Impact of Post-Mortem Events on Estate Tax Valuations

By Ted D. Englebrecht and John J. Masselli

Estates are to be valued as of the date of death or the alternate valuation date. To what extent can events occurring after the valuation date impact such valuation? Recent court cases indicate a more permissive attitude in this area.

The statement that hindsight is 20-20 is a very common and perhaps overutilized cliché used to emphasize that current information was not available at the time a past decision was made. In Federal estate taxation, hindsight in many cases is known as post-mortem facts and circumstances. This concept of timeliness and the knowledge of future events is one of the most difficult issues surrounding the valuation of a decedent's gross estate. In valuing an estate, appraisers are essentially asked to go back in time and place a fair market value on the estateÑignoring the benefit of events that occurred after the valuation date. This notion of assessing whether information known at the time of the appraisal existed at the valuation date is paramount to the ability to use such information in the appraisal. Although the IRS will maintain that each estate valuation is unique based on all relevant facts and circumstances, it does allow for the use of post-mortem facts to the extent such facts were deemed known or foreseeable at the valuation date. Interestingly enough, several recent court cases have indicated a potential willingness of the courts to relax the restrictions on the use of post-mortem facts and circumstances in valuation cases.

Valuation Factors

An estate tax is an excise tax levied on the passing of property at death. The triggering event in estate taxation is the death of a taxpayer. Upon a taxpayer's death, the executor of an estate must deal with settling any estate tax liability due the Federal government. Two items that must be addressed very early in this process are the selection of a valuation date and, more importantly, the determination of the fair market value of the gross estate.

Valuation Date. The choice of a valuation date is somewhat limited. The estate must be valued either on the date of death or the alternate valuation date (AVD) which is six months after the date of death. IRC Sec. 2032 (AVD provisions) was enacted by Congress as a relief provision for estates whose value declined shortly after the date of death. The AVD provisions are elective, and the estate must meet certain criteria before such election can be made. An estate can elect the AVD only if it will result in a reduction of both gross estate and net estate tax payable. As with many elective provisions, the election is irrevocable. Although a reduction in estate tax results, other potential disadvantages related to other taxation provisions may exist. The AVD is a marvelous estate planning mechanism. It should not be elected, however, without adequate consideration of other relevant factors.

Valuation Methodology. To determine the proper valuation of an estate, the definition of "fair market value" must first be understood. The estate and gift tax regulations define fair market value 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. The IRC and accompanying regulations provide for circumstances where special-use valuations may be utilized. Since the scope of this discussion focuses on the effect of post-mortem events on estate valuations, the discussion will be concerned with the general fair market value definition as opposed to specific situations covered in special use valuation provisions under IRC Sec. 2032A.

Several methods currently utilized for the determination of fair market values are accepted by the appraisal community as well as the courts. Obviously, assets such as cash and marketable securities are much easier to value than real estate, other personal property, and intangibles. When faced with the dilemma of establishing value of the more difficult properties, methods such as the market, income, and cost approaches are used. For example, if the market approach is used to value an asset, a persuasive basis would be an actual arm's-length sale that occurred within a reasonable time after the valuation date. Other possibilities include comparable sales of similar property, sales involving hypothetical willing buyers and sellers, or, in some instances, even offers received by the estate from willing purchasers that were subsequently rejected. In any event, a multitude of appraisal methods exist. The issue at hand, however, is that of time, post-mortem events, and information that becomes available after the valuation date.

Administrative Stance

In general, the IRS's interpretation of valuation begins with the value originally submitted by the taxpayer on the estate tax return. If the value is adjusted by the IRS after examination, the adjusted value is presumed to be correct. The burden of proving that the return value is correct rests with the taxpayer. It is interesting to note that IRC Sec. 2031 dealing with valuation has very little statutory instruction as to the method of valuation. Congress left the interpretation and implementation of this section up to the IRS via administrative pronouncements.

An understanding of the IRS's overall perspective on valuation may be useful before trying to establish which approach to take. The following excerpt is from an IRS valuation training manual for appeals officers.

There are five truisms that anyone approaching the subject of valuation should be aware of as a frame of reference:

* Each valuation case is unique. Little or no precedent is to be obtained from earlier cases. The cases are rarely on point and a significant differentiation of the facts can usually be made.

* In valuation there are no absolutes and only general guidelines to which individual judgments must be applied.

* There is no irrefutable right answer.

* Experts will differ.

* There are available substantive aids and/or methods which are generally recognized and accepted by the appraisal profession and the Courts.

