Estate Argues Its Partnership Interest in Lottery Payments Should Not Be Valued

A. Parties

STATEMENT REGARDING ORAL ARGUMENT

TABLE OF CONTENTS

INDEX OF AUTHORITIES

STATEMENT OF JURISDICTION

STATEMENT OF ISSUES

STATEMENT OF THE CASE

STANDARD OF REVIEW AND APPLICABLE LAW

ARGUMENT AND AUTHORITIES

POINT OF ERROR

CERTIFICATE OF SERVICE

CERTIFICATE OF COMPLIANCE

Bank of California v. United States, 672 F.2d 758 (9th Cir. 1982)

Bowden v. Comm'r, 234 F.2d 937 (5th Cir. 1956)

Dresser Indus., Inc. v. Comm'r, 911 F.2d 1128 (5th Cir. 1990)

Estate of Andrews v. Comm'r, 79 T.C. 938 (1982)

Estate of Bright v. United States, 658 F.2d 999, 1005-06 (5th Cir. 1981)

Estate of Dunn v. Comm'r, 301 F.3d 339 (5th Cir. 2002)

Estate of Green v. Comm'r, 22 T.C. 728 (1954)

Estate of Gribauskas v. Comm'r, 116 T.C. 142 (2002)

Estate of McCormick v. Comm'r, 70 T.C.M. (CCH) 318 (1995)

Estate of Weinberg v. Comm'r, 79 T.C.M. (CCH) 1507 (2000)

Hamm v. Comm'r, 325 F.2d 934 (8th Cir. 1963)

Hanley v. United States, 63 F. Supp. 73 (Ct. Cl. 1945)

Huntington Nat'l Bank v. Comm'r, 13 T.C. 760 (1949)

Mandelbaum v. Comm'r, 69 T.C.M. (CCH) 2852 (1995), aff'd, 91 F.3d 124 (3rd Cir. 1996)

McFarland v. Comm'r, 72 T.C.M. (CCH) 673 (1996)

McIngvale v. Comm'r, 936 F.2d 833 (5th Cir. 1991)

McKeever v. Comm'r, 80 T.C.M. (CCH) 358 (2000)

O'Reilly v. Comm'r, 973 F.2d 1403 (8th Cir. 1992)

Shackleford v. United States, 262 F.3d 1028 (9th Cir. 2001)

Shackleford v. United States, 1998 WL 723161 (E.D. Cal. 1998)

Smith v. Comm'r, 78 T.C.M. (CCH) 745 (1999)

Vernon v. Comm'r, 66 T.C. 484 (1976)

Weller v. Comm'r, 38 T.C. 790 (1962)

Wheeler v. United States, 116 F.3d 749 (5th Cir. 1997)

Fed. R. Civ. P. 52

H.R. 100-795 at 591 (July 25, 1988)

1. Whether the Tax Court erred by mandating that the value of the Lottery Prize, the major asset of the Partnership, must be determined by using a particular valuation method when determining the fair market value of the Partnership Interests.

2. Whether the Tax Court erred in determining that the Lottery Prize must be valued under the Annuity Tables rather than under fair market value principles where the Annuity Tables produce an unreasonable and unrealistic result and a where a more realistic and reasonable means of determining the value of the Lottery Prize exists.

3. Whether the Tax Court erred in disregarding the clear terms of the Internal Revenue Code and Treasury Regulations when it determined value based on the Annuity Tables rather than under Treas. Reg. § 20.2031-9, entitled "Valuation of Other Property."

[5] This case arises from the Notice of Deficiency issued by the Commissioner of Internal Revenue ("the Commissioner") on June 25, 1999, alleging a federal estate tax deficiency of $873,554 and an I.R.C. § 6662 penalty in the amount of $168,999 against the Estate. (Stip. 3, 5; Exh. 1-J)¹ The Estate's petition was timely filed with the United States Tax Court on September 21, 1999. (Stip. 6)

[6] On May 16, 2000, the parties filed a Stipulation of Facts with the Tax Court. (Doc. 11) In that Stipulation, the parties agreed that the only disputed issue in this case is whether, in valuing the Estate's interests in the Partnership, the 19 annual lottery installment payments to be paid by the Texas Lottery Commission to the Partnership must be valued as a private annuity under the Annuity Tables. If it is determined that the Annuity Tables must be applied when valuing the Lottery Prize when determining the value of the Estate's interest in the Partnership, the parties stipulated that the value of the Partnership Interests held by Mrs. Cook at her death would be $2,908,605. (Stip. 2(a)) If it is determined that fair market value principles, rather than the Annuity Tables, should be applied in valuing the Lottery Prize, the fair market value of the Partnership Interests would be $2,237,140. (Stip. 2(b))

