Opinion
No. 82-1134.
November 16, 1983.
Edward F. Sutkowski, David L. Higgs, Sutkowski Washkuhn, Peoria, Ill., for plaintiffs.
Gerald F. Fines, United States Attorney, Janet L. Jannusch, Assistant United States Attorney, Peoria, Ill., James K. Wilkens, Ellen Carpenter, Department of Justice, Washington, D.C. for defendant.
Order
In 1982 Plaintiffs filed suit against the United States seeking a refund of income taxes paid for the calendar year ending December 31, 1976. Plaintiffs claim that the Internal Revenue Service erroneously included $25,500 in Plaintiffs' gross income by virtue of Donald B. St. John's receipt of a 15% interest in the Stark County Health Center partnership. The Plaintiffs were assessed $11,567.16 representing an additional tax, penalty and interest. After a trial before this Court on September 15, 1983, this Court found that the Stark County Healty Center partnership became a partnership under Illinois law in 1975. The Court ruled that the 15% partnership interest received by the Plaintiff Donald B. St. John was in 1975 subject to a substantial risk of forfeiture, as defined in § 83 of the Internal Revenue Code of 1954 and Treasury Regulations, § 1.83-3(c). By the end of 1976, the partnership interest was not subject to a substantial risk of forfeiture. The additional income received by the Plaintiffs in the form of a partnership interest was therefore properly assessed against them for the taxable year 1976. The Court also ruled that assessment of a negligence penalty against the Plaintiffs pursuant to § 6653(A) of the Internal Revenue Code of 1954 was improper.
The Court found that the partnership interest received by St. John was not capital in nature, but rather was a profit/loss interest as a result of the oral agreement between St. John and the other partners. The partners orally agreed that St. John would receive nothing upon liquidation of the partnership unless and until the other partners first received their initial cash contributions (collectively $170,000). The Court reserved ruling on the issue of the fair market value of the 15% interest and requested briefs from both parties.
The Defendant in its brief argues that the Plaintiffs have failed to overcome the presumption that the fair market value of St. John's partnership interest was $25,500. "Fair market value" is defined 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". Treas. Reg. § 20.2031-1(b). A federal tax assessment, the Defendant asserts, is presumed to be correct and a taxpayer has the burden of proof to establish that the assessment is incorrect. United States v. Janis [76-2 USTC ¶ 16,229], 428 U.S. 433, 440-41 (1976). The taxpayer's burden has been described as a "double burden of proof" for a taxpayer because, in addition to proving that the assessment was erroneous, he must also prove that the United States owes him a specific amount of money as a refund. See Timken Roller Bearing Company v. United States [66-1 USTC ¶ 9151], 35 F.R.D. 57, 61-62 (N.D. Ohio 1964); Crosby v. United States [74-2 USTC ¶ 9550], 496 F.2d 1384, 1390 (5th Cir. 1974). The Defendant alleges that the Plaintiffs failed to introduce any evidence on the question of the "fair market value" of St. John's interest in that the testimony presented by the Plaintiffs related only to the value of St. John's interest upon liquidation. The issue is not, however, the Defendant asserts, the "liquidation value" but rather the "fair market value", and since the Plaintiffs presented no evidence as to the value a willing buyer and a willing seller would have placed on the interest, their argument must fail.
The Defendant suggests in a footnote that tax losses are marketable commodities in that partners are entitled to report losses on their personal income tax returns. The fact that a buyer could have purchased a tax loss, the Defendant claims, reflects favorably on the fair market value of the partnership interest. The Plaintiffs reply that St. John was not entitled to his share of the loss, and the Internal Revenue Service expressly denied such loss in 1976. Second, the Plaintiffs assert, tax losses have value only if they are ultimately offset by profits. The Court adopts the position and arguments of the plaintiff on this issue.
