UNITED STATES TAX COURT

T.C. Memo. 2004-46

UNITED STATES TAX COURT

ESTATE OF LEA K. HILLGREN, DECEASED, MARK HILLGREN, EXECUTOR,

Petitioner v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 13394-01.

Filed March 3, 2004.

Paul Frederic Marx, for petitioner.

Thomas J. Fernandez, Hieu C. Nguyen, Edwin Herrera, for

respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

COHEN, Judge:

Respondent determined a deficiency of

$1,269,498 in the Federal estate tax of the estate of Lea K.

Hillgren (decedent), Mark Hillgren, executor, and an accuracyrelated penalty under section 6662(a) of $247,691.

After

- 2 concessions by the parties, the issues for decision are:

(1) Whether an entity entitled “The Lea K. Hillgren Partnership,

A California Limited Partnership” (LKHP or partnership) is a

partnership that should be disregarded under section 2036(a) in

valuing seven properties in which decedent had an interest;

(2) the effect of a Business Loan Agreement (BLA) between

decedent and her brother on the value of four properties in which

decedent had an interest.

Respondent concedes that the estate is

not liable for the accuracy-related penalty under section 6662.

Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect as of the date of decedent’s

death, and all Rule references are to the Tax Court Rules of

Practice and Procedure.

FINDINGS OF FACT

Some of the facts have been stipulated, and the stipulated

facts are incorporated in our findings by this reference.

Lea K.

Hillgren (decedent) was a resident of California at the time of

her death.

The executor of decedent’s estate, her brother, Mark

Hillgren (Hillgren), resided in California when the petition in

this case was filed.

Decedent’s Background

Decedent graduated from California State University with a

degree in restaurant and hotel management.

She was a restaurant

manager for Hamburger Hamlet, attended cooking school in France,

- 3 and was in the catering business at various times.

1979, decedent was a professional snow skier.

she was a golfer.

In 1978 and

Later in her life,

During her life, decedent owned various

income-producing properties that she acquired through a

combination of purchase and inheritance from her grandfather.

Decedent did not marry and did not have any children.

Decedent was treated for mental illness beginning in 1984.

Decedent’s psychiatrist, Dr. Carolyn Hays (Hays), practiced

psychiatry in Beverly Hills, California.

Hays began treating

decedent for depression in 1987 and treated her regularly

beginning in 1994.

Decedent’s boyfriend in 1996, Michael O’Brien (O’Brien), was

a golf professional at decedent’s golf club.

O’Brien was

approximately 10 years younger than decedent.

Around October

1996, decedent ended her relationship with O’Brien.

On October 31, 1996, decedent attempted to commit suicide by

intentional overdose of medications and alcohol and by carbon

monoxide poisoning.

The attempt was unsuccessful because she was

discovered by a police officer.

She was taken to Hoag Memorial

Hospital Presbyterian (Hoag hospital) in Newport Beach,

California, and was admitted for treatment for a week or two at

Cedars Sinai Medical Center (Cedars Sinai) in Los Angeles,

California.

Decedent’s treating psychiatrist at Cedars Sinai and

- 4 Hays changed decedent’s medication, prescribing a new

antidepressant for her.

After decedent’s suicide attempt, she tried to resume her

relationship with O’Brien.

The relationship did not continue,

and O’Brien seemed to lose interest in decedent.

On March 21, 1997, decedent was admitted to Hoag hospital

for pain in her arm and neck.

different medications.

At the time, she was taking five

Decedent also suffered from a

degenerative disc disease of the cervical spine.

On March 28,

1997, decedent received a cervical epidural steroid for her back

pain at Hoag hospital.

On June 5, 1997, at the age of 41,

decedent committed suicide by carbon monoxide poisoning.

According to Hays, several factors possibly contributed to

decedent’s suicide, including the relationship with O’Brien; the

death of decedent’s cat; and a combination of prescription

medication that decedent was improperly taking.

Decedent was survived by her parents, Carl C. Hillgren and

Kay Schureman; by her brother, Hillgren; and by Hillgren’s

children, Sophia M. Hillgren and Carl R. Hillgren.