It appears quite clear from the above text that the IRS treats case-law decisions on estate valuations similar to letter rulings. The IRS believes reliance on a particular case will suffice only to the extent that the facts of the subsequent case are almost identical to the cited case. Naturally, this interpretation sends a message to a petitioner that simply referencing a case as support for a position is contrary to the IRS's philosophy on the use of case law in valuation disputes. Consequently, a failure by the parties to reach an agreement in the appeals process will usually end up being settled in court by a preponderance of the evidence. The IRS's position on the issue of post-mortem facts and circumstances affecting valuation can be gauged from the following:

Events subsequent to the valuation date should not be considered in the appraisal of a property, unless knowledge of their eventuality was available to the market at the date of the valuation and the events could reasonably be expected to occur within the foreseeable future...While evidence of subsequent events may be admissible in settling the value of property for tax purposes, it is not appropriate to consider such data in an appraisal of the property. This is also known as the "hindsight rule" which permits the admission of evidence to prove or disprove the validity of any claim of value.

The above excerpt from the IRS training manual provides some additional insight into estate valuations. Specifically, it articulates that an appraisal should not include subsequent information. Nevertheless, it appears the use of the same subsequent information to prove or disprove the validity of a claim is an acceptable procedure. If subsequent information is admissible for proving a claim, why shouldn't it be used in making the original appraisal? As the cases in the next section will indicate, the IRS demonstrates a willingness to allow post-mortem events in estate valuations. Of course, it is no surprise that often the post-mortem event results in a higher valuation than the method originally used.

Judicial Interpretation

Several recent judicial decisions have demonstrated a propensity of the courts to relax their position on the use of post-mortem information in estate valuations. In fact, even the IRS has acknowledged this trend as evidenced by the following excerpt from their training manual for appeals officers: "There has been a recent tendency of the Tax Court to admit a subsequent event if it is relevant and reasonably timely." Clearly, the subjective issues of relevance and timeliness are obstacles that must be overcome before use of such subsequent evidence is allowed. As will be demonstrated, there are a number of cases where post-mortem facts have been considered in the determination of value. In many situations a compromise was reached, and in others the outcome was not in favor of the taxpayer. However, the more important issue is that post-mortem information was admitted in the proceedings.

Necastro. The Estate of Dominick A. Necastro (68 TCM 227) deals with the valuation of a land parcel that was subsequently determined to be environmentally contaminated. The decedent passed away on October 25, 1985. The alternate valuation date was not chosen for this estate. In May and November 1990, environmental assessment information surfaced, indicating the property had several different types of environmental contamination. On August 15, 1990, after the May 1990 report, the petitioner made a claim for refund with the IRS on the grounds the original property valuation on the estate tax return was overstated. Before the valuation could be adjusted, a determination had to be made as to whether the contamination discovered in the studies existed at the valuation date. Several experts in environmental contamination were engaged by both the petitioner and the respondent. On several issues, the experts from both sides agreed. It was determined that clearly some contamination existed at the original valuation date. Since the extent of the remaining environmental issues could not be proven to have existed at the valuation date, the Tax Court was not willing to provide for a reduction in value based on the possibility that contamination might (emphasis added) have existed at the valuation date. The Tax Court ultimately allowed a reduction in the value of the property in the amount of $288,000 that represented the estimated cost of treating the environmental conditions perceived to have affected the property on the valuation date.

Although the overall result of the case was a compromise between the taxpayer's request and that of the IRS, the more crucial issue was that post-mortem information obtained almost four years after the valuation date was admitted and resulted in a revised valuation. As expected, the primary focus depended on whether the contamination existing on the original valuation date would have been discovered by a hypothetical willing buyer in 1985.

Because the property was retained by the decedent's heirs, an actual sale was never realized. Accordingly, for lack of information to the contrary, the court allowed the reduction in value for the estimated cost of removing the contamination estimated to have existed in 1985.

Scull. In the Estate of Robert C. Scull (67 TCM 2953), the issue at hand was the valuation of the decedent's 65% undivided interest in an art collection. The taxpayer passed away on January 1, 1986. The alternate valuation date was not elected by the estate.

For Scull's originally filed estate tax return, the executor had the interest in the art collection appraised, obtained a high and a low value, and selected the mean value as the estate tax valuation for the art collection. Almost 11 months after the valuation date, an auction was held that resulted in a higher valuation for the art collection. As such, the IRS charged that, rather than using the mean value of the appraisals, the auction value adjusted for any appreciation from the date of death to the date of the auction should be the determinant of value.

