In response to the Tax Court’s decision in Kohler, the IRS has issued proposed regulations clarifying that under Sec. 2032 an estate may take into account a reduction in the value of the gross estate following the decedent’s death in determining the value of the estate on the alternate valuation date if the reduction is due to market conditions but not other post-death events. In Kohler, TC Memo 2006-152, the Tax Court upheld an estate’s determination of the Sec. 2032 alternate valuation date value of the decedent’s stock in a privately held family corporation that took into account transfer restrictions and a purchase option that were placed on the stock in a Sec. 368(a) reorganization that occurred after the decedent’s death but before the alternate valuation date.
Kohler Co. (Kohler) is a diversified privately held company owned predominately by the descendants of its founder, John Michael Kohler. On March 4, 1998, one of these descendants, Frederic Kohler, died unexpectedly. Frederic Kohler owned approximately 12.85% of the outstanding Kohler stock, and the stock passed to his estate. At the time of his death, Kohler family shareholders, various charities, and trusts for the benefit of Kohler family members owned most of the Kohler stock. Shareholders outside these groups owned about 4% of the Kohler stock.
In the mid-1990s, the Kohler family and the company’s management decided they wanted to rid the company of the outside owners and considered various options for doing so. They eventually decided that the best method would be a corporate reorganization, and they hired a law firm in early 1996 to assist with the reorganization. The corporation completed the reorganization in May 1998, a little more than two months after Frederic Kohler’s death. As a result of the reorganization, Frederic’s estate received voting and nonvoting stock in the reorganized Kohler, all of which was subject to transfer restrictions and a purchase option to ensure the shares did not pass outside of the Kohler family.
Frederic’s estate elected to value the stock for estate tax purposes on the Sec. 2032 alternate valuation date of September 4, 1998. The estate hired a nationally known appraisal company to determine the stock’s value on that date. The appraisal company determined that the stock’s value was approximately $47 million. The value reflected a discount for lack of marketability due to the transfer restrictions and the purchase option on the shares. The estate reported the stock at this value on its estate tax return.
On examination, the IRS determined that the estate had undervalued the Kohler stock. The IRS engaged its own expert, who determined that the stock’s value on the alternate valuation date was $144.5 million. The Service issued a deficiency notice to the estate based on this value. The estate subsequently filed a petition with the Tax Court contesting the deficiency notice.
The IRS advanced two arguments in Tax Court. First, the Service argued that the court should value the pre-reorganization stock at the alternate valuation date because Regs. Sec. 20.2032-1(d) requires that the stock as it existed at the decedent’s date of death be the basis of the valuation on the alternate valuation date. Alternatively, the IRS argued (citing Flanders, 347 FSupp 95 (N.D. Cal. 1972)) that if the court valued the post-reorganization stock, it should not take into account the transfer restrictions and the purchase option on the shares because the legislative history of Sec. 2032 indicates that the alternate valuation date method is intended only to address changes caused by declines in the market for the property to be valued, not changes in the character of the property. According to the Service, the transfer restrictions and the purchase option changed the character of the stock owned by the decedent at his death.
Tax Court’s Decision
The court rejected both of the IRS’s arguments and held that it should value the post-reorganization stock taking into account the transfer restrictions and the purchase option. The court rejected the pre-reorganization stock argument because it found that Regs. Sec. 20.2032-1(d) did not support the Service’s position. It stated that the regulation was applicable to certain types of property interests, such as dividends and leased property, that may change form with the passage of time but did not cover property received in tax-free reorganizations. Therefore, there was no authority for the Tax Court to disregard the reorganization and base its valuation on the pre-reorganization stock.
With respect to its argument for disregarding the transfer restrictions and the purchase option, the Tax Court found the IRS’s reliance on legislative history misplaced. According to the Tax Court, it will look to legislative history only when the statutory language is ambiguous, and, in this case, Sec. 2032 is not ambiguous. The court found that Sec. 2032 and Regs. Sec. 20.2032-1(c)(1), which require property that is disposed of to be valued as of the date of disposition, clearly do not include the exchange of stock in a tax-free reorganization as a disposal of property. Therefore, the Tax Court held that the valuation of the stock for estate tax purposes should be based on the post-reorganization stock, taking into account the transfer restrictions and the purchase option, on the alternate valuation date.
The IRS has issued proposed regulations that would amend Regs. Sec. 20.2032-1(f) to clarify that only reductions in value of a gross estate due to changes in market conditions following the date of the decedent’s death are allowed to be taken into account in determining the estate’s value on the alternate valuation date. Changes in value due to a mere lapse of time or to other post-death events will not be allowed to be taken into account.
The term “market conditions” is defined in the proposed regulations as “events outside of the control of the decedent (or the decedent’s executor or trustee) or other person whose property is being valued that affect the fair market value of the property being valued.” The proposed regulations state that post-death events include, but are not limited to, “a reorganization of an entity . . . in which the estate holds an interest, a distribution of cash or other property to the estate from such entity, or one or more distributions by the estate of a fractional interest in such entity.” The proposed regulations provide several examples to illustrate the rules. The first of these is based on the Kohler case and says that post-death application of transfer restrictions to stock is not attributable to market conditions and therefore not taken into account in valuing the stock on the alternate valuation date.
Frustrated by its inability to convince the Tax Court that the regulations supported its argument, the IRS has simply changed the regulations. The Tax Court’s decision in Kohler invited this response, but because it did not reach the Service’s arguments about changes in the character of property in the decision, it remains to be seen whether the Tax Court or other courts will find that the legislative history of Sec. 2032 supports the IRS’s narrow interpretation of the provision. While the estate in Kohler certainly gained an advantage by using the alternate valuation date method, it is debatable whether the estate abused the intent of Sec. 2032 or merely benefited from the application of the provision as it is written to the peculiar facts of its case.