.S. 546, 551 (1973). The standard is objective,
using a hypothetical willing buyer and seller, each of whom would
seek to maximize economic return. Estate of Jameson v.
Commissioner, 267 F.3d 366, 372 (5th Cir. 2001). Thus, the
hypothetical “willing seller” is not the estate itself. Estate of
Bonner v. United States, 84 F.3d 196, 198 (5th Cir. 1996).
A fractionalization discount accounts for the fact that the
sum of all fractional interests in property is worth less than the
whole. It also takes into account the restrictions on sale or
transfer of the property when more than one person or entity holds
undivided fractional interests in the property. “Potential costs
and fees associated with partition or other legal controversies
among owners, and a limited market for fractional interests and
lack of control, are all considerations rationally related to the
value of an asset.” Bonner, 84 F.3d at 197-98.
3
Baker. A copy of his report was attached to the notices of
proposed adjustments.
Concluding that there were no reliable market comparable
sales, Baker’s explanation for his opinion, relating to Mr. Baird’s
estate, is as follows:
Using the recommended full interest value for
the 2,957 acres of $4,685,331, a discount can
be determined using a cost of a revised timber
inventory, surveying the property into equal
valued “lots” and legal costs associated with
the partition of the property. Dividing the
property into 40 acre “lots”, or variations
thereof, and an estimated $1,000 per survey
mile results in survey cost[s] of $49,250. A
revised timber inventory would cost $8,871.
Legal cost, as recommended by the Estate
Agent, would approximate $100,000. The total
cost of partition would approximate $158,121.
Louisiana law cites all partition cost[s] are
borne in the pro-rata share of ownership.
Subtracting the partition cost of $158,121
from the recommended value of $4,685,331,
results in an after cost value of $4,527,210.
Mr. John Baird owned a 14/65th interest in the
property or a total recommended estate value
[of] $975,091.
Baker made similar calculations for Mrs. Baird’s 17/65 interest.
The estimated costs were equivalent to discounts of 3.37% for Mr.
Baird’s estate and 3.11% for Mrs. Baird’s estate.
In August 1998, the estates filed protest letters in response
to the notices of proposed adjustments. Attached to the protest
letters were expert reports responding to Baker’s analysis,
criticizing Baker’s use of transactions involving sales of
controlling interests, and explaining the risks and difficulties
involved with partitioning the 16 tracts. The protest letters
4
stated that, under the circumstances, any attempt to partition the
16 tracts would be vigorously resisted by the remaining co-owners.
The parties attended an Appeals Conference in Shreveport,
Louisiana, on October 20, 1998. At that conference, counsel for
the estates offered to settle for a 45% fractionalization discount.
That offer was not accepted.4
On February 24, 1999, the co-executors sent a letter to the
IRS Appeals Office repeating their offer to settle for a 45%
fractionalization discount. The letter stated that the offer would
remain open only until March 17, 1999, the day before the
expiration of the three-year limitation period for filing a notice
of deficiency. The IRS did not respond to this letter.
The IRS issued notices of deficiency on March 4, 1999. In the
notices of deficiency, the agency took the same position -- that
the only discount from fair market value should be the cost of
partitioning the property, based on Baker’s report. The notices of
deficiency sought to collect additional tax from each estate based
on valuation of the tracts at the exact amounts set forth in
Baker’s report.
4
At oral argument, counsel for both parties referred to a
purported statement by the Appeals Officer at the Appeals
Conference to the effect that he would try to obtain approval to
extend an offer to settle for a 20% discount. The Estates’ brief
filed in this court states, at page 17, without record citation,
that the Appeals Officer offered to settle for a 20% discount. We
have been unable to find any evidence in the record that the IRS
actually made an offer to settle for a 20% discount.
5
On March 18, 1999, Mr. Baird’s estate filed a second claim for
refund based on increasing the fractionalization discount from 50
to 60%. Mrs. Baird’s estate filed a claim for a refund on May 11,
1999, based on increasing the fractionalization discount from 50 to
60%.
On May 10, 1999, both estates filed in the Tax Court petitions
for redetermination of deficiencies. In its answers to the
petitions, the IRS asserted the same position it had asserted in
the notices of deficiency: that the only discount allowable was
the estimated cost of a hypothetical partition in kind, as
calculated in the Baker report.