The Original Lea K. Hillgren Trust

On April 10, 1984, decedent established the Lea K. Hillgren

Trust (original trust).

Under the original trust, decedent could

revoke or amend the trust, in whole or in part, during her

lifetime.

Decedent and Hillgren were named as cotrustees of the

- 5 original trust, and Hillgren was named as the beneficiary.

The

“Schedule I” attached to the original trust specified the

property that was transferred to the trust and included shares of

stock in Sea Shell Properties, Limited (Sea Shell Limited), and

unspecified real estate partnership interests.

On November 24,

1986, decedent executed a durable power of attorney, appointing

Hillgren as her agent.

Business Entities

Prior to 1988, decedent, as trustee of the original trust,

owned a California corporation, Sea Shell Limited.

In December

1988, Sea Shell Limited dissolved, and all of its assets were

distributed to decedent as trustee of the original trust.

Decedent then conducted business as a sole proprietor under the

name Sea Shell Properties.

(“Sea Shell” will be used to refer to

Sea Shell Properties and its predecessor and related entities

that were essentially controlled by decedent and bore names used

interchangeably in referring to decedent’s business activities.)

On December 12, 1997, after decedent’s death, Hillgren filed a

fictitious business name statement in California for Sea Shell

Limited, naming decedent as the registrant.

As of the date of decedent’s death, Hillgren had worked in

the real estate industry for 27 years.

Prior to December 1986,

Hillgren established, merged, and dissolved various entities,

some with similar names, to conduct his real estate activities.

- 6 In December 1986, one of Hillgren’s entities, Seaward Properties,

Limited, dissolved, and its assets were distributed to Seaward

Partners, a California general partnership owned 89 percent by

Hillgren and 11 percent by Carl C. Hillgren.

(“Seaward” will be

used to refer to Seaward Partners and its predecessor and related

entities that were essentially controlled by Hillgren.)

From

1987 through 1997, Hillgren held a general partnership interest

in two partnerships, LKHP and Seaward.

Seaward also held general

partnership interests in three other partnerships.

At the date

of decedent’s death, Hillgren had executed several certificates

of partnership.

Business Loan Agreement

Around April 1994, decedent and Hillgren entered into the

BLA, which was drafted by their attorney, Jeffrey Walsworth

(Walsworth).

The BLA described a series of events occurring

between decedent, doing business as Sea Shell and referred to as

the “debtor”, and Hillgren, doing business as Seaward and

referred to as the “lender”.

Hillgren, but was undated.

The BLA was signed by decedent and

The term of the BLA was for 29 years.

The BLA was never recorded.

Several properties were the subject of the BLA.

The BLA

discussed “Properties” (Orange County properties) as described in

exhibit “A” and the “University Industrial Park” (University

property) as described in exhibit “B”.

The Orange County

- 7 properties, however, were actually described in exhibit B,

whereas the University property was described in exhibit A,

because the exhibits were inadvertently switched when the BLA was

signed.

The Orange County properties included properties on West

Collins Avenue (West Collins), North Main Street (North Main),

and North Enterprise Street (Enterprise) in Orange County,

California.

The BLA provided that, in exchange for the consideration

given by Hillgren, decedent encumbered the Orange County

properties as collateral for the fulfillment of decedent’s

obligations to Hillgren.

Hillgren also had the sole right and

discretion to determine if and when any of the Orange County

properties should be sold for up to 29 years after the date of

the BLA.

As stated in the BLA, Hillgren would also provide

$1 million, if necessary, to maintain decedent’s financial

obligations in the University property.

Decedent granted to

Hillgren a 25-percent interest in “all net cash sales/refinance

proceeds” (25-percent lender interest) from the University

property.

The 25-percent lender interest was defined in the BLA

as any cash proceeds available from refinancing or cash from a

sale of the property, after payment of all preexisting debts.

The BLA appointed Hillgren as decedent’s “attorney-in-fact” for

the duration of the contract.

delinquent property taxes.

Pursuant to the BLA, decedent paid

- 8 1.

