Davis v . United States of America 04-CV-273-SM 06/13/07 P UNITED STATES DISTRICT COURT
DISTRICT OF NEW HAMPSHIRE
Mary C . Davis, Executrix of the Estate of Kenneth Freeman, Plaintiff
v. Civil N o . 04-cv-273-SM Opinion N o . 2007 DNH 077P United States of America, Defendant
O R D E R
The question presented by this case is how a decedent’s
state lottery winnings (in the form of 10 annual payments of
approximately $209,000) should be valued for federal estate tax
purposes. The government argues that the right to ongoing
lottery payments is properly valued by reference to the annuity
tables set out in the Internal Revenue Code (“IRC”), yielding a
taxable value, in this case, of $1,607,164.
Plaintiff, on the other hand, argues that because the
estate’s right to receive future lottery payments i s , by law,
non-assignable, the asset is necessarily less valuable than it
would be if it were freely transferable. Accordingly, says
plaintiff, reference to the annuity tables produces a distorted
and over-stated value for tax purposes, thereby justifying use of
an alternate valuation methodology. Based on her expert’s appraisal, plaintiff asserts that the asset should be valued at
$803,582 for estate tax purposes (i.e., half the value yielded by
the tax valuation tables).
Background
In 1989, plaintiff’s decedent, Kenneth Freeman, won the
Massachusetts lottery and received the first of 20 annual
payments of $209,220 from the Commonwealth. Slightly more than
nine years later (after receiving 10 annual payments from the
Commonwealth), M r . Freeman died. Upon his death, the remaining
10 annual payments became payable to Freeman’s estate. The
Commonwealth of Massachusetts has made the annual payments to the
estate.
At the time of his death, M r . Freeman was a resident of
Somersworth, New Hampshire. His federal estate tax return, filed
on February 1 , 2000, reported a tax due of $520,012, a prior
payment of $530,624, and a refund due of $10,612. On Schedule F
of the return, the estate disclosed the remaining 10 annual
payments due from the Commonwealth as an asset of the estate.
The estate valued that asset at $1,584,690, based upon the
annuity tables found in section 7520 of the IRC. 26 U.S.C. §
7520.
2 Subsequently, the Internal Revenue Service audited the
estate’s return and determined that the 10 remaining payments
from the Commonwealth were properly valued slightly higher, at
$1,607,164. The reason for that discrepancy is not material - it
resulted from a minor computational error by the estate. Both
parties agree that, if the court decides that the value of the
annuity payments must be determined by reference to the annuity
tables in the IRC, the correct value of the asset is $1,607,164.
As a result of the changes made by the IRS to the decedent’s
tax return (including revaluation of the lottery annuity), the
estate’s tax liability was actually reduced from $520,012 to
$506,622. Nevertheless, the executrix had second thoughts about
how the lottery annuity had been valued (by both the estate
itself and the I R S ) . She determined that reference to the IRC
annuity tables was not appropriate under the circumstances. On
December 2 8 , 2001, the estate filed an informal claim for refund,
asserting that the correct value of the remaining 10 annuity
payments for estate tax purpose was $800,000 (roughly half the
value ascribed to it by the IRC annuity tables).
The estate explained the difference by pointing out that the
annuity tables fail to take into account the non-transferable
3 character of the right to receive future payments. That is to
say, the right to receive those payments cannot be sold,
assigned, pledged as collateral, or otherwise transferred.
Consequently, said the estate, the asset has a significantly
lower fair market value than the tables establish. The estate’s
informal claim for a tax refund was denied on November 2 1 , 2002.
Plaintiff then filed this timely suit seeking a tax refund.