Since the type of property in question is art, which poses a host of valuation issues unto itself, the use of an auction to determine value is acceptable. Whereas, in many cases, an auction implies some form of a forced sale, it is generally held that one of the relevant markets for art is an auction. As a result, the Tax Court's acceptance of the auction value is not surprising and coincides with the treatment provided in Technical Advice Memorandum #9235005. Nonetheless, the issue of the time lag between the valuation date (January 1, 1986) and the auction date (November 11­12, 1986) must be considered an issue. Obviously, given the choice between a hypothetical willing buyer and seller and an actual buyer and seller, the reasonable choice would be the actual buyer and seller. Here an auction occurred 11 months after the valuation date where actual buyers and sellers determined the value of the art collection. The result proved beneficial to the government. Questions that now surface are whether the auction would have been accepted as the proper value if the auction value was less than the original amount reported, or in the absence of the auction, would the original value have been challenged by the IRS's art valuation section? Once again, even though the taxpayer did not benefit from the result, post-mortem facts were used to retroactively restate value.

Andrews. In the Estate of Andrews (850 F Supp 1279), the valuation question surrounded an intangible asset. That is, the value of an author's name. The taxpayer in question passed away on December 19, 1986. The alternate valuation date was not elected by the estate.

In this case, the decedent, Virginia C. Andrews, was an internationally recognized author of paperback fiction novels. Andrews' creative efforts became associated with a literary style called the "children in jeopardy" genre. As with most successful authors, the more Andrews' popularity grew among her readership, the more influential and valuable her name and writing style became in the publishing community. Subsequent to her death, her publishing company, in an attempt to perpetuate her stories and writing style, approached her estate about the possibility of using a ghostwriter to continue the "children in jeopardy" theme. The ghostwriter would write the novel but use Virginia Andrews' name. The estate negotiated a contract with the publisher for the first two books to be written by the ghostwriter. Since Andrews' name would continue to be used and the estate would be compensated for such use, the IRS believed the name was an intangible asset with an assessable value. At the time the original estate tax return was filed, no value was placed on Virginia Andrews' name. In this court case there was no disagreement with the concept of valuing the name, but there was on the amount assessed.

Many concerns surfaced as the value of Virginia Andrews' name was being established. The executors were very anxious that Andrews' name and literary reputation might actually be damaged by a poor ghostwritten novel. As a result, a real possibility of reduced royalties on previous novels might be the outcome. A host of uncertainties surrounded this whole campaign, but the estate proceeded with the contract anyway.

The valuation of Andrews' name initially relied heavily on post-mortem facts and circumstances. Only the contract amount for the first two books existed at the valuation date. The contract initially agreed upon by the estate was a clone of that originally signed by Andrews herself immediately prior to her death. Various terms were changed, but the dollar values remained in effect. All other information was obtained post mortem. In fact, the IRS's initial valuation considered not only the first contract for two books, but also extended the results to six additional books anticipated by the publisher. Consequently, the IRS's valuation clearly ignored the fact that the name should be valued at the date of death (December 19, 1986). The IRS's appraiser failed to establish what relevant facts would have been reasonably known at the valuation date. The level of success of the ghostwriter's creations could not possibly have been known on the valuation date. In fact, looking past the first negotiated book would have been unrealistic. Naturally, a failed first novel would have terminated the possibility of future books.

The incorrect methodology used by the IRS was corrected as part of the case proceedings. The focus of the valuation was on the first contracted book since that is all that could possibly have been known at the date of death. The real issue here is that, by the time the issue of valuing the author's name surfaced, the success of the ghostwriter's novels had already occurred. Any concerns as to failure were essentially eliminated.

Obviously, when determining a risk factor for discounting the initial contract, the fact the novels were already successful hurt the petitioners' case for establishing a larger discount percentage. Here is a situation where post-mortem events hurt the petitioner. Even though the court succeeded in preventing the IRS from relying on information that certainly would not have been known at the valuation date, the knowledge of the success of the first novel more than likely contributed to a higher value for the intangible asset.

Other Decisions on Post-Mortem Events. Several other, less recent cases exist that discuss the issue of admitting post-mortem events as evidence for determination of value. Many of these cases are cited in the cases discussed above. The common element among all the cases is that the valuation date is still the primary concern. The acceptance of post-mortem events in determining value is only allowed to the extent the outcome or information provided by these events was deemed to be in effect or at least reasonably foreseeable at the valuation date.

The First National Bank of Kenosha v. U.S. (763 F.2d 891) dealt specifically with the issue of whether subsequent information relating to a piece of real property would have been reasonably foreseeable to a hypothetical buyer and seller. In this case, the estate had been approached by a development company fifteen months after the valuation date to discuss the purchase of the real property in question. Since the agreement between the development company and the estate dissolved, the estate attempted to have the terms of the agreement excluded from evidence in the valuation dispute. The court allowed the post-mortem event into evidence that impacted the jury's determination of value.