An IRS Appeals Officer attempted to arrange another Appeals
Conference in Houston to discuss settlement of the valuation issue,
but the estates refused to authorize their counsel to attend unless
the IRS would first agree to a minimum fractionalization discount
of 45%. The IRS would not agree, and so the conference did not
take place. On the eve of trial, the IRS offered to discuss
settlement with counsel for the estates. According to the Tax
Court’s opinion, that discussion was futile because counsel for the
estates demanded a 70% fractionalization discount.
On April 13, 2000, a little over a month prior to trial, the
estates served on the IRS the expert witness reports of James A.
Young, Lewis C. Peters, and James C. Steele, III. All of these
reports contain a discussion of the costs, time, and risks involved
in a partition proceeding. Attached as an appendix to Peters’s
6
report is a report prepared by Edward Benjamin, a Louisiana
attorney, setting forth his opinion on the time, costs, and other
difficulties in obtaining a partition of property in Louisiana.
Another appendix to Peters’s report states that recently the IRS
had issued a Technical Advice Memorandum that stated a new position
by the IRS with respect to discounts for undivided ownership
interests in real estate: A discount for an undivided interest
will be limited to the petitioner’s pro-rata share of the estimated
cost of a partition of the property. Peters states that, in
arriving at this conclusion, the IRS was either unaware of or
ignored a significant body of data suggesting that the discounts
for undivided interests should be significantly higher than the pro
rata share of the estimated cost of partition.
At trial, the estates presented one fact witness and three
expert witnesses. The IRS offered Francis X. Burns as an expert
witness, but the Tax Court ruled that he was incompetent to testify
as an expert. Baker was listed as a witness for the IRS in its
trial memorandum and he prepared an expert witness report, but he
did not testify at trial and his report was not offered into
evidence at trial.
The Tax Court held that the estates had established 55% as the
average amount by which non-controlling fractional interests in
Louisiana timberland are discounted, and that an additional 5%
discount was appropriate in these cases due to peculiar
7
circumstances with respect to the decedents’ remaining family
members.
The estates moved for an award of reasonable litigation costs
and administrative expenses. The Tax Court denied the motion,
holding that the position taken by the IRS in the administrative
and judicial proceedings was substantially justified.
II
A
A prevailing party in a tax case may be awarded reasonable
administrative and litigation costs under 26 U.S.C. § 7430.
Generally, a prevailing party is one who has substantially
prevailed with respect to the amount in controversy or with respect
to the most significant issue or issues. 26 U.S.C. §
7430(c)(4)(A)(i)(I) and (II). However, “[a] party shall not be
treated as the prevailing party ... if the United States
establishes that the position of the United States in the
proceeding was substantially justified.” 26 U.S.C. §
7430(c)(4)(B)(i).
The IRS has the burden of establishing that its position was
substantially justified. 26 U.S.C. § 7430(c)(4)(B)(i); Maggie
Management Co. v. Commissioner of Internal Revenue, 108 T.C. 430,
437-38 (1997).5 The agency’s position is substantially justified
5
Prior to the effective date of the 1996 amendments, the
taxpayer had the burden of proving that the government’s position
was not substantially justified.
8
if it is justified to a degree that could satisfy a reasonable
person. Terrell Equipment Company, Inc. v. Commissioner of
Internal Revenue, 343 F.3d 478, 482 (5th Cir. 2003) (citing Pierce
v. Underwood, 487 U.S. 552, 565 (1988)). “It is not enough that a
position simply possesses enough merit to avoid sanctions for
frivolousness; it must have a reasonable basis both in law and
fact.” Lennox v. Commissioner of Internal Revenue, 998 F.2d 244,
248 (5th Cir. 1993). In the context of this case, the “position of
the United States” is the position taken by the IRS in the Tax
Court, and its position in the administrative proceeding is the
position asserted as of the date of the notices of deficiency. See
26 U.S.C. § 7430(c)(7); Nicholson v. Commissioner of Internal
Revenue Service, 60 F.3d 1020, 1027 n.11 (3d Cir. 1995). “Although
we must determine the Commissioner’s position as of the date of the
Notice of Deficiency ..., the Commissioner’s position on that date
must be viewed in the context of what caused the IRS to issue the
Notice of Deficiency.” Cervin, 111 F.3d at 1263.