Agent Jerry Brune testified for the Defendant that the Internal Revenue Service, when it determines the "fair market value" of a partnership interest received in exchange for services, computes the estimated fair market value of the services that were rendered. Brune stated that one of the best ways of determining this value is to multiply the total capital in the partnership by the percentage of the partnership interest received. Brune testified that based upon existing case law, it made no difference in computing the fair market value of St. John's interest whether he received an interest in partnership capital or a profit/loss interest. The Defendants place some reliance on Sol Diamond v. Commissioner [74-1 USTC ¶ 9306], 492 F.2d 286 (7th Cir. 1974), aff'g [CCH Dec. 30,838] 56 T.C. 530 (1971). In Sol Diamond, the Seventh Circuit considered the issue of the value of a partnership interest received in exchange for services rendered. The tax court refused to accept the taxpayer's argument that since he received only an interest in the partnership's profits and losses, he did not receive income subject to tax pursuant to § 721 of the Internal Revenue Code of 1954 (26 U.S.C.) and the regulations thereunder. The tax court held that the fair market value of the taxpayer's interest, whether a capital or a profit/loss interest, was includable in his income and upheld the assessment.
The Plaintiffs suggest that there is substantial evidence in the record that, because of the specific nature of St. John's interest, it had a market value as of December 31, 1976, of zero. They argue that there is no evidence in the record to support a finding of a value of $25,500, and thus, the Defendant's only position is to try to refute the evidence of value which was presented at trial. The Plaintiffs assert that witnesses for both parties indicated that the proper method for a determination of the value of the partnership interest was based on its liquidation value. Brune, the Plaintiffs assert, testified as to the routine procedures of the Internal Revenue Service in determining the value of a partnership interest. That method is to take the liquidation value of such interest, i.e., each partner's ratable share of the partnership assets. The obvious fallacy of the Internal Revenue Service's determination, the Plaintiffs claim, is that the Internal Revenue Service failed to take into account the fact that St. John's interest was different from the other partners in that St. John would receive no portion of the first $170,000 in liquidation. Agent Brune admitted that the value of the partnership interest would be directly affected to the extent it had subordinate rights in liquidation.
Orville Frank, a certified public accountant, testified at trial on at least five occasions that the value of St. John's interest as of December 31, 1976 was zero. Frank therefore did not include a specific value for the interest on the 1976 income tax return. The primary basis for Frank's opinion, the Plaintiffs assert, was that St. John would get nothing in liquidation as of the end of 1976. Additional factors affecting Frank's opinion were that St. John's interest was not a capital interest, the nursing home was not in operation as of the end of 1976 nor was it even licensed, and some of the facility's original capital had already been spent. The Plaintiffs conclude that Frank's testimony does not necessarily equate market value with liquidation value, but that as a result of the liquidation value and other factors, the value of St. John's interest was zero. St. John concurred in Frank's opinion.
The Plaintiffs argue that all three witnesses thus effectively determined value by determining the amount of money St. John would have received had the partnership dissolved and the assets been liquidated and distributed. This is precisely the method Brune said was routine for valuing a partnership interest, the Plaintiffs assert, inasmuch as he merely took a pro rata share (15%) of the partnership assets ($170,000) in determining the value of St. John's interest. Brune, however, the Plaintiffs claim, failed to consider the particular liquidation characteristics of St. John's interest as a result of St. John's agreement with the partners that his interest was subordinate. On December 31, 1976, the partnership had assets worth less than $170,000 and thus on liquidation St. John would have received nothing.
Courts have given effect to the liquidation value of property as its market value for tax purposes in several cases where the factual circumstances warranted such an approach. In Estate of Garrett v. Commissioner [CCH Dec. 19,925(M)], 12 TCM 1142 (1953), for example, the Court looked at the liquidation value of certain property as its market value where a logging company had long ceased to be active, its equipment was antiquated and its supply of timber nearly exhausted. In Learner v. Commissioner [CCH Dec. 39,946(M)], 45 TCM 92 (1983), the Court adopted the liquidation method for determining value of petitioner's minority interest where there were reasonable prospects that the company would be liquidated. The value of the business was viewed as that of its underlying assets. Berckmans v. Commissioner [CCH Dec. 24,755(M)], 20 TCM 458 (1961), involved an inactive and unproven corporation where numerous contingencies indicated that the corporation might acquire ongoing businesses or that it might remain nothing but a shell. The Court in that case ruled that the value of the stock at the date of its sale was not greater than its book value since the business outlook of the corporation was uncertain.