[7] On June 1, 2000, the parties filed a Joint Motion for Leave to Submit Case under Tax Court Rule 122. (Doc. 12) The Tax Court issued a memorandum decision on July 9, 2001, holding that the Annuity Tables must be applied to value the Lottery Prize owned by the Partnership. (Doc. 17) Based on this holding, the fair market value of the Estate's interests in the Partnership on Decedent's date of death would be $2,908,605. (Stip. 2(a)) The Court's decision was entered on October 23, 2002. The Estate filed a timely notice of appeal. (Doc. 21)

B. Statement of Facts

1. The Partnership

[8] Mrs. Cook and her former sister-in-law, Myrtle M. Newby ("Mrs. Newby"), had a decades-old partnership, an informal agreement under which they jointly purchased lottery tickets and shared in the winnings. (Stip. 7)

[9] On July 8, 1995, Mrs. Cook purchased on behalf of the partnership a winning ticket in the Texas Lottery. (Stip. 8) The face value of the prize was $17 million, payable over 20 years. (Stip. 9) The initial payment, made on July 10, 1995, was $858,648. Subsequent installments of $853,000 were payable on July 15 of each of the next 19 years. (Stip. 9)

[10] On July 12, 1995, Mrs. Cook and Mrs. Newby converted their unwritten general partnership to a formal limited partnership. Mrs. Cook and Mrs. Newby each received a 2% general partnership interest and a 48% limited partnership interest in the Partnership. (Stip. 11) Mrs. Cook and Mrs. Newby assigned the winning lottery ticket to the Partnership. (Stip. 11; Exh. 2-J)

[11] Mrs. Cook died unexpectedly at age 76 on November 6, 1995 ("the Valuation Date"). (Stip 12; Exh. 3-J at 1) On the Valuation Date, Mrs. Cook owned a 2% general partnership interest and a 48% limited partnership interest in the Partnership. (Exh. 3-J at Schedule F) The Partnership's only assets having value on the Valuation Date were the Lottery Prize (the right to receive 19 future lottery payments of $859,648) and $391,717 in cash. (Stip .11)

[12] At the time of Mrs. Cook's death, Texas law provided that lottery prizes payable in installments could not be transferred, other than pursuant to court order, nor could they be converted to a lump sum at any time. (Stip. 9) Therefore, there was no market for Texas lottery prizes payable in installments on the Valuation Date. (Stip. 9)

[13] The Estate's Federal Estate Tax Return, Form 706 ("the Estate Tax Return"), was timely filed with the Internal Revenue Service on August 5, 1996. The value of Mrs. Cook's interests in the Partnership was reported on the Estate Tax Return at a date of death value of $1,529,749. (Stip. 13; Exh. 3-J) The Estate Tax Return reported and paid an estate tax liability of $266,269. (Stip. 14)

2. Peter Phalon's Valuation Opinion

[14] The value of the Partnership Interests reported on the Estate Tax Return was determined by a valuation expert, Peter Phalon, of Bernstein, Phalon & Conklin ("Phalon"). Phalon determined the value of the Partnership Interests under an asset-based approach. He determined the value of the Partnership's assets and subtracted the liabilities to obtain the Partnership's net asset value. Phalon then applied discounts for lack of control (because ownership of the Partnership Interests did not provide Mrs. Cook with full control over the Partnership's affairs) and lack of marketability (because there was no ready market for an interest in a closely held partnership) to Mrs. Cook's pro-rata net asset value to determine the fair market value of the Partnership Interests.

[15] The first step in Phalon's analysis was to determine the value of the Lottery Prize. Phalon opined that a discounted cash flow model was appropriate for use in determining the fair market value of the Lottery Prize. (Exh. 3-J, attachment labeled Exhibit 2, entitled "Valuation Report Concerning MG Partners, Ltd.,² at 5-7) Phalon determined that the income stream most similar to the Lottery Prize was that of AAA-rated general obligation bonds of the State of Texas. However, Phalon noted that the major difference between these bonds and the Lottery Prize was the tax-exempt nature of the bond income and the right to sell, trade, pledge, or otherwise assign the rights to the bond. Phalon pointed out that the yield on such bonds recognized these factors. Accordingly, Phalon determined that it was necessary to adjust the payment stream and the yield of the payments receivable to achieve a direct comparison between the tax-exempt, freely transferable AAA bonds and the taxable, non-transferable Lottery Prize. (Exh. 3-J, Phalon, at 5-7)