In making the determination whether the IRS has satisfied its
burden of proving that its position was substantially justified,
the court examines the facts and legal precedents available at the
time the IRS took its position. Nalle v. Commissioner of Internal
Revenue, 55 F.3d 189, 191-92 (5th Cir. 1995). The court considers
all of the facts and circumstances surrounding the dispute to
determine whether the IRS knew or should have known that its
position was invalid. Id. “Of course, the ultimate failure of the
9
government’s legal position does not necessarily mean that it was
not substantially justified. It is, however, a factor to be
considered.” Lennox, 998 F.2d at 248; Nalle, 55 F.3d at 192
(Commissioner’s loss in underlying litigation not determinative,
but it is a factor). The Tax Court’s decision on substantial
justification is reviewed for abuse of discretion. Estate of
Cervin v. Commissioner, 111 F.3d 1252, 1256 (5th Cir. 1997).
“Thus, we reverse only if we have a definite and firm conviction
that an error of judgment was committed.” Nalle, 55 F.3d at 191
(internal quotation marks and citation omitted).
At the outset, we note that it is important to define the
IRS’s “position” during the administrative and court proceedings.
In its brief, the IRS distances itself from the specifics of
Baker’s report by asserting that the IRS position of a discount of
less than 25% was far more important than the actual 3% figure
asserted by the agency.6 Therefore, according to the IRS, the Tax
Court did not abuse its discretion by characterizing the IRS’s
“position” as being that partition was a viable alternative and
that the cost of partition would be less than the amount of the
discounts claimed by the estates.
6
At oral argument, counsel for the Government stated that the
agency’s position changed during the course of the administrative
and judicial proceedings, but she acknowledged that there is
nothing in the record to indicate any change in the Government’s
position. We note, however, that in its supplemental response to
the estates’ motion for an award of fees and costs, the agency
characterized its position as being “that there was a genuine issue
of fact regarding the valuation discounts asserted by petitioners.”
10
At one point in its opinion, the Tax Court states that the
IRS’s “position during the administrative proceeding was that the
only reduction or discount from the fair market value of the
trust’s real property should be the cost to partition the realty so
that the partitioned interest of each decedent could be converted
into and sold as a full fee interest.” Later in its opinion, the
Tax Court describes the IRS’s position as follows: “partition was
a viable alternative and that the cost of partition would be less
than the amount of the discounts claimed by the estates.” This
characterization is quite inconsistent with the record. The IRS
acknowledges in its brief that the reasonableness of its position
in the administrative proceedings must be determined as of the date
of the notice of deficiency. The valuation of the 16 tracts at
issue in the notices of deficiency is exactly the same amount
determined in the Baker report, which was attached to the notices
of proposed adjustments. In its post-trial brief, the IRS asked
the court to value the decedents’ interests in the 16 tracts at the
exact same amounts referenced in the Baker report and the notices
of deficiency. Thus, the record demonstrates that the position of
the IRS remained the same throughout the administrative and
judicial proceedings in this case: The only discounts allowable
were those determined by Baker in his report, based on the
estimated costs of a hypothetical partition in kind. As we have
noted, the IRS bears the burden of proving that this position was
substantially justified.
11
The Tax Court held that the IRS’s position was substantially
justified for the following reasons: (1) during the administrative
and pretrial proceedings, the estates did not present facts or
arguments to the IRS to discredit the IRS’s position that partition
was a viable alternative; and (2) the estates increased the amount
of discount claimed from 25% to 50%, from 50% to 60%, and from 60%
to 90%. We shall examine each of these bases separately.
B
(1)
The Tax Court held that because the estates refused to
authorize their counsel to attend a second Appeals Conference in
Houston after the estates filed their petitions, unless the Appeals
Officer agreed to a minimum discount of 45%, the estates failed to
present facts or arguments to the IRS to discredit the IRS’s
position that partition was a viable alternative. Thus, according
to the Tax Court, the IRS was not confronted with the facts
concerning the difficulties connected with the use of partition
until receipt of one of the estates’ expert’s reports approximately
30 days prior to trial; and the factual assumptions in that report
were not fully addressed until the estates’ witnesses testified at
trial. Accordingly, the Tax Court concluded that the IRS was not
confronted with the factual predicate that partition may not have
been a viable approach until trial.