The parties have stipulated that the 10 future payments owed
by the Commonwealth to the decedent on the date of his death
constitute an “annuity” within the meaning of sections 2039 and
7520(a) of the IRC and that the decedent’s interest in those
payments was an “ordinary annuity interest” within the meaning of
the Estate Tax Regulation set forth in 26 C.F.R. § 20.7520-
3(b)(1)(i)(A). They also agree that, at the time of the
decedent’s death, the remaining 10 lottery payments due to him
were neither marketable nor assignable. Finally, as noted above,
the parties agree that, if the court determines that the fair
market value of the estate’s annuity is properly determined by
reference to the IRC annuity tables, it is correctly valued at
$1,607,164.
4 By order dated December 1 9 , 2005, the court denied the
parties’ cross-motions for summary judgment. The court observed
that, for estate tax purposes, the general rule requires that
assets of the estate be valued at their fair market value and
that the estate’s annuity be valued by reference to the IRC
annuity tables. But, there is an exception to that rule. Use of
an alternate valuation method might be warranted if the plaintiff
could prove that: (1) the value ascribed to the decedent’s
annuity by the IRC tables is “unrealistic and unreasonable,” and
(2) there is a more reasonable and realistic means by which to
determine its fair market value.
The court then concluded that the nonmarketable right to
receive 10 annual payments from the Massachusetts Lottery
Commission is likely less valuable than it would be if that right
were freely alienable. In other words, the annuity’s fair market
value i s , to some degree, less than its present value (as
determined by the IRC tables), since those tables do not take
into account the fact that the annuity is nonmarketable.1
1 An annuity’s “present value” is the lump-sum amount that, if invested today, together with interest earnings (at an assumed rate of interest), would be enough to meet each of the payments as it fell due and, at the time of the last payment, the invested fund would be exactly zero.
5 Importantly, however, the court noted that there remained a
genuinely disputed material fact: the correct tax value of the
annuity if an alternate reliable valuation method is employed.
Accordingly, it held that plaintiff failed to carry her burden of
demonstrating that the value yielded by the IRC tables is
“unrealistic and unreasonable.”
At this juncture, all the court can conclude is that the “present value” of the annuity (as determined by the IRC annuity tables) is likely to be higher than its “fair market value.” That conclusion might suggest that to properly value the annuity in this case reference to the IRC annuity tables is inappropriate. But, any discrepancy between the IRC tables and the “true” fair market value of the annuity in question does not necessarily compel the conclusion that it is improper to employ those tables. Using a valuation method other than the annuity tables is only warranted if the difference between the value yielded by the IRC tables and the value determined by an alternate valuation method is sufficiently substantial to warrant the conclusion that the IRC annuity tables produce an “unreasonable and unrealistic” value. Given the existence of a genuinely disputed material fact (i.e., the fair market value of the annuity if another, reliable valuation method is used), the court cannot determine the proper valuation method as a matter of law.
Davis v . United States, 2005 DNH 168 at 17-18 (D.N.H. Dec. 1 9 ,
2005)(emphasis in original).
In response, and in light of the fact that determining the
proper method for valuing the annuity for tax purposes is
6 essentially a question of law, the parties have waived their
requests for a jury trial and agreed to resolution of the case
based upon submitted expert valuation reports in support of their
respective positions.
The government asserts that, even using alternate valuation
methods to determine the annuity’s “fair market value,” the
results are so close to those yielded by the IRC tables that, as
a matter of law, the stipulated value of $1,607,164, yielded by
the tables, is the correct one for federal estate tax purposes.
Plaintiff, on the other hand, asserts that the true “fair market
value” of the annuity is only one-half of the amount suggested by
the IRC tables. Consequently, says plaintiff, the IRC tables
yield an “unrealistic and unreasonable” approximation of the
annuity’s fair market value and the appropriate value the court
should ascribe to the annuity is only $803,582.
Discussion
In support of her position, plaintiff has submitted a
valuation report prepared by Eugene A . Sommer (document n o . 30-
2). That report is flawed. In reaching his conclusion that the
value of the annuity yielded by the IRC tables should be
7 discounted by fifty percent (50%) to account for its lack of
marketability, M r . Sommer relies upon a mistaken assumption.