[16] Phalon determined that to adjust for the federal income tax benefits associated with the tax-free bond, it was necessary to remove the income tax burden from the payment receivable. Phalon thus subtracted income taxes from the payment, based on a marginal rate of 39.6%. Phalon then selected a AAA general bond obligation yield as of November 19, 1995, of 5.46%. Using a discounted cash flow analysis, Phalon determined that the present value of the income stream to the Partnership from the Lottery Prize as of the Valuation Date, prior to any adjustment for the Lottery Prize's lack of marketability, was $6,097,760. (Exh. 3-J, Phalon, at 5-7)

[17] Phalon opined that because (a) the State of Texas prohibited the sale of the income stream from the Lottery Prize, and (b) no modification could be made to the size of the income stream, the payment structure, or the timing of payments from the Lottery Prize, a 25% discount should be applied to the present value as of the Valuation Date of the annual income stream to be received, to reflect the lack of marketability of the Partnership's right to receive the 19 annual lottery payments. (Exh. 3-J, Phalon, at 5-7) Phalon relied upon traditional lack of marketability studies in arriving at his 25% lack of marketability discount attributable to the Lottery Prize. Phalon therefore determined that the fair market value of the Partnership's Lottery Prize was $4,575,000. (Exh. 3-J, Phalon, at 5-7; Exh. 6-J) The value of the Partnership Interests held by Mrs. Cook at her death were consequently reported on the Estate Tax Return at $1,529,749. (Exh. 3-J, Phalon, at 20)

3. The IRS Notice of Deficiency

[18] On June 25, 1999, the Commissioner issued a notice of deficiency, determining that the Estate owed additional estate taxes of $873,544. (Stip. 16) The Commissioner also asserted a penalty of $168,999 under I.R.C. § 6662.³ The notice of deficiency determined that the total value of the Lottery Prize, before discounts attributable to the existence of the Partnership, was $8,557,850. (Stip. 17) The notice of deficiency determined that the fair market value of Decedent's interest in the Partnership was $3,222,919. (Exh. 1-J)

4. William Frazier's Valuation Opinion

[19] After the case was docketed in the Tax Court, Petitioner requested William H. Frazier of Howard Barker Frazier Elliott, Inc. ("Frazier") to provide his opinion of the fair market value of the Partnership Interests. (Stip. 19; Exh. 4-P) Frazier calculated the value of the Partnership Interests under a combination of an asset-based approach and an income approach.

[20] In Frazier's opinion, use of the Annuity Tables to determine the fair market value of the Lottery Prize under the asset- based approach produced an unreasonable and unrealistic value for the Lottery Prize because the Annuity Tables fail to take into account the impact of the transfer restrictions on the Lottery Prize imposed by the State of Texas. (Exh. 4-P at 46)

[21] In determining the value of the Lottery Prize under his asset-based approach, Frazier, like Phalon, used a discounted cash flow approach. In Frazier's opinion, the Lottery Prize is, with one major exception, analogous to a long-term AA-rated (by Standard & Poor's) taxable bond given that the bonds issued by the State of Texas carried AA ratings at the Valuation Date. Long-term yields for AA-rated industrial bonds were approximately 7.2% at the Valuation Date, according to the December 1995 Standard & Poor's Bond Guide. However, the 7.2% yield represents the yield on a marketable security -- an investment that can be readily converted to cash if desired. (Exh. 4-P at 21-22) The Lottery Prize, however, could not be converted to cash; as of the Valuation Date, there was no market for unassignable future interests in lottery prize winnings under Texas law. (Exh. 4-P at 20-25; Stip. 9)

[22] To quantify the valuation impact resulting from the fact that the Lottery Prize is not marketable, Frazier contacted three nationwide firms who specialize in the acquisition of future winning payments resulting from lottery prizes. These firms were Stone Street Capital, Inc. of Bethesda, Maryland ("Stone Street"); Singer Asset Finance Company of West Palm Beach, Florida ("Singer"); and Prosperity Partners of Denver, Colorado ("Prosperity"). Prize brokers, as they are known, purchase lottery jackpots that states like California and New York pay off in installments (usually 20 years) from winners who prefer a lump sum of cash rather than installment payments. Fourteen states (not including Texas on the Valuation Date) allowed the assignment of lottery prizes, which is a necessary requirement for most prize brokers to conduct business. (Exh. 4-P at 22-24)

[23] Frazier learned in discussions with these prize brokers that in determining the present value of the stream of income to be received from the lottery prizes, the prize brokers used discount rates ranging from 8% to 12%. These rates are significantly higher than the required rates on the aforementioned AA-rated taxable issues because the prize brokers are middlemen and therefore require a fee for creating the market. However, the lottery prizes purchased by Stone Street, Singer, and Prosperity are readily assignable. In other words, the discount rates used by these prize brokers assume that a firm could acquire a lottery prize, thereby becoming a direct payee of the relevant state, and resell it at a profit. But it was impossible for prize brokers to purchase Texas lottery prizes because the prizes were not assignable on the Valuation Date. (Exh. 4-P at 22)