The estates contend that the Tax Court was completely
mistaken. They assert that in their protests dated August 5, 1998
12
-- more than six months before the IRS issued the notices of
deficiency -- they objected to Baker’s partition analysis because
it was based on self-serving assumptions contrary to the facts and
lacked legal support; and they pointed out that if a hypothetical
willing buyer had attempted an actual partition of the 16
noncontiguous tracts, it would have been vigorously resisted by the
remaining co-owners. Attached to the protests were letters from
experts dated July 29 and July 31, 1998, summarizing substantial
difficulties involved in a hypothetical Louisiana partition
proceeding. The estates assert that the IRS was thus in possession
of this information well before it took its position. Furthermore,
the estates contend that the IRS has a duty to conduct a reasonable
investigation that would have revealed the flaws in its position
and is chargeable with knowledge of relevant judicial decisions.
Thus, the IRS knew or had reason to know of the difficulties
connected with the use of partition in these cases well before it
took its position.
The estates also contend that the Tax Court erroneously relied
on their refusal to attend a settlement conference in Houston.
They point out that they had already attended one appeals
conference in Shreveport on October 20, 1998, and had made a good
faith effort to settle with the IRS. They state that they
considered sending their counsel to Houston, but declined to do so
based on the assessment of their likelihood of success, the costs,
and no assurance of any meaningful concessions by the IRS. They
13
state that they nevertheless continued to correspond and negotiate
with the appeals officer by telephone, which resulted in settlement
of the vast majority of the other issues that were in dispute.
The estates contend further that the IRS, by relying on
Baker’s report, was attempting to recycle the “unity of ownership
for disposal” theory that this court rejected in Estate of Bright
v. United States, 658 F.2d 999 (5th Cir. 1981) (en banc), insofar
as it sought to apply family attribution. They maintain that
implicit in Baker’s opinion that Mr. Baird’s interest in the 16
non-contiguous tracts could be easily partitioned into equally
valued lots is the assumption that co-owners will cooperate such
that a partition in kind would be voluntary or uncontested. In
Baker’s theoretical partition in kind, all of the co-owners act as
a unit for purposes of disposing of all 16 tracts and share the
partition costs pro rata. The estates argue that Louisiana law
does not provide that attorneys’ fees or other costs of partition
will be apportioned pro rata among the co-owners when the partition
is contested. The estates assert that, under Bright, the interests
of Mr. and Mrs. Baird’s relatives are irrelevant in determining the
value of their estates’ interests; the fact that Mr. and Mrs. Baird
were married to one another and related to the other beneficiaries
of the trust and the trustees is irrelevant; the fact that Mr.
Baird’s interest passed at his death to other family members is an
irrelevant, post-death fact; a hypothetical seller and buyer must
be used, not Mr. Baird or his estate or the trustees; a
14
hypothetical buyer is deemed to be aware of the identities of the
other co-owners and that they are all members of the same family;
and Mr. Baird’s 14/65 interest is viewed as a stand-alone, non-
controlling interest, and Mrs. Baird’s 17/65 interest is viewed
likewise.
The IRS responds that it justifiably relied on Baker’s report,
that it had no duty to conduct an independent investigation into
the viability of partition prior to issuing the notices of
deficiency, and that it is not unreasonable for the agency to
require a taxpayer to submit documentation in support of its
position and for the IRS to refuse to concede the case until the
taxpayer produces such documentation. It argues that the estates
failed to provide any detailed or specific facts in support of
their contention that partition would be impracticable.
Our study of the record leads us to conclude that the Tax
Court abused its discretion by determining that the IRS satisfied
its burden of proof of substantial justification for its position.
The Tax Court based its determination on the argument that the IRS
received insufficient information from the estates with respect to
the viability of partitioning the 16 tracts at issue. We shall
therefore describe the information provided by the estates in some
detail.
(2)
Mr. Baird’s initial estate tax return, filed on March 18,
1996, reported the value of his 14/65 interest in the 16 tracts
15
held by the trust as $707,972. In support of that valuation, the
return included an appraisal report that contained an opinion as to
the fair market value of the undivided fee interest in the 16
tracts held by the trust, and then applied a 25% discount for Mr.