The IRC imposes a tax on “the transfer of the taxable estate
of every decedent who is a citizen or resident of the United
States.” 26 U.S.C. § 2001(a). For tax purposes, a decedent’s
estate includes “the value at the time of his death of all
property, real or personal, tangible or intangible, wherever
situated.” 26 U.S.C. § 2031(a). The pertinent tax regulations
make clear that all assets included in the decedent’s estate are
valued at their “fair market value,” which is defined to mean
“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 sell and both having reasonable knowledge of
relevant facts.” 26 C.F.R. § 20.2031-1(b).
The “property” at issue i s , of course, the estate’s
enforceable and virtually risk-free (albeit non-assignable) right
to receive 10 annual payments of approximately $209,000 from the
Commonwealth. Consequently, the question presented in this case
is this: How much would a willing and fully informed hypothetical
buyer pay for a legally enforceable, virtually risk-free, right
8 to receive 10 annual payments of roughly $209,000 that cannot be
assigned to a third party?
In his report, M r . Sommer did not attempt to assess how much
the hypothetical, fully-informed buyer would be willing to pay
for such an asset. Instead, he attempted to calculate the amount
for which the estate could sell the annuity (if it so chose) to a
fully-informed, willing, hypothetical buyer. Critically,
however, such a buyer would be acquiring less than what the
estate has. Because the annuity is non-assignable and non-
transferable, the hypothetical buyer in M r . Sommer’s calculations
would “recogniz[e] that the intangible asset will be paid by the
[Commonwealth] only to the winner of the lottery and not to a
third party.” Sommer Report at 2 , para. 2.1. Thus, one of M r .
Sommer’s fundamental assumptions is that the hypothetical
purchaser of the annuity would discount its value substantially,
not simply because he or she would have difficulty selling it to
another party, but also because “the income stream by a potential
buyer is at risk.” Id.
Plainly, however, the income stream is not at risk due to
potential insolvency of the Commonwealth. S o , the risk that M r .
Sommer assumed exists must originate elsewhere. Given that, it
9 seems that M r . Sommer envisioned a situation in which the estate
would “sell” the (non-assignable) annuity to a third party, who
would depend on the estate to continue receiving payments from
the Commonwealth and then remit those payments to the third
party. In light of those assumptions, M r . Sommer concludes that:
Therefore the hypothetical buyer of a Massachusetts Megabucks lottery prize lacks the ability to perfect a security interest; would be unable to collect if the seller became mentally incompetent or died; and would also suffer from lack of marketability, as there would be no public market for the future cash flow stream.
Sommer Report at 3 , para. 3.1. As the United States District
Court for the District of Massachusetts has observed, “[t]hose
risks would be relevant here if the issue were valuation of the
estate of a buyer of lottery winnings.” Estate of Donovan v .
United States, 2005 WL 958403 at *5 (D.Ma. April 2 6 , 2005)
(emphasis in original). That, however, is not the issue before
the court.
For purposes of determining the fair market value of the
estate’s annuity, the assumptions underlying M r . Sommer’s report
are incorrect. The question here is not how much a hypothetical
buyer would pay the estate for its “used” lottery ticket.
Instead, the question is how much that hypothetical buyer would
pay to stand in the shoes of the estate. The government’s
10 expert, Professor Jarrell, correctly made this observation in his
report, noting:
Mr. Sommer’s opinion that a 50% discount for lack of marketability is applicable, is based on the incorrect assumption that the hypothetical buyer could not gain legal rights to the ten-payments annuity even if they were the highest bidder in the auction. The correct hypothetical question is to determine the price that a hypothetical bidder would pay assuming that the hypothetical buyer could gain full legal rights to the ten-payments annuity but could not resell those rights.
Report of Gregg A . Jarrell, Ph.D. (document n o . 30-4) at 2-3.