Purchase of the University Property

The University property was a multitenant industrial park

located in Tempe, Arizona.

In December 1985, the University

property was acquired by Hillgren and decedent from the Huettner

Limited Partnership (Huettner).

Hillgren signed the purchase

agreement as the “buyer” of the property.

The University

property was purchased for $3,831,800 with cash of $319,194.78,

assumption of the existing mortgage of $1,518,432.05 (Safeco

loan), and assumption of a second mortgage previously carried by

Huettner of $1,966,567.95 (Huettner loan).

The loans on the

property were nonrecourse.

Under the warranty deed for the property, Sea Shell and

Seaward each held title to 50 percent of the property.

On

December 23, 1985, a promissory note for the Huettner loan made

Sea Shell and Seaward jointly and severally liable on the debt.

Hillgren signed the promissory note as president and secretary of

Seaward and as vice president of Sea Shell.

On July 1, 1986,

Seaward executed a quitclaim deed where it relinquished its

interest in the University property to Sea Shell.

The quitclaim

deed on the University property was not recorded until May 23,

1994.

2.

Financing of the University Property

The BLA recited that Hillgren had assisted decedent in her

acquisition of the University property by lending her $485,000.

- 9 In 1986, decedent suffered a “negative cashflow exclusive of

depreciation” exceeding $115,000 on the University property.

After 1986, decedent continued to incur a negative cashflow on

the property.

In 1987, due to the financial problems associated

with the University property, Hillgren “facilitated” a loan of

$400,000 from Louis Puccio to decedent (Puccio loan).

On

April 27, 1988, in his capacity as trustee of the original trust,

Hillgren signed a promissory note between Louis Puccio and Sea

Shell.

The promissory note was secured by a deed of trust on the

North Main property.

According to the BLA, by 1988, decedent

owed $285,000 to Hillgren and $400,000 on the Puccio loan.

From

1988 through 1993, decedent continued to incur a negative

cashflow on the property, she did not pay the Puccio loan, and

she continued to be indebted to Hillgren.

The BLA recited that, as of 1994, decedent owed $1.3 million

on a first trust deed (Safeco loan) and $1.5 million on a second

trust deed (Huettner loan), both secured by the property, in

addition to the Puccio loan and her remaining debt of $150,000 to

Hillgren.

In August 1994, the Huettner loan and the Puccio loan

were to become due and payable, but decedent was unable to pay

the loans because of her negative cashflow on the property.

The

BLA provided that Hillgren assist decedent in obtaining an

extension of the Puccio loan and that Hillgren became a guarantor

of the loan.

On May 11, 1994, Hillgren executed a Forbearance

- 10 and Guaranty Agreement on the Puccio loan, extending the

collection of the principal of the loan until January 1, 2001.

Hillgren also placed his assets as collateral on the Puccio loan.

Hillgren assisted decedent in obtaining a forbearance and

extension on other loans as well, including the Huettner loan.

On May 1, 1994, the terms of the Huettner loan were modified,

reducing the amount of the loan to $1,481,567.95.

To secure the

payment of the modified loan, Sea Shell and Seaward executed a

second in priority deed on the “Arizona Property” and a deed of

trust on the North Main property, in favor of Huettner.

(It is

unclear from the exhibit whether the “Arizona Property” referred

to is the same as the University property or is another property

owned by Nordica Properties (Nordica), a California general

partnership, also owned by decedent and Hillgren, which owned

properties in Phoenix, Arizona.)

On April 15, 1994, Hillgren and

Carl C. Hillgren modified the Safeco loan by becoming guarantors

of the loan, reducing the interest rate and extending the

maturity date.

3.

Refinancing of the University Property

On May 20, 1999, the University property was refinanced by

LKHP when a new first mortgage in the amount of $2.5 million was

obtained from Baltimore Life Insurance Co.

As a result of the

refinancing, the net cash proceeds totaled $369,329.

Hillgren

did not receive a distribution of loan proceeds during the

- 11 refinancing in accordance with his 25-percent lender interest in

proceeds from refinancing as provided by the BLA.