Baird’s fractional interest. The appraisal report explains that
the fair market value of an undivided interest in timberland is
generally less than the pro rata portion of the fair market value
of the whole as a result of the lack of marketability and the lack
of control over the management of the property. The appraisers
estimated a 25% discount for the 16 tracts at issue based on the
fact that a minority owner of timberland cannot force the sale of
the timber and marketing of timberland has a relatively high degree
of difficulty which is compounded by a minority interest. In
support of their estimate of the 25% discount, they cited and
attached copies of two cases: Estate of Cervin v. Commissioner, 68
T.C.M. 1115 (1994) (allowing 20% discount for minority interest and
lack of marketability for decedent’s 50% undivided community
interest in four parcels of real estate) and Lefrank v.
Commissioner, 66 T.C.M. 1297 (1994) (allowing 20% discount for
minority interest and 10% discount for lack of marketability). The
25% discount was an average of the discounts allowed in those two
cases.
Also attached to Mr. Baird’s estate’s initial tax return was
a supplemental statement containing additional information about
the valuation of the 16 tracts and the justification for claiming
16
a 25% fractionalization discount. The statement cites this court’s
decision in Bright, for the proposition that the valuation of Mr.
Baird’s interest should be determined as if it were being purchased
by a hypothetical willing purchaser. The statement asserts that an
in-kind partition of the property could only be accomplished with
the unanimous consent of all remaining co-owners and the co-
trustees of the trust, and that, under the circumstances, the
likelihood of an in-kind partition is so remote as to be
negligible. It asserts that a hypothetical willing purchaser of
the 14/65 interest, who chose to receive his pro rata share of
distributions from timber cutting, would likely discount the price
by substantially more than 25% because he would have no right to
enter into timber cutting or other agreements without the joinder
of the other co-owners. Finally, the statement lists the
considerations that would have to be taken into account by a
hypothetical willing purchaser who chose to file a lawsuit to force
a partition by licitation (sale of the entire property at a
sheriff’s sale).
A copy of the trust agreement for the trust holding the 16
tracts was also attached to Mr. Baird’s initial estate tax return.
The trust agreement provides that any transfer of trust property
shall be made only to a principal or income beneficiary of the
trust unless written consent is given by all current beneficiaries
for sale to a third party. It provides further that any sale or
17
transfer of trust property is subject to the terms and conditions
of the trust.
Mrs. Baird’s initial estate tax return, filed on January 31,
1997, and Mr. Baird’s amended estate tax return, filed on February
24, 1997, claimed a 50% fractionalization discount from the pro
rata fair market value of each of their interests in the 16 tracts
held by the trust.
In support of the 50% discount, both returns attached a
supplemental statement and an appraisal by James A. Young. The
supplemental statement asserts that a 50% discount is appropriate
based on lack of control. It asserts further that the likelihood
of an in-kind partition is so remote as to be negligible. The
statement explains that the 25% discount claimed in Mr. Baird’s
original return was based on an appraisal which did not take into
account any actual comparable transactions, but was instead an
average of discounts allowed in the two cases cited in the
appraiser’s report.
Young’s report described transactions involving the
acquisition of non-controlling fractional interests in Louisiana
timberland from August 1992 through August 1996. The transactions
analyzed by Young reflected that the fractionalization discounts
were much larger for sales of non-controlling interests (sales in
which the purchaser’s interest after acquisition was less than 80%)
than for sales of controlling interests (sales in which the
purchaser’s interest after acquisition equaled or exceeded 80%).
18
In August 1998, the estates filed a protest letter in response
to the IRS’s notices of proposed adjustments. The protest letter
observes that at a March 27, 1998 meeting -- before the date of the
Baker report -- the IRS examining agent’s supervisor, Frederick J.
Herzog, insisted that all fractionalization discounts are invalid.
The letter states that Herzog persisted in that belief even after
the estates’ counsel cited several cases in which such discounts
were allowed and approved by the courts. The protest letter points
out that, under Louisiana law, a buyer of timberland from a co-
owner or co-heir may not remove the timber without the consent of
co-owners representing at least 80% of the ownership interest in
the land and quotes the relevant Louisiana statute in its entirety.