That i s , the question before the court is the fair market value
of an annuity that would provide its owner with all the rights
the estate currently has - including, of course, the legally
enforceable right to compel the Commonwealth to make the annual
payments, independent of the life or mental status of any
individual. See, e.g., Guggenheim v . Rasquin, 312 U.S. 254
(1941) (holding that for gift tax purposes, the value of a life
insurance policy is the cost to purchase that (or a similar)
policy, rather than its cash surrender value).
Given M r . Sommer’s assumptions, it is not surprising that he
concludes that a hypothetical buyer of an enormously risky
investment would purchase it only at a sizeable discount. But,
because the court concludes that the assumptions underlying M r .
11 Sommer’s conclusions are faulty, it cannot credit his conclusion
that the fair market value of the annuity in question is only
fifty percent (50%) of its present value (i.e., $ 803,582).
The government’s experts, on the other hand, persuasively
reason that a hypothetical purchaser of a virtually risk-free,
but non-assignable, right to receive 10 annual payments from the
Commonwealth would be willing to pay something very close to the
present value of those 10 payments. In fact, one of the
government’s experts - M r . Goldsholle - credibly argues that the
hypothetical buyer might even be willing to pay slightly more
than the value yielded by the IRC tables, given the fact that the
income stream the annuity generates is as close to a risk-free
investment as one might imagine. See Valuation Report by Gerry
H . Goldsholle (document n o . 30-3) at 16 (observing that
financially stable insurance companies selling 10-year immediate
annuity certain contracts paying $209,000 annually for ten years
charge more for such annuities than the figure yielded by the IRC
tables).
In his report, M r . Goldsholle credibly concludes, among
other things, that:
12 1. The estate’s right to receive ten annual payments of approximately $209,000 from the Commonwealth is substantially similar to a non-commutable, 10-year, immediate annuity certain contract;
2. Given that, a reasonable and accurate approximation of the fair market value of the estate’s annuity is the amount that an insurance company would charge for a similar annuity (or, viewed from a slightly different perspective, the amount a fully informed buyer would pay for such an annuity in the retail market);
3. There is no established secondary market in which holders of either winning lottery tickets or commercially-issued annuities might sell those assets;
4. Despite the lack of an established secondary market in which holders of annuities might sell those assets, the lack of liquidity does not appear to affect the price at which insurance companies sell those annuities or the price that annuity buyers are willing to pay;
5. Given that there is virtually no risk that the Commonwealth will default on its obligations under the annuity held by the estate, the hypothetical fully-informed buyer would be willing to pay at least as much (if not more) for that asset as the amount that insurance companies charge for similar annuities;
6. The IRC tables provide an accurate estimation of the fair market value of an annuity, taking into consideration the many variables that would affect an individual annuity’s value (e.g., financial strength of the issuing company, risk of default, etc.) and, if anything, those tables may actually under- estimate the fair market value the estate’s annuity.
13 Id. at 7-16.
Given the record before i t , the court concludes that the
non-assignable nature of the estate’s annuity has a minimal (if
any) effect on its fair market value. At the very most, its lack
of assignability would result in a five percent (5%) discount
relative to comparable, but freely transferable, annuities. See
Report of Gregg Jarrell at 5 ; Report of Gerry Goldsholle at 15-
16. In light of the virtually non-existent risk of default by
the Commonwealth, however, it is entirely possible that the
estate’s annuity actually has a fair market value slightly in
excess of the value ascribed to it by the IRC tables.
Assuming that the true fair market value of the estate’s
annuity is five percent (5%) less than the amount yielded by the
IRC table, the next question presented is whether that difference
is sufficiently substantial to render the IRC figure “unrealistic
and unreasonable.” It is not. See, e.g., Anthony v . United
States, 2005 WL 1670697 (M.D. L a . June 1 7 , 2005) (holding that
the value yielded by the IRC tables was not unrealistic or
unreasonable, despite plaintiff’s evidence that the fair market
value of the annuities in question was thirty-two percent lower).