In 2001,

however, in his capacity as general partner of LKHP, Hillgren

paid himself $92,332, representing 25 percent of the net loan

proceeds from the 1999 refinancing of the University property.

The Amended Trust

On January 29, 1997, the original trust was amended and

restated (amended trust).

Decedent and Hillgren were named as

cotrustees of the amended trust.

Whereas Hillgren was the

beneficiary of the original trust, Hillgren and his two children

were the beneficiaries of the amended trust.

The amended trust

provided for payment of the estate’s expenses and taxes after

decedent’s death.

The amended trust was funded by the items listed in

“Schedule A”.

Schedule A included:

The Orange County

properties, the University property, a partnership interest in

Nordica, decedent’s personal residence, three other properties

(Crescent Bay, Railroad, and Manzanita), and several additional

assets including bank accounts.

Also on January 29, 1997,

decedent executed a will, naming Hillgren and his children as the

sole beneficiaries of decedent’s estate.

Loans Between Decedent and Hillgren

Over a number of years, decedent and Hillgren engaged in

several loan transactions.

When one sibling needed money, the

- 12 other would lend money.

In 1994, Hillgren was paying decedent

10-1/2 percent interest whereas decedent was paying Hillgren

8-1/2 percent.

Separate loan accounts were maintained for loans

between decedent (doing business as LKHP, the amended trust, or

Sea Shell) and Hillgren (doing business as Seaward).

One account

tracked the amounts borrowed by decedent from Hillgren, and

another account tracked the amounts borrowed by Hillgren from

decedent.

The balances in the two accounts were reported

separately in the general ledger and financial statements of LKHP

and the amended trust.

Sea Shell’s balance sheets for 1987

through 1994 did not reflect accrued interest on the loans

between decedent and Hillgren, nor was interest included in the

balances of these loans when computing the net asset value of

LKHP as reported on decedent’s estate tax return.

The accrued

interest on the loans from Seaward to Sea Shell was not paid

until December 1997, and the accrued interest on the loans from

Sea Shell to Seaward was not paid until 1998.

In December 1993, decedent sold a house, and the proceeds

were disbursed to Seaward as the $20,000 remaining principal on a

loan and $265,000 as a new loan to Seaward.

At the time that the

BLA was signed, if the balances in the accounts were netted,

Seaward owed more money to Sea Shell than Sea Shell owed to

Seaward.

- 13 The Partnership

1.

Formation of LKHP

Decedent and Hillgren formed LKHP with an effective date of

January 1, 1997.

29 years.

The term of the partnership was set for

Walsworth represented both decedent and Hillgren in

the formation of the partnership.

Decedent held a 99.95-percent

capital interest and a 75-percent profit interest in LKHP.

Decedent gave Hillgren a .05-percent capital interest and a

25-percent profit interest in the partnership.

The term “profit

interest” was defined in the partnership agreement as “a

partnership interest other than a capital interest * * * which

will give rise to a partnership capital account * * * only if and

when there is future economic income” (25-percent profit

interest).

The partnership agreement also provided Hillgren with

25 percent of the amount, if any, by which the partnership

profits from operations in any year exceeded profits from

operations realized by decedent in 1996 from the properties

transferred (25-percent operational interest).

The 25-percent

operational interest was compensation to Hillgren for time spent

in the management of LKHP.

Decedent made no other gifts of

partnership interests.

Decedent contributed seven properties (the LKHP properties)

to LKHP, as described in exhibit B to the partnership agreement.

Hillgren did not contribute any property to LKHP.

The seven LKHP

- 14 properties that were contributed to the partnership at its

formation included the three Orange County properties and the

University property that were already the subject of the BLA and

that were used to fund the amended trust.

In addition, the other

three properties that were contributed were the Crescent Bay,

Railroad, and Manzanita properties in California that also

previously were used to fund the amended trust.

After the

initial contributions were made, no additional property was

transferred to the partnership.

Decedent did not deed or transfer title to the seven LKHP

properties to the partnership.