The protest notes that Baker’s report ignores the fact that, at the
time of the decedents’ deaths, no co-owner had a large enough
interest in the 16 tracts to obtain the legal right to cut timber
by purchasing either decedent’s interest. The protest discusses
case law in which large fractionalization discounts were allowed,
and it quotes at length from a Ninth Circuit case that discusses
the difficulties of partition. The protest points out that Baker’s
approach is based on speculation about the costs of partition; and
that no empirical data is offered to support any of his assumptions
regarding the costs of a Louisiana partition proceeding. It notes
that Baker’s reliance on the Estate Agent for his assumption that
the legal costs of a partition proceeding would be $100,000 is
unfounded, and questions whether the Estate Agent has the knowledge
19
or experience to make such an estimate. The letter cites Tri-State
Concrete Co., Inc. v. Stephens, 395 So.2d 894 (La. App. 2d Cir.
1981), as an example of the Louisiana partition process. Finally,
the letter states that Baker’s opinion that the tracts could easily
be partitioned into “equal valued lots” is unfounded, as well as
contrary to the facts and judicial experience regarding Louisiana
partitions. It states that, “[u]nder the circumstances of this
case any attempt to partition the sixteen (16) tracts in question
would have been vigorously resisted by the remaining co-owners.”
Attached to the protest letter were letters from two of the
estates’ experts, Lewis C. Peters and James A. Young, commenting on
Baker’s report. Young’s letter discusses the difficulties and
risks involved in a partition proceeding. He states that the fact
that the timberland has varying road frontages and varying timber
volumes and different land qualities makes it most difficult to
assume that one could divide the tracts acre per acre. Although a
division of value would be more reasonable, a very extensive tally
of timber would be required, as well as complete surveys of the
property. According to Young, this would be a very time-consuming
process requiring numerous experts to include surveyors,
appraisers, foresters, legal counsel, etc.
Peters’s letter states that, while an owner would consider the
partition alternative, including the uncertainty, time, and cost,
it is “quite another thing to think that the hypothetical willing
20
buyer would wade into such a fracas with the sellers’ relatives
only to be reimbursed his out-of-pocket costs.”
Finally, the Tax Court’s opinion in which it allowed the 60%
discount states that the facts available to a hypothetical
knowledgeable buyer, which should be factored into the discount,
include (1) that the family had experienced prior disagreement
which precipitated the creation of the trust; and (2) that one
family member had been allowed to independently manage the 16
parcels and that his management was poor. The Tax Court stated
that these circumstances, that would have been perceived by a
willing buyer, indicate that the remaining family members would be
resistant to and make it difficult for an outside buyer. If these
facts were available to a knowledgeable buyer, it is obvious that
they were equally available to the IRS at the time it took its
position based on Baker’s report.
(3)
Based on the foregoing, it is clear that, before the IRS
issued the notices of deficiency, the estates had provided enough
information to the IRS to alert it to the fact that the in-kind
partition described in the Baker report was not viable, and that
his estimate of the costs of a hypothetical partition in kind was
speculative and unsupported. The IRS has a duty to examine the
information provided by taxpayers and to make some effort to
substantiate a demand for payment of additional taxes in a notice
of deficiency. See Estate of Johnson v. Commissioner of Internal
21
Revenue, 985 F.2d 1315, 1319 (5th Cir. 1993); Portillo v.
Commissioner of Internal Revenue, 988 F.2d 27, 29 (5th Cir. 1993)
(holding that Tax Court abused its discretion in denying costs
where notice of deficiency “lacked any ligaments of fact” and was
issued on the basis of an unsubstantiated and unreliable 1099
Form); Lennox, 998 F.2d at 248 (IRS’s suspicion regarding ownership
of apartments “was not a sufficient basis for issuance of the
notice [of deficiency], in light of the opportunity for further,
and much needed, investigation”); Nicholson, 60 F.3d at 1029
(holding that IRS could have discovered that its position was not
justified had it “adequately investigated the case before issuing
the Notice [of deficiency]”). The IRS cannot merely rely on an
expert’s opinion, especially when that expert’s opinion is
unfounded and speculative. See Minahan v. Commissioner of Internal
Revenue, 88 T.C. 492 (1987) (IRS’s “assertion that the litigation
position was reasonable solely because valuation is a factual
inquiry and that the valuation herein was based on an expert
appraisal is woefully inadequate to establish that his position is
reasonable”) (cited with approval by this court in Cervin, 111 F.3d
at 1263).