The Plaintiffs argue that Estate of Lee v. Commissioner [CCH Dec. 35,017], 69 T.C. 860 (1978) is analogous to the situation in the case at bar. In Lee a husband and wife had formed a corporation for which there were 50,000 shares of preferred and 5,000 shares of common stock. The preferred was entitled to a $200 per share preference in liquidation. In deciding the value of the preferred shares, the Court allocated nearly all the value of the corporation to the preferred. The Court said:
"The common shareholders were entitled to no distribution until the corporation had sufficient assets to meet the $10,000,000 (liquidation preference) value. This potential return to common shareholders was speculative and could be anticipated to occur, if at all, only many year later."
Thus, the Court looked at the factual circumstances underlying the value of the stock in determining its fair market value.
The case of Sol Diamond, on which the Defendant relies, is distinguishable from the case at bar. In Sol Diamond, it was clear that the interest involved did have a value since within 30 days of receipt of the interest, it was sold for $40,000. This does not mean, however, that all profit interests have a substantial market value. In discussing the value of a profit interest, the Seventh Circuit noted that:
"There must be wide variation in the degree to which a profit-share created in favor of a partner who has or will render service has determinable market value at the moment of creation. Surely in many if not the typical situations it will have only speculative value, if any." 492 F.2d at 290.
In discussing the value to be allocated to the interest in Sol Diamond, the Seventh Circuit noted that there is no statute or regulation which expressly prescribes the income tax effect at the moment a partner receives a profit-share in return for services. The Court noted that "there is a startling degree of unanimity that the conferral of profit-share as compensation for services is not income at the time of the conferral, although little by way of explanation of why this should be so, or analysis of statute of regulation to show that it is prescribed." 492 F.2d at 289. Commentator Willis suggests that:
"However obliquely the proposition is stated in the regulations, it is clear that a partner who receives only an interest in future profits of the partnership as compensation for services is not required to report the receipt of his partnership interest as taxable income. The rationale is two-fold. In the first place, the present value of right to participate in future profits is usually too conjectual to be subject to valuation. In the second place, the service partner is taxable on his distributive share of partnership income as it is realized by the partnership. If he were taxed on the present value of the right to receive his share of future partnership income, either he would be taxed twice, or the value of his right to participate in partnership income must be amortized over some period of time."
Willis on Partnership Taxation, 84-85 (1971), as quoted in Sol Diamond, 492 F.2d at 289. It is also noted in McKee, Nelson and Whitmire, Federal Taxation of Partnerships and Partners, ¶ 5.06 at 5-32 (1977), that "many profit interests will be virtually valueless when received."
Internal Revenue Service Code § 83 requires this Court to determine the fair market value of St. John's interest as of December 31, 1976. The fair market value is defined as the price at which the property would change hands between a willing buyer and a willing seller, both having reasonable knowledge of relevant facts. Treas. Reg. § 20.20311(b). Thus, the issue to be resolved in this case is what a willing buyer would pay St. John for his subordinated interest in the partnership. Based on this Court's determination that St. John's interest was merely a profit interest and was different from the capital interests that the other partners had, the Court must look beyond St. John's pro rata share of 15% in the partnership assets of $170,000 in determining the value of St. John's interest.
In 1976, the nursing home's success was undetermined and speculative. It was not licensed nor operational and the partnership operated at a loss of $26,140 for that year. It was not clear when, if ever, the partnership would be profitable. Thus, the liquidation approach to value is the proper method for determining the fair market value of St. John's subordinate interest in the partnership.
The burden of proof is clearly on the Plaintiffs to establish that determination of their tax liability by the Internal Revenue Service is incorrect. The Plaintiffs have met this burden and have proved the amount of refund due. They have established, based on both testimony at trial and legal authority, that St. John had merely a profit interest and that the liquidation method is the proper one for determining the value of that interest. They have shown that the Defendant's determination of a value of $25,500 was erroneous in that it failed to consider that St. John's interest was merely a profit interest. St. John's interest had a value of zero for the taxable year 1976 since he would receive nothing in liquidation on December 31, 1976.
Judgment is entered in favor of the Plaintiffs in the amount of $11,567.15 plus interest. Each party is to bear his own costs.