The partnership agreement

provided that title to any property that was contributed by a

limited partner, and was deemed to be owned by the partnership,

would remain in the name of the limited partner for the benefit

of the partnership.

The leases that encumbered the LKHP

properties were not formally assigned to LKHP prior to decedent’s

death.

The leases remained in the name of decedent, or in the

name of Sea Shell, after LKHP was formed.

The title remained in

the name of decedent or Sea Shell in order to hide the change of

ownership from the general public and from the tenants of the

properties.

Under the partnership agreement, Hillgren could

conduct partnership business without disclosing the existence of

the partnership.

The partnership was designed generally to be

- 15 invisible to the public and to persons with whom decedent and

Hillgren did business.

On May 27, 1997, decedent executed seven quitclaim deeds,

transferring her interest in the LKHP properties to the amended

trust.

The deeds were unrecorded at the time of her death.

Also

on May 27, 1997, decedent assigned her partnership interest to

the amended trust.

2.

Operation of LKHP

The partnership agreement provided that the general partner

need not open a bank account in the name of the partnership, but

could instead maintain the existing bank account that was used by

Sea Shell and the amended trust.

As a result, LKHP did not have

a dedicated bank account during decedent’s lifetime.

Decedent

held a bank account at Wells Fargo Bank (Wells Fargo) that

operated under the name of the amended trust, doing business as

Sea Shell.

The Wells Fargo account was used for operation of

LKHP.

LKHP’s financial statement dated June 5, 1997, and its

general ledger from January 1 through June 30, 1997, included

decedent’s residence, the mortgage on her residence, and the

mortgage and property tax payments that were made on the

residence.

Decedent’s residence and the expenses attributed to

the residence were removed from the ledger in a journal entry by

an adjustment dated January 1, 1997.

The adjusted journal entry

- 16 was not posted until after decedent’s death.

It was the practice

of decedent and Hillgren to post the opening entries on their

accounting books anywhere from 6 to 8 months after the start of

the year.

As a result, the opening entries for LKHP were not

made until after decedent’s death.

Also, the balance sheets,

ledgers, and check registers that represented the financial

information of LKHP were actually maintained under the name of

Sea Shell.

After the formation of LKHP, leases were executed on the

LKHP properties in the name of Sea Shell.

Also after the

formation, all contracts that were entered into for maintenance

and improvement of the LKHP properties, as well as all bills that

were received, were in names other than that of LKHP.

On

March 12, 1997, a check was issued under the name of Sea Shell to

pay property taxes for various properties including Manzanita and

Enterprise.

On May 22, 1998, Sea Shell also paid for landlord’s

insurance on the Manzanita property.

After the formation of LKHP, Nordica completed refinancing

of its properties.

During the loan application process, it was

represented to a mortgage broker, Walker Mortgage, and a lender,

Homesteader’s Life Co., that decedent owned and controlled all of

the LKHP properties.

No mention was made to either the mortgage

broker or the lender that the properties were restricted by the

BLA or that they were owned by LKHP.

The disclosure was not made

- 17 to the lender because it might have caused the refinancing to

fail.

There were no recorded minutes of any meetings of partners

of LKHP.

On May 13, 1999, after decedent’s death, a certificate

of limited partnership was filed for LKHP with the California

Secretary of State.

3.

LKHP Distributions

The partnership agreement provided for distributions of cash

at the sole discretion of Hillgren, as the general partner.

From

January 1 through June 5, 1997, decedent received distributions

totaling $99,363.

Hillgren did not receive any distributions

during this period.

The distributions that were received by

decedent during 1997 were made specifically to enable decedent to

pay her living expenses, and she was dependent on the cashflow of

the partnership to cover her personal expenses.

LKHP also paid the costs of the estate.

On March 5, 1998,

distributions in the amounts of $135,000 and $80,000 were made

from the partnership to the amended trust.

The distributions

were applied to pay installments of decedent’s estate taxes due

to the Internal Revenue Service (IRS) and to the California State

Treasurer.