Furthermore, the IRS is charged with knowledge of relevant
legal authorities. See Cervin, 111 F.3d at 1262 (observing that
this court and other circuits have held that IRS’s position was not
substantially justified when it ignored state law that clearly
supported taxpayer’s position); Bouterie v. Commissioner, 36 F.3d
22
1361, 1372-73 (5th Cir. 1994) (rejecting IRS’s position where it
deliberately ignored settled law); Nicholson, 60 F.3d at 1029
(noting that “[e]ven a cursory analysis of New Jersey law would
have revealed the deficiency in [the Commissioner’s] position”).
The estates had furnished citations to relevant authorities to
the IRS to support their claimed discounts long before the notices
of deficiency were issued. Thus, the IRS is charged with the
knowledge that in Bright, this court rejected the family
attribution doctrine. Accordingly, it is charged with the
knowledge that Baker had no basis for assuming that the co-owners
would cooperate and voluntarily agree to a partition in kind
because they were all members of the same family. The IRS is also
charged with knowledge of this court’s decision in Bonner. In
Bonner, we said:
[C]ourts have consistently recognized that the
sum of all fractional interests in a property
is less than the whole and have upheld the use
of fractional interest discounts in valuing
undivided interests. The discount is an
acknowledgment of the restrictions on sale or
transfer of property when more than one
individual or entity hold undivided fractional
interests. Potential costs and fees
associated with partition or other legal
controversies among owners, along with a
limited market for fractional interests and
lack of control, are all considerations
rationally related to the value of an asset.
Bonner, 84 F.3d at 197-98 (citations omitted; emphasis added).
This case makes clear that the costs of partition are only one
among many considerations in valuing fractional interests in
23
property. Therefore, Bonner alerts the IRS to the incorrectness of
Baker’s report, which took the position that the costs of partition
were the sole discount allowable.
Finally, the IRS is charged with knowledge of Louisiana law
relating to the partition of real property. The case cited in the
estates’ protest letter in August 1998 further undermines Baker’s
opinion regarding the viability of partitioning the 16 tracts. See
Tri-State Concrete, 395 So.2d at 897-97 (stating that to effect
partition in kind, property must be divided into lots, which are
then drawn for by the parties by chance; that there must be as many
lots as there are shares or roots involved; and describing the
difficulty of dividing real property into tracts of equal value,
and the need for expert testimony and extensive survey work to
accomplish such a division).
Moreover, it is apparent that the IRS had locked into its
story and was sticking to it. Even after the trial -- when the IRS
had in its possession all of the evidence supporting the discounts
claimed by the estates, and all of the evidence demonstrating that
partition of the property was not feasible -- the IRS persisted in
maintaining an unjustifiable position that the property should be
valued at the amounts calculated in the Baker report. In its post-
trial brief, the IRS continued to argue that partition could be
accomplished easily and that no fractionalization discount was
warranted in this case.
24
The Tax Court therefore abused its discretion by accepting the
IRS’s argument that its position was substantially justified
because the estates failed to furnish detailed information about
the risks and difficulties of partition. This justification would
make sense only if the IRS had changed its position after it
received the information we have detailed above. Its post-trial
brief demonstrates that it did not change its position after it
came into possession of the information. Therefore, the evidence
offers no support for an assumption that the IRS would not have
issued notices of deficiency, and would not have maintained its
position that no fractionalization discount was warranted, even if
it had in its possession all of the evidence presented by the
taxpayers at trial.7
C
The second justification relied on by the Tax Court in finding
that the IRS’s position was substantially justified is the fact
that the estates increased the amount of discount claimed from 25
7
Without commenting on its relevance, we granted the estates’
motion to supplement the record on appeal with a copy of Baker’s
report of May 28, 2004, in which he cited the Tax Court’s opinion
in the case before us, but nevertheless proposed to allow only a
4.59% discount from the fair market value of the 9.23% interest in
the same 16 tracts owned by Mrs. Baird’s now-deceased brother, O.