[24] In Frazier's opinion, an investor would have to be rewarded (in terms of a higher return or discount rate) in order to compensate the investor for the lack of transferability or marketability inherent in the Lottery Prize. Frazier considered traditional lack of marketability studies that primarily involve equity investments as well as other liquidity alternatives available to the Partnership (such as using the Lottery Prize as a basis for securing a loan) in determining the valuation impact attributable to the lack of transferability. Based on this information, Frazier opined that, as against a 10% benchmark discount rate (the midpoint between the 8-12% rates required by the prize brokers), a 25% lack of transferability discount, which represented the inability to assign the Lottery Prize, was appropriate, resulting in a 13.33% discount rate to be used to determine the then-present value of the future stream of income from the Lottery Prize. Frazier's discount rate was computed as follows: 10% ÷ (1-.25%) = 13.33%. (Exh. 4-P at 23) Applying the discount rate of 13.33% to the 19 annual lottery prize payments of $853,000 (the gross annual lottery payment), Frazier determined that the fair market value for the Lottery Prize was $6,053,189 as of the Valuation Date. (Exh. 4-P at 25-26; Exh. 6-J)⁴

5. Francis X. Burn's Valuation Opinion

[25] In preparation for trial in the Tax Court, the Commissioner requested Francis X. Burns of IPC Group, Inc. ("Burns") to determine the fair market value of Mrs. Cook's interests in the Partnership. (Exh. 5-R)

[26] Burns determined that the Partnership was most analogous to an investment holding company that owned a single asset -- the right to future cash flows from the winning lottery ticket. As such, Burns believed that Decedent's interest in the Partnership was "best valued under the net asset value approach." (Exh. 5-R at 4)

[27] Like Phalon and Frazier, Burns used a discounted cash flow model to determine the fair market value of the Lottery Prize under his asset-based approach. (Exh. 5-R at 4) Burns determined that the 19 annual lottery payments of $853,000 would be reduced by the 28% federal withholding tax withheld from each installment, reducing the amount to be received to $614,160. Burns assumed an effective tax rate of 35%, which corresponds to a net income level for a hypothetical investor in the Lottery Prize of $450,000 per year. (Exh. 5-R at 5)

[28] After adjusting the annual payments of $853,000 to account for tax liabilities, Burns determined the present value as of the Valuation Date of the after-tax payments by applying a tax-free discount rate. Burns concluded that because the lottery payments resembled the periodic coupon payments generated by a bond and the lottery payments were paid out of the Texas General Revenue Fund, a bond issued by the State of Texas represented the most comparable financial instrument to the lottery payments. Burns determined that on November 6, 1995, the yield on Texas general obligation bonds with a maturity similar to the expected lottery payments was 5.55%. The Texas general obligation bonds are municipal bonds that are free from federal income tax. Using this tax-free rate to discount the expected future cash flows from the Lottery Prize back to the Valuation Date resulted in a value of $6,486,119. (Exh. 5-R at 5)

[29] After determining the date-of-death present value of the cash flows from Lottery Prize payments, Burns determined that a discount of 11% from the then-present value of the cash flows from the lottery payments was reasonable to account for the reduced marketability of the Lottery Prize. Burns determined his lack of marketability discount based on the potential costs that a lottery winner might incur to create liquidity through a loan transaction. (Exh. 5-R at 5-6)⁵

[30] Applying fair market value concepts and taking into account the lack of transferability inherent in the Lottery Prize, Phalon, Frazier, and Burns determined that the fair market value of the Lottery Prize was $4,575,000, $6,053,189, and $5,762,791, respectively. Conversely, if the Annuity Tables were used to value the Lottery Prize, the value of the Lottery Prize would be $8,557,850. (Op. at 4) The Annuity Table's result ranges from approximately $2.5 million to almost $4 million more than the actual fair market value of the Lottery Prize as documented by the three valuation experts.