14 See generally Cook v . Comm’r of the IRS, 349 F.3d 8 5 0 , 854 (5th
Cir. 2003) (“In enacting § 7520(a)(1) and requiring valuation by
the tables, Congress displayed a preference for convenience and
certainty over accuracy in the individual case.”).
The court has not found (nor has plaintiff cited) any cases
in which such a minor deviation from the figure yielded by the
IRC tables warranted a departure from those tables. See
generally Cook, 349 F.3d at 855 (collecting cases in which the
courts concluded that a departure from the IRC tables was
justified due to faulty assumptions made by the tables, which
resulted in substantially overstating the fair market value of
the asset in question). Even the two circuit courts of appeals
that have concluded that lottery annuities should not be valued
by reference to the IRC tables did so only after finding that the
IRC tables yielded a value that deviated from the annuities’
“true” fair market value by more than twenty five percent ( 2 5 % ) .
In Shackleford v . United States, 262 F.3d 1028 (9th Cir.
2001), the court of appeals affirmed the district court’s
conclusion that the IRC tables underestimated the fair market
value of a non-assignable lottery annuity by fifty percent ( 5 0 % ) .
Importantly, however, neither the district court nor the court of
15 appeals explained why the lack of marketability, alone, reduced
the annuity’s fair market value so substantially (other than to
observe that the right of alienability is an essential property
right). In this case, the government’s experts have plausibly
and credibly reasoned that purchasers of annuities are, generally
speaking, interested in acquiring a stable and steady income
stream; they are not generally concerned with liquidity.
Accordingly, the fair market value of an annuity is not,
generally speaking, adversely affected in any substantial way by
its lack of marketability. Given the evidence of record in this
case, the court is not persuaded by the reasoning in Shackleford.
In Estate of Gribauskas v . Comm’r of Internal Revenue, 342
F.3d 85 (2d Cir. 2003), the Commissioner actually agreed that
“the estate’s valuation of the [lottery annuity], a figure over
$900,000 below that prescribed by the § 7520 standardized
valuation tables, accurately reflects the market discount
attributable to those restrictions.” Id. at 8 8 . Given that
concession by the government - that i s , that the IRC tables over-
valued the annuity by roughly thirty percent (30%) - the court
understandably concluded that, in that particular case, deviation
from the IRC tables was appropriate. In this case, however,
there is no such stipulation. And, beyond that, the government
16 has introduced two expert reports that credibly conclude that the
fair market value of the estate’s annuity is not substantially
reduced by virtue of its lack of marketability.
Conclusion
Unlike either Shackleford or Gribauskas, the record in this
case simply does not permit the court to conclude that the IRC
tables substantially overvalue the estate’s annuity. At most,
the court could plausibly conclude that there is a five percent
(5%) difference between the “true” fair market value of the
estate’s annuity and the value yielded by the IRC tables. That
discrepancy, however, is insufficient to warrant a departure from
those tables. Even if the IRC tables are, in this particular
case, off by as much as five percent ( 5 % ) , plaintiff has failed
to demonstrate that such a relatively minor discrepancy is
sufficient to warrant the conclusion that the value those tables
ascribe to the decedent’s annuity is “unrealistic and
unreasonable.”
On the record before i t , the court concludes that plaintiff
has failed to carry her burden of demonstrating that the estate’s
annuity should be valued by some method other than reference to
the IRC tables. Accordingly, for federal estate tax purposes,
17 the court concludes that the proper value for the estate’s
annuity is the stipulated figure of $1,607,164, prescribed by the
IRC tables.
The Clerk of Court shall enter judgment in favor of
defendant and close the case.
SO ORDERED.
s/even J. McAuliffe 'S hief Judge
June 1 3 , 2007
cc: Peter S . Black, Esq. Valerie Wright, Esq. William C . Knowles, Esq. Stephen T . Lyons, Esq.