E. Williams. His report also states that such a partition would
take less than one year to complete. The estates argue that,
notwithstanding the Tax Court’s decision in this case that a 55%
fractionalization discount is the average for non-controlling
interests in Louisiana timberland, Baker’s report will force
Williams’s estate to litigate the same issue that the Tax Court has
already decided in these cases. A time comes when even the most
tenacious should recognize a losing position and act in good grace.
25
to 50%, from 50 to 60%, and from 60% to 90%, with each claimed
discount supported by expert opinion. The Tax Court cited
authority for the proposition that values or discounts reported or
claimed on an estate tax return may be considered admissions and to
some extent binding or probative and may not be overcome without
proof that such admissions are wrong. See Estate of Hall v.
Commissioner, 92 T.C. 312, 342 (1989); Estate of Pillsbury v.
Commissioner, T.C. Memo. 1992-425; Estate of McGill v.
Commissioner, T.C. Memo. 1984-292. It stated that the estates had
failed to demonstrate that any facts or legal principles changed
between the time the 25% discount was claimed and the time the 90%
discount was claimed.
The estates contend that the Tax Court erred by focusing on
the estates’ position, which is irrelevant to whether the IRS met
its burden of proving substantial justification for its position
that the estates were entitled to discounts of only 3.37% and
3.11%. Because the IRS’s position was based on Baker’s report, the
estates contend that the relevant inquiry is whether the grounds
described in Baker’s report were sufficient to establish that the
IRS acted reasonably at the time it took its position. They
maintain that Baker made numerous unsupported assumptions in his
hypothetical partition valuation and offered no factual or legal
support for them.
The estates explain that when they filed Mr. Baird’s original
return, they did not have an appraisal showing the proper amount of
26
fractionalization discount, and the report filed with the return
estimated a 25% discount based on an average of discounts allowed
in two court decisions. Subsequently, they hired an expert whose
original report stated that 50% discounts were appropriate; his
report provided the necessary support for the 50% discount claimed
in Mrs. Baird’s estate tax return and Mr. Baird’s amended return
and first claim for refund. According to the Tax Court’s opinion
in 2001, holding that a 60% discount was appropriate in this case,
the estates discovered information that caused them to further
reduce the reported value of the fractional interests by claiming
a 60% discount. The estates assert that they first argued that a
90% discount was appropriate in their first post-trial brief, long
after the IRS had taken its position; and the 90% figure was based
on market comparables introduced into evidence at trial.8
We think that the Tax Court abused its discretion by relying
on the increases in the discounts claimed by the estates as proof
of substantial justification. The IRS’s consistent position was
that no discounts should be allowed other than the costs of
partition estimated in the Baker report. The cases cited by the
Tax Court are unrelated to the issue of whether the IRS’s position
was substantially justified. Furthermore, those authorities are
off point as related to this case because the estates offered
8
James Steele, one of the estates’ expert witnesses, testified
at trial that if, hypothetically, he were to make an offer for Mr.
Baird’s interest, he would require a 90% discount.
27
evidence to explain each of the changes, and supported each of
their claimed discounts with expert opinion. Finally, the 90%
discount was claimed post-trial. The IRS had already taken its
position at the time of its notice of deficiency, a position that
it maintained in its answer to the estates’ petition and, indeed,
throughout the litigation; thus the post-trial increase from 60 to
90% had no effect whatsoever on the litigating position of the IRS.
The IRS did not present any credible evidence or call any competent
witnesses to support the reasonableness of its position during the
course of the litigation and, accordingly, it has failed to satisfy
its burden of proving that its position was substantially
justified. See Lennox, 998 F.2d at 248-49 (IRS’s position must be
supported by record evidence in order to be substantially
justified); Nicholson, 60 F.3d at 1029 (“The Commissioner cannot
have a reasonable basis in both fact and law if it does not
diligently investigate a case.”) (internal quotation marks and
citation omitted).
III
In the Tax Court, the IRS contended that, if its position was
found not to be substantially justified, then the amount of the
estates’ claim for attorneys’ fees is unreasonable because it
exceeds the statutory limit. Thus, a remand is necessary for the
Tax Court to determine the amount of fees to be awarded.
28
IV
For the foregoing reasons, the judgment of the Tax Court is
REVERSED, and the case is REMANDED to the Tax Court for a
determination of the amount of fees and costs to be awarded to the
taxpayers.
REVERSED and REMANDED.
29