6. The Parties' Stipulations

[31] On May 16, 2000, the parties filed with the Tax Court their Stipulation of Facts. In the Stipulation, the parties agreed that the only remaining disputed issue in this case is whether, in valuing the Estate's interest in the Partnership, the Lottery Prize, which was the primary asset of the Partnership, must be valued as a private annuity under the Annuity Tables. The parties agreed that if it is determined that the Annuity Tables must be applied in valuing the Lottery Prize when determining the value of the Estate's interest in the Partnership, the fair market value of the Estate's interest in the Partnership will be $2,908,605. (Stip. 2(a)) If it is determined that the fair market value principles, rather than the Annuity Tables, should be applied in valuing the Lottery Prize, the fair market value of the Estate's interest in the Partnership will be $2,237,140. (Stip. 2(b))

7. The Tax Court's Opinion

[32] The Tax Court held that the Annuity Tables must be used to determine the fair market value of the Lottery Prize owned by the Partnership. (Op. at 14) The Tax Court recognized that "[i]t is well established that the tables should be used where annuities are being valued 'unless it is shown that the result is so unrealistic and unreasonable that either some modification in the prescribed method should be made . . . or complete departure from the method should be taken, and a more reasonable and realistic means of determining value is available." (Op. at 9-10) But the Tax Court opined that Estate had not met that burden. Relying on Estate of Gribauskas v. Comm'r, 116 T.C. 142 (2002), the Tax Court held that "mere illiquidity and/or lack of marketability of the asset does not lead to, or create, an unreasonable result requiring an alternative valuation method." (Op. at 11) The Tax Court further opined that "there is no difference between a right to receive lottery payments that is owned by a partnership in which the decedent owned an interest and an identical night to receive lottery payments that was owned directly by the decedent." (Op. at 13-14)

[34] As a matter of law, no single valuation method must be employed to value the Partnership Interests, and the Tax Court erred reversibly by failing to recognize this well settled valuation rule. The property included in the Estate under I.R.C. § 2033 and subject to estate tax is the Partnership Interests transferred by Mrs. Cook at her death. It was the Partnership, not Mrs. Cook, that possessed the right to receive the future lottery payments. Consequently, Mrs. Cook did not transfer the Lottery Prize, or even a portion of the Lottery Prize, at her death. Only if an asset-based approach to value is used to value Mrs. Cook's interest in the Partnership is it necessary to determine the fair market value of the Lottery Prize. As often enunciated by this Court and others, there is no single method of valuation; as demonstrated by Frazier's appraisal, there is more than one appropriate valuation method for use in determining the value of Mrs. Cook's interests in the Partnership.

[35] Even if the value of the Partnership Interests should be determined solely through use of an asset-based approach, the Tax Court erred reversibly in requiring the use of the Annuity Tables to determine the value of the Lottery Prize. The Annuity Tables are not, as a matter of law, required to be used when those tables produce an unreasonable and unrealistic result, and a more reasonable and realistic means of determining value is available. As demonstrated by all three expert valuation reports presented to the Tax Court in this case, the Annuity Tables overvalue the Lottery Prize by at least $2.5 million. The Tax Court's blind application of the Annuity Tables for purposes of "administrative efficiency" overlooks substantial authority that demands departure from the Annuity Tables when, as in this case, the facts demonstrate that the result produced is both unrealistic and unreasonable, and a more realistic and reasonable means of determining value is available. The expert testimony introduced in this case conclusively demonstrates that the Annuity Tables produce an unreasonable and unrealistic result, and a more reasonable and realistic means of determining value exists -- traditional fair market value concepts that recognize the lack of marketability of the Lottery Prize.

[36] Finally, the Tax Court erred by failing to value the Partnership's interest in the future lottery payments under Treas. Reg. § 20.2031-9. While the Tax Court classified the Lottery Prize as an asset to be valued under Treas. Reg. § 20.2031-7, Treas. Reg. § 20.2031-9, "Valuation of other property," more accurately encompasses the Partnership's interest in the future lottery payments. Because the Lottery Prize is not described in Treas. Reg. §§ 20.2031-2 through 20.2031-8, under Treas. Reg. § 20.2031-9, valuation is to be made in accordance with the general principles set forth in Treas. Reg. § 20.2031-1.

[39] In light of this basic principle, in 1988 Congress amended the Internal Revenue Code of 1986 (as amended, "the Code") to update the Annuity Tables. Congress's purpose in statutorily directing the creation of Treas. Reg. § 20.7520, by enacting I.R.C. § 7520(c), was to "result in more accurate valuation of such interest[s]." H.R. 100-795 at 591 (July 25, 1988). Thus, fair market value remains the standard by which valuation is to occur and "[a] regulation that produces a result different from that intended by Congress has no validity." Hanley v. United States, 63 F. Supp. 73, 81 (Ct. Cl. 1945). Rather, the valuation of property interests "is ever one of fact and not of formula." Hamm, 325 F.2d at 938.

[40] The primary issue before the Court is the determination of whether the Tax Court erred in its selection of valuation method to be used in valuing the Partnership Interests on the Valuation Date. The primary asset of the Partnership was the Lottery Prize. Under Texas law, Mrs. Cook did not own the Lottery Prize and did not transfer the Lottery Prize as a result of her death. Tex. Rev. Civ. Stat. Ann. art. 6132a-1, § 7.01 (Vernon Supp. 2000) ("A partner has no interest in specific limited partnership property.").