From 1998 until 2002, distributions were consistently

made from LKHP to the amended trust to continue payment of

decedent’s estate taxes to the IRS and to the California

Franchise Tax Board.

- 18 4.

Management of the LKHP Properties

MSL Properties, Inc. (MSL), is a property management company

in Orange, California, with the same business address as

Hillgren.

Debra Gates (Gates) is the president and registered

agent of MSL.

Gates and decedent met in 1984 and became friends.

Decedent appointed Gates as an alternate under decedent’s durable

power of attorney for health care.

Since MSL was incorporated in 1986, MSL continuously managed

properties that were owned by Hillgren family entities.

MSL had

approximately 12 clients in addition to LKHP, all of which were

related entities of the Hillgren family.

The related entities

included, among others, the amended trust, Carl C. Hillgren,

Hillgren, Hillgren’s children, the Mark Hillgren Children’s

Trust, and Seaward.

The duties that were performed by MSL

included property management, general office functions, and

bookkeeping.

Gates worked with decedent in managing the

properties, and decedent would set parameters for Gates’s

responsibilities.

Prior to the formation of LKHP, MSL managed the seven LKHP

properties.

In 1997, MSL continued to manage the LKHP properties

after the formation of LKHP.

Gates understood that LKHP was to

continue using the Wells Fargo bank account, used previously by

Sea Shell and the amended trust, after the partnership commenced.

- 19 To perform its bookkeeping duties, MSL gave each client an

individual company number in order to keep their books.

The LKHP

properties were managed under “company number 50" prior to the

formation of LKHP.

From January 1 through June 30, 1997, the

LKHP properties continued to be managed for LKHP under company

number 50.

After formation of the partnership, the books

remained the same as before.

Gates planned to make journal

adjustments for the partnership for “year-end tax return

purposes”.

5.

LKHP’s Federal Tax Returns

For 1997, LKHP filed a Form 1065, U.S. Partnership Return of

Income (1997 return).

income to LKHP.

The 1997 return reported no ordinary

On LKHP’s Schedule K, Partners’ Shares of

Income, Credits, Deductions, etc., the partnership reported net

income from real estate activities of $93,304, depreciation of

$1,011, and distributions of $100,601.

On LKHP’s Schedule K-1,

Partner’s Share of Income, Credits, Deductions, etc., filed for

the amended trust, as a partner, the partnership reported income

from rental activities of $93,257, depreciation of $1,010, and

distributions of $100,601.

The amended trust was allocated a

99.95-percent interest in LKHP.

The Schedule K-1 filed for

Hillgren reported income from rental activities of $47 and

depreciation of $1.

The schedule of activities that was filed

with the 1997 return reported rental real estate income or loss

- 20 associated with the seven LKHP properties as allocated to both

the amended trust and Hillgren, as reported on their respective

Schedules K-1.

The partnership also filed a statement with the

1997 return notifying the IRS that it intended to file an amended

return.

For 1997, LKHP filed an additional Form 1065 as an amended

return (1997 first amended return).

The 1997 first amended

return made an election to adjust the basis in the LKHP

properties under section 754.

The Schedule K and Schedules K-1

remained the same as in the original return.

Also for 1997, LKHP filed an additional Form 1065 as an

amended return (1997 second amended return).

The 1997 second

amended return was filed to correct the allocation of partnership

income as 75 percent to the amended trust and 25 percent to

Hillgren.

The Schedules K-1 for the amended trust, and for

Hillgren, were adjusted for this change, showing that the amended

trust held a 99.0027-percent capital interest and a 75-percent

profit interest and that Hillgren held a .9973-percent capital

interest and a 25-percent profit interest.

As a result, the net

income from real estate and the depreciation on the Schedules K-1

were reallocated accordingly.

The reported distribution of

$100,601 to the amended trust remained allocated to the amended

trust on the Schedule K-1.

- 21 For 1998, LKHP filed a Form 1065 (1998 return) with attached

Schedule K reporting net income of $389,124 and distributions of

$423,500.

The 1998 return’s Schedule K-1 for the amended trust

reported allocations of $388,929 of income in accordance with the

99.95-percent profit interest and the entire amount of the

distribution.

