Nelson v. IRS A Victory for the Service – Or Was It?

Nelson v. IRS A Victory for the Service – Or Was It?

The Tax Court’s ruling is another example of why parties need to look closely at transfer documents.

June 16, 2020

The U.S. Tax Court recently ruled in the case of James C. Nelson & Mary P. Nelson v. Commissioner of the Internal Revenue (“Service”) (T.C. Memo 2020-81).[1] The decision at first glance appears to be a victory for the Service, as the case revolved around the Nelsons’ (“petitioners”) transactions involving Longspar Partners, Ltd., a family limited partnership that owned 27% of Warren Equipment Co. (WEC). Specifically, the court found that the fixed dollar amounts of certain gifts ($2.1 million made by the petitioners in December 2008) and a sale of Longspar interests ($20.0 million in January 2009), were in fact gifts and a sale of specific percentage interests. Accordingly, the size of the gifts/sale, in terms of percentage interests in the partnership, could not be adjusted in audit to ensure the values of such transfers did not exceed $2.1 million and $20.0 million, respectively, as intended by petitioners.

The Service had sought $6.7 million in gift tax deficiencies and $1.3 million in accuracy-related penalties prior to trial. How could this be? A decision contrary to those of Wandry,[2] McCord,[3] and Petter[4]? Ultimately, the court looked to the precise and literal terms of the transfer documents. These terms called for the percentage interests to be calculated based on fair market value as determined by a qualified appraiser within a certain number of days (90 with respect to the gifts and 180 with respect to the sale) of the effective date of assignment, which is ultimately what occurred. According to Judge Cary Douglas Pugh, for the court to find otherwise would be asking it to ignore the operative language of the transfer documents regarding fair market value as determined by a “qualified appraiser,” and instead assume the interest should be determined based on fair market value as finally determined for gift and estate tax purposes. In the words of Judge Pugh “while the taxpayer may have intended this, they did not write this.” The lesson to be learned here seems to be that the devil is in the detail when drafting transfer documents using a formula clause.

Ultimately, after deciding that the gifts and sale were of specific interests as opposed to fixed dollar amounts, the court had to tackle the determination of the fair market value of the transferred interests. The primary value driver was the 27% interest in WEC, which in turn held 100% interests in seven operating subsidiaries. The subsidiaries operated in the retail of heavy moving equipment and various services for the oil industry. As both sides agreed to the starting value of the operating subsidiaries, the battle was over discounts at both the WEC level as well as the Longspar level.[5] The court determined the values of the gifts and sale at $2.5 million and $24.1 million, respectively. These values were far less than the $3.5 million and $33.6 million in the notice of deficiency, and the $3.1 and $29.8 million provided by the Service’s expert at trial. In doing so, the court applied a discount for lack of control at the WEC level of 15%, and accepted a 30% discount for lack of marketability as put forth by both sides. In addition, the court, noting flaws in all analyses submitted by the experts, applied additional second-level tiered discounts for lack of control and lack of marketability to a minority interest in Longspar of 5% and 28%, respectively. The application of the tiered-level discounts resulted in an overall discount of approximately 59%. Yes, ultimately the values of the gifts/sale were adjusted upward at trial, but nowhere near the level of value the Service was seeking. In addition, the court once again accepted the application of tiered discounts.

  1. Cases were consolidated July 14, 2014.
  2. Dean Wandry v. Commissioner of Internal Revenue, T.C. Memo. 2012-88.
  3. Succession of McCord v. Commissioner of Internal Revenue, 461 F.3d 614 (5th Cir. 2006).
  4. Estate of Petter v. Commissioner of Internal Revenue, T.C. Memo. 2009-280.
  5. In the center of the battle over the appropriate discounts between the experts was the concept of what level of control the various indications of value represent. In other words, are certain discounts appropriate if the valuation of a certain entity reflects a minority level of value compared with a control level of value. Stay tuned for a further analysis of what we can learn from Judge Pugh’s discussion and findings on this subject.