[41] * * * the Tax Court stated that "there is no difference between a right to receive lottery payments that is owned by a partnership in which [the] decedent owned an interest and an identical right to receive lottery payments that was owned directly by [the] decedent." (Op. at 13-14) But the Tax Court's erroneous conclusion ignores the fact that the property transferred under state law as a result of Mrs. Cook's death and, therefore, the property that is required to be valued under I.R.C. §§ 2031 and 2033, is Mrs. Cook's interests in the Partnership, not the Lottery Prize owned by the Partnership.

[42] The question for the Tax Court was not just whether the Lottery Prize must be valued using the Annuity Tables, but whether, in determining the value of the interest in the Partnership transferred as a result of Mrs. Cook's death, the Lottery Prize must be valued as a private annuity under the Annuity Tables. (Stip. 1) This difference is significant, for there are different approaches to valuing an interest in a closely held entity. Under an asset-based approach to value, the value of an interest in an entity is based on the value of the entity's assets. See Estate of Dunn, 301 F.3d at 353. Under an income approach, the value of an interest in an entity is based on the income stream to be earned from the interest in the entity through operations. Id. at 349-55.

[43] In this case, requiring the Lottery Prize to be valued by use of the Annuity Tables mandates that the asset approach will be used to value the Partnership Interests, for it is not necessary for the value of the Partnership assets to be determined when valuing the Partnership Interests under an income approach. But there is no one single method of valuation to be applied in determining the value of the Partnership Interests.⁷See Estate of Andrews, 79 T.C. at 945 ("[C]ourts should not restrict consideration to only one approach to valuation . . . [t]he regulations call for all relevant factors to be examined . . . ."); McFarland v. Comm'r, 72 T.C.M. (CCH) 673, 674 (1996) ("We do not believe that we would be properly discharging our duty if we were to set forth at this point one (and only one) method of valuation that must be used to determine the fair market value of Decedent's partnership interest. Cases of valuation require us to determine the price that a hypothetical willing buyer would pay a hypothetical willing seller, both persons having reasonable knowledge of all relevant facts and neither person being under any compulsion to buy or to sell."); Estate of Weinberg v. Comm'r, 79 T.C.M. (CCH) 1507, 1514 (2000); Smith v. Comm'r, 78 T.C.M. (CCH) 745, 748 (1999). The Tax Court's holding would erroneously render inapplicable the income approach when valuing an interest in an entity holding a Lottery Prize, or holding an annuity, for that matter. Consequently, the Tax Court's opinion that the Partnership's Lottery Prize must be valued using the Annuity Tables when determining the fair market value of Mrs. Cook's interest in the Partnership is reversible error.

[45] In this case, the expert valuation reports provided to the Tax Court conclusively demonstrate that the application of the Annuity Tables renders an unreasonable and unrealistic result. The experts determined that the fair market value of the Partnership's right to receive the lottery payments over the remaining 19-year term was between $2.5 million and $4 million less than the value of the lottery payments determined under the Annuity Tables. The values of the Lottery Prize as determined by the valuation experts in this case and as calculated under the Annuity Tables are as follows:

       Phalon         Frazier        Burns          Annuity Tables

[46] The primary reason for the differences in the values determined by the experts and those derived under the Annuity Tables is the fact that the State of Texas prohibits the transfer of lottery winnings. Because the Annuity Tables fail to reflect the undisputed fact that the Lottery Prize is not transferable and therefore, not marketable, the opinions expressed in all of the expert reports conclusively demonstrate that the Annuity Tables greatly overvalue the Partnership's interest in the future Lottery Prize.

[47] In a case directly on point with the present case, the Ninth Circuit Court of Appeals affirmed a district court's decision to depart from the annuity tables when valuing a lottery prize issued by the State of California for estate tax purposes. See Shackleford, 262 F.3d at 1033. In Shackleford, the Ninth Circuit affirmed the departure from the Annuity Tables because the "statutory restrictions on transfer reduced the fair market value of the right to receive future lottery payments." Id. at 1032. The Ninth Circuit reasoned that, given the expert testimony presented (which showed that fair market value appraisal methods produced a result almost 40% less than the Annuity Tables), the district court did not err in analyzing the fair market value under the hypothetical willing buyer willing seller test. Id. The Ninth Circuit stated as follows:

[48] In this case, the Tax Court sought to reject the district court's holding in Shackleford by erroneously holding that "mere illiquidity and/or lack of marketability of the asset does not lead to, or create, an unreasonable result requiring an alternative valuation method." (Op. at 11) But discounts for lack of marketability of property interests have long been recognized as appropriate for federal estate tax valuation purposes. See, e.g., Estate of McCormick v. Comm'r, 70 T.C.M. (CCH) 318, 332 (1995); Mandelbaum v. Comm'r, 69 T.C.M. (CCH) 2852, 2862-64 (1995), aff'd, 91 F.3d 124 (3d Cir. 1996). In the unique circumstances of this case, however, the Annuity Tables ignore these fair market value factors. As the Ninth Circuit found in Shackleford, "the right to transfer is 'one of the most essential sticks in the bundle of rights that are commonly characterized as property' . . . [and] [it] is axiomatic that if an asset's marketability is restricted, it is less valuable than an identical marketable asset." Shackleford, 262 F.3d at 1032 (citations omitted).

[49] The Tax Court's holding that "illiquidity and/or lack of marketability of the asset does not lead to or create an unreasonable result" (Op. at 11) requiring departure from the Annuity Tables "defies reason and makes no economic sense." Estate of Dunn, 301 F.3d at 359 (reversing Tax Court where valuation methodology employed by the Tax Court was inconsistent with evidence presented and the Tax Court's factual findings). Even the Lottery Prize value determined by the Commissioner's expert ($5,762,791), when compared to the value resulting from use of the Annuity Tables ($8,557,850), creates a difference of almost $3 million, which is an amount almost twice the difference that led the Shackleford court to depart from the use of the Annuity Tables in that case. The taxpayer's value in Shackleford, which took into account lack of marketability, was 40% lower than that proposed by the Commissioner under the Annuity Tables. In this case, the numbers are quite similar: The values derived by each of the experts, all of which take into account the inherent lack of marketability of the Lottery Prize, are lower than the value produced by the Annuity Tables by a range of 29.3% to 46.5%. The expert testimony submitted to the Tax Court provides a compelling contrast to the Tax Court's holding that the Lottery Prize should be valued in the same manner as a fully marketable government bond under the Annuity Tables. Although blind application of the Annuity Tables might promote efficiency and uniformity, it does not result in the determination of fair market value as required by Treas. Reg. § 20.2031-1(b). See Shackleford, 262 F.3d at 1032-33.

[50] Other cases allowing departure from the Code's annuity or actuarial tables embrace the same standard articulated in Shackleford; that is, if the proponent of departure from the Annuity Tables establishes that those tables would produce an unreasonable and unrealistic valuation result, the Annuity Tables should be ignored. For instance, in O'Reilly, the Commissioner successfully argued against blind adherence to the valuation tables when such adherence produced an unreasonable and unrealistic result. The Court found that formulaic use of the gift tax actuarial tables without regard to the valuation result "uprooted § 25.2512-5 [an analogous gift tax regulation] and its tables from their statutory foundation -- to determine the fair market value of the property on the date of the gift."⁸O'Reilly, 973 F.2d at 1408. The Court reasoned that the taxpayer's gifts of reciprocal remainder interests were unreasonably and unrealistically undervalued given that the actuarial tables assumed a 10% annual rate of return, while the actual yield typically was about 0.2%.⁹Id. at 1404. The O'Reilly court found that the difference between the valuation tables and actual returns was so unreasonable and unrealistic as to require a departure from the tables, as the table result did not reflect fair market value. Id. at 1408.

[51] Likewise, where an elderly widow's health was poor, the Tax Court rejected the use of the actuarial tables to value the life estate left to her by her husband six months before she died because such use produced "a result substantially at variance with the facts." Huntington Nat'l Bank, 13 T.C. at 772. Under the tables, the widow's life expectancy was slightly over four years. Id. at 769. In actuality, however, the widow was bedridden for most of the year prior to her death, in part due to her advanced age and in part due to cancer. Id. at 765. Because her actual life expectancy was not more than a year, the Court allowed departure from the actuarial tables, instead using a one-year life expectancy and a lower percentage yield than was indicated in the tables. Id. at 772. The Court reasoned that because use of the actuarial tables would yield an unrealistic and unreasonable result, departure from the tables was necessary.

[52] In this case, the Tax Court examined the differences in the valuation results reached by the experts and opined that "differences among [experts with] the amounts of the valuations . . . make a compelling argument justifying the use of valuation tables." (Op. at 12) But the methods used by the experts to value the Lottery Prize were the same -- the experts determined the stream of cash flows to be received from the Lottery Prize and discounted the stream of cash flows by what each determined to be the appropriate discount rate to determine the date-of-death present value of the stream of income to be received. All three experts used a discounted cash flow approach and applied a discount for lack of marketability to determine the value of the Lottery Prize. (Compare Exh. 3-J, Phalon, with Exh. 4-P, with Exh. 5- R) While differences in the underlying factual assumptions applied by each of the experts existed,¹⁰ all three used the same valuation method -- a discounted cash flow approach coupled with a discount for lack of marketability.

