Court says the IRS' recourse to 7520 tables "unrealistic and unreasonable". Jan Piotrowski is a senior associate of FMV Opinions, a valuation and financial advisory services firm.

Overview

In the space of a month Carol Negron became executrix of two separate estates whose decedents had jointly won the Ohio Lottery a decade earlier. On top of the difficulties involved with computing -- and paying -- the tax liabilities associated with the major assets of the decedents' estates (in this case annual lottery payments), Negron would find herself embroiled in a court case with profound implications for the valuation of lottery prizes with restricted marketability.

The primary issues in Carol Negron et al. v. United States (No. 1:05-cv-02305 (June 2007)) evoke important points made in a similar case: Thomas J. Shackleford v. United States (U.S. Dist. LEXIS 16375 (E.D. Cal., August 1999)). Both cases deal with the reasonableness of current methodologies for valuing annual lottery payments with restricted marketability. Although we can draw strong parallels to the conclusions drawn in Shackleford, Negron's ending seems, as yet, unwritten.

Background

On 19 January 1991, Mary Susteric and Mildred Lopatkovich won the Ohio Super Lotto jackpot and soon received the first of 26 annual payments of $256,410 from the state of Ohio. That state's law prohibited any assignment or collateralization of these annual payments, materially affecting their marketability.

Susteric passed away on 30 October 2001. About a month later Lopatkovich died as well. Negron was appointed executrix of both estates.

The decedents' estates disclosed the remaining 15 annual payments due from the state of Ohio as assets on their estate tax returns. Both estates valued the remaining payments at $2.3 million, based on their respective lump-sum distributions from the Ohio Lottery Commission, which had used a 9.0% discount rate in computing the amount of these distributions.

Subsequent audits by the Internal Revenue Service (IRS), using Internal Revenue Code Section 7520 annuity tables, determined that the value of the remaining payments was $2.7 million for the Susteric estate and $2.8 million for the Lopatkovich estate. As a result of these audits, the Susteric estate tax liability increased by $148,368 and the Lopatkovich estate tax liability went up by $367,297.

Both estates subsequently filed refund claims. They were denied on 18 March 2005.

On 29 September 2006, Negron filed a complaint in the U.S. District Court for the Northern District of Ohio, Eastern Division, against the United States, alleging an improper tax assessment on the Susteric and Lopatkovich estates. On 10 July 2006, the government filed a motion for summary judgment and Negron filed a motion for partial summary judgment.

The Government's motion for summary judgment required that it show that there was no genuine issue in dispute.

The expert for Shackleford, Lance Hall of FMV Opinions argued for the application of valuation methodologies that considered attempted arm's-length transactions in non-assignable lottery prizes. These transactions mimicked the restricted marketability at issue in both cases because they were subject to, and denied, state court approval because of state laws prohibiting assignment of lottery prizes.

Based on an analysis of the rates of return sought in these transactions, Hall concluded with a fair market value for the lottery prize that was less than 50% of the fair market value determined through use of the 7520 tables. The district court supported Hall's analysis, stating that Shackleford had met the "substantial burden of proof" showing that the 7520 tables had resulted in unreasonable values, and that a more applicable valuation methodology was available.

Although the IRS appealed, the Ninth Circuit upheld the previous decision, decreeing a new standard: "if the taxpayer proves that a more realistic and reasonable valuation method exists that more closely approximates fair market value, courts are free to employ it."

Conclusion

Ultimately, the court denied the government's motion for summary judgment and granted Negron's motion in part, noting that she successfully convinced the court that the 7520 tables, in this instance, produced unrealistic and unreasonable results, but did not establish a more viable methodology for valuing the annuity. "To wit," the court ruled, "it makes fundamental economic sense that the transferability of an annuity would affect its fair market value. Therefore, the court finds that Negron successfully demonstrates that the value ascribed by the annuity tables for both estates' taxes is 'unrealistic and unreasonable.' It appears that due to the bifurcated nature of the expert discovery, there has yet to be any testimony by experts in this case regarding a more reasonable means to calculate the fair market value. Negron fails to satisfy the second element of the exception to applying the annuity tables; that there is a more reasonable and realistic means to determine the fair market value."

Final thoughts

Although the court has instructed both parties to confer and submit a joint position statement by 22 June 2007, it is the author's opinion that a useful step for the taxpayer would be to examine historical precedent, such as Hall's analysis for Shackleford, in its search for a reasonable and well-articulated methodology for valuing lottery payments with restricted marketability. Negron may find that this chapter has already been written, after all.

Watch this space, as they say, for more on this case and its implications for the valuation of lottery payments for estate tax purposes. -FWR

This is not intended or written to be used by any taxpayer or advisor to a taxpayer for the purpose of avoiding penalties that may be imposed upon the taxpayer or advisor by the IRS. This writing is not legal advice, nor should it be construed as such.

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