The Estate of Max Shlensky (36 TCM 629) involved a real estate situation where subsequent events that occurred almost fifteen months after the valuation date were admissible by the Tax Court and allowed to set the value of the real property at the date of death. The Tax Court's justification was that the facts and circumstances giving rise to the transaction had not materially changed in the subsequent period.

In U.S. v. G. Simmons (346 F.2d 213), the issue surrounded the value of an income tax refund claim. The amount of the refund was not agreed upon until almost five years after the valuation date. In this situation, the court held that reasonable knowledge of the relevant facts surrounding the claim would have revealed the refund claim had value. As a result, the court allowed the value to be set by the subsequent event.

Where the above cases allowed the subsequent events to set value, in the Estate of Eleanor O. Pillsbury (64 TCM 284) the result was different. The court noted that, even though the subsequent facts indicated a potential hazardous waste problem may have existed on the property at the valuation date, the failure of the appraiser and the estate to follow up on the potential concerns led the court to believe neither party felt a problem existed. Consequently, the court took the position that a hypothetical buyer would not have believed a problem existed either. This is a situation where relying solely on subsequent events without taking the steps necessary to prove the facts were reasonably foreseeable at the valuation date will not result in the admission of post-mortem evidence into the proceeding.

Analysis

The issue of post-mortem events as evidenced by the above discussion is not one that should be taken lightly. The admissibility of subsequent events varies on a case-by-case basis. The process of estate valuation begins with the value submitted by the executor on the original estate tax return. Three possibilities exist after the return is filed. The return can be accepted without question. The IRS can adjust the value of the estate placing the burden of proof on the taxpayer to challenge the IRS's adjusted value. The last possibility involves the taxpayer requesting an adjustment to the original estate valuation.

It is the third criteria that is in need of expansion. Since the value stated on the original return is an admission by the taxpayer, a lower value cannot be substituted without cogent proof that the reported value was erroneous. It is in this situation where estates should not ignore subsequent events. Judicial interpretation has demonstrated flexibility in the admission of subsequent events to the extent it can be proven that the post-mortem information existed or was reasonably foreseeable at the valuation date. Consequently, if post-mortem facts and circumstances emerge that indicate the value as originally reported may have been overstated, a claim for adjustment can be made. It is important to remember that the burden of proof will be on the estate to prove existence at the valuation date in this type of a case.

In Scull, where an auction established the value over the original art appraisal, there are several issues inherent in this decision. As provided in Scull, the auction value used to assess the value of the art collection was the hammer price plus the commission paid. This treatment is in accordance with the procedures set forth in Technical Advice Memorandum 9235005. Although auctions are a relevant market for sales of art, selling the art through another sales medium may have resulted in a lower liability since the commission may have been reduced or eliminated, thus lowering the value. Of course, if the estate had held onto the art collection, additional emphasis would have been placed on the hypothetical buyer-and-seller method. The lack of an actual sale may have enabled the original appraisal to stand without question.

The Necastro and Pillsbury cases appear to provide the largest incentives for the examination of post-mortem events. In both instances, the issue of environmental contamination was raised. Although in Pillsbury, the Tax Court chastised the estate and the appraisers for ignoring a potential problem, the tone was such that the Court appeared somewhat sympathetic to environmental issues. Since environmental concerns are very prevalent in today's society and very often have a delayed discovery, the ability to introduce post-mortem facts may enable taxpayers to retroactively restate value to the extent the problems existed, though undetected, at the valuation date. Nevertheless, it is difficult to assess the extent to which the Court's compassion is related to environmental aspects associated with these claims or an overall willingness to allow well-documented subsequent events to affect value.

For a summary of post-mortem events affecting estate tax valuations, see the Exhibit. *

Ted D. Englebrecht, PhD, is KPMG Peat Marwick Professor, School of Accountancy, Georgia State University. John J. Masselli, MST, CPA, is an instructor at the same institution.

SEPTEMBER 1995 / THE CPA JOURNAL

EXHIBIT

(1)Estate of Dominick A. Necastro

(68 TCM 227)

(2)Estate of Robert C. Scull

(67 TCM 2953)

(3)Estate of Andrews v. U.S.

(850 F.Supp 1279)

(4)Estate of Eleanor Pillsbury

(64 TCM 284)

(5)First National Bank of Kenosha v. U.S. (763 F.2d 891)

(6)Estate of Max Shiensky

(36 TCM 629)

(7)U.S. v. G. Simmons

(346 F.2d 213)

SEPTEMBER 1995 / THE CPA JOURNAL

The IRS's appraiser failed
to establish what relevant
facts would have been
reasonably known at
the valuation date.