[53] In contrast to the Annuity Tables, the approaches taken by the experts provide a much more realistic approach to valuing the Lottery Prize than the Annuity Tables, given that the Annuity Tables completely ignore rates of return on comparable investments and the lack of marketability inherent in the property.

[55] Although the Tax Court would have the Court assume that the Lottery Prize is an annuity, there is no support in the Regulations for this erroneous interpretation. Treas. Reg. § 20.2031-7 provides numerous examples of annuities. None resembles a Lottery Prize. An annuity is defined as "an arrangement whereby an individual transfers property . . . to a transferee who promises to make periodic payments to the transferor for the remaining life of the transferor." BNA, Tax Management Estates, Gifts & Trust Portfolios, No. 805-2nd, Private Annuities and Self-Canceling Installment Notes, B-305 (2002).

[56] The examples listed in Treas. Reg. § 20.2031-7 for annuities assume that payments to be received (for life or for a fixed period of years) represent a combination of return of capital and interest on the initially invested capital. See Treas. Reg. §§ 20.2031-7(d)(2)(iv)(B) and 20.2031-7(d)(5). However, in the case of the right to receive lottery winnings, there is no initial investment, but rather a wager that provides the payoff; there is no return of capital, and no interest is earned on that capital.

[57] Furthermore, those same examples indicate that property to be evaluated under Treas. Reg. § 20.2031-7 is freely transferable. Not one example listed contemplates a property interest with any restrictions on transfer, much less one with transfer restrictions as severe as those limiting the Lottery Prize. Because Treas. Reg. § 20.2031-7 does not contemplate the future nontransferable right to receive lottery winnings, Treas. Reg. § 20.2031-9, the "other property" provision, encompasses lottery winnings and requires that fair market value, not the Annuity Tables, be used to value such property. See Treas. Reg. § 20.2031-9 ("The valuation of any property not specifically described in §§ 20.2031-2 through 20.2031-8 is made in accordance with the general principles set forth in § 20.2031-1. For example, a future interest in property not subject to valuation in accordance with the actuarial principles set forth in § 20.2031-7 is to be valued in accordance with the general principles set forth in § 20.2031-1").

²A reference to this valuation report and its attachments is as follows: "Exh. 3-J, Phalon, at____."

³The Commissioner conceded the penalty before the case was submitted to the Tax Court. (Stip. 3)

⁴Frazier determined that the collective fair market value of Mrs. Cook's 2% general partnership interest and 48% limited partnership interest was $2,067,867 on the Valuation Date. (Exh. 4-P at 38)

⁵Burns determined that the fair market value of Mrs. Cook's combined 2% general partnership interest and 48% limited partnership interest was $2,406,413 on the Valuation Date. (Exh. 5-R at 14)

⁶For purposes of determining the fair market value of the interests transferred by Decedent, the identity and intentions of those persons actually receiving the interests is irrelevant. The standard is an objective test using hypothetical buyers and sellers in the marketplace, and is not a personalized one that envisions a particular buyer and seller. Estate of Bright v. United States, 658 F.2d 999, 1005-06 (5th Cir. 1981).

⁷The Tax Court's opinion is also contradicted by the Treasury Regulations' requirement that "[a]ll relevant facts and elements of value . . . shall be considered," which of course includes the nontransferable nature of the Lottery Prize. Treas. Reg. § 20.2031-1(b). See also Rev. Rut. 59-60, 1959-1 C.B. 237 ("[W]here market quotations are not available, all other available financial data, as well as all relevant factors affecting the fair market value must be considered for estate tax and gift tax purposes. No general formula may be given that is applicable to the many different valuation situations arising in the valuation of such stock.")

⁸Because gift taxes and estate taxes are considered in pari materia, the standards for use of the Annuity Tables must be the same when determining the fair market value of property under I.R.C. § 2031 or I.R.C. § 2512. Wheeler v. United States, 116 F.3d 749, 761 (5th Cir. 1997).

⁹Dividends in the three years prior to the gift were $13 per share, and the stock was valued at $9,639 per share. Id. at 1404.

¹⁰For example, the rate used by Frazier in his discounted cash flow approach was derived from the rates applied by firms specializing in the purchase of lottery prizes applied to pre- tax cash flows of the Lottery Prize, while the discount rates used by Phalon and Bums were derived from tax-free returns from government bonds applied to an after-tax rate of return. While the Estate believes that Frazier's overall analysis provides a more realistic measure of value because it focuses on the discount rates used by actual buyers and sellers of Lottery Prizes, Phalon's and Bums' approaches are also reasonable.