Hillgren’s Schedule K-1 reported $195 in income

and no distribution.

Also for 1998, LKHP filed an amended

Form 1065 (1998 amended return).

The 1998 amended return reduced

the net income to $320,369 and reported guaranteed payments to

partners of $68,755.

The distribution remained unchanged.

Similar to the 1997 second amended return, the 1998 amended

return reported a corrected allocation of the 25-percent profit

interest to Hillgren.

The income that was reported on the

Schedules K-1 was reallocated accordingly, but the amount of the

distribution to the amended trust remained the same.

For 1999, LKHP filed a Form 1065 and an amended Form 1065 to

report again the corrected allocation of the profits interest and

to report guaranteed payments to partners.

For 2000 and 2001,

LKHP filed Forms 1065 with the correct allocation of the profits

interest, and no amended returns were filed.

Estate Tax Return

On August 28, 1998, the estate filed decedent’s Form 706,

United States Estate (and Generation-Skipping Transfer) Tax

Return (estate tax return).

The estate provided financial

- 22 statements and a summary of liabilities to Higgins, Marcus &

Lovett, Inc., who prepared the appraisal (Higgins appraisal) of

decedent’s interest in LKHP.

The Higgins appraisal was filed

with the estate tax return.

The Higgins appraisal was conducted on behalf of the estate

by Thomas E. Higgins (T. Higgins), an Accredited Senior Appraiser

of the American Society of Appraisers, and by Mark C. Higgins

(M. Higgins), an Accredited Member of the American Society of

Appraisers.

Both T. Higgins and M. Higgins specialize in the

business valuation discipline.

The appraisal was dated June 22,

1998, but valued the partnership interest as of June 5, 1997.

The estate’s attorney, Richard Albrecht (Albrecht), instructed

the appraisers to value the interest as a limited partnership

interest.

The Higgins appraisal reported that the fair market

value of decedent’s 99.95-percent limited partnership interest in

LKHP on June 5, 1997, was $2,266,000, after discounts for lack of

marketability and for lack of control.

On the estate tax return,

decedent’s gross estate was reported as $2,543,378.

On

February 3, 1999, respondent commenced an examination of the

estate tax return.

Examination

On February 4, 1999, the IRS sent an audit letter to Maurice

Polner, the accountant for the estate.

On May 23, 2001, Hillgren

responded to questions that were posed by IRS estate tax attorney

- 23 Jay Goldenberg (Goldenberg).

Hillgren answered questions

regarding the BLA, LKHP, the appraisal of decedent’s interest in

LKHP, and a mortgage.

In response to questions regarding the BLA, Hillgren told

Goldenberg that he did not know when the BLA was signed and that

Walsworth drafted the agreement.

Hillgren also told Goldenberg

that he complied with the requirements in the BLA to extend the

Huettner and Safeco loans.

Hillgren stated that the only

document that encumbered the properties that were subject to the

BLA was the agreement itself.

Hillgren stated that he took over

management control of the properties subject to the BLA but that

he also controlled the day-to-day management of decedent’s other

properties not subject to the BLA.

In response to questions that were posed by Goldenberg

regarding LKHP, Hillgren explained the purpose of forming the

partnership as “Lea suffered from depression.

husband.

She was dating a young guy.

motives and she was worried too.

asset protection.”

She did not have a

He was worried about his

The Partnership served as an

Hillgren gave the same answer in response to

questions as to why they formed the partnership when Hillgren was

already managing decedent’s properties under the BLA.

Hillgren

also stated that his rights under the BLA were senior to the

partnership agreement and that he gave his consent for the

transfer of the properties to LKHP.

- 24 On August 24, 2001, a notice of deficiency was sent to the

estate.

LKHP.

The notice increased the value of decedent’s interest in

The notice determined decedent’s 99.95-percent interest in

LKHP to be valued at $4,526,740 based upon the undiscounted

values of the LKHP properties.

The notice determined a

deficiency in the estate tax of $1,269,498.

The increased

values, as determined in the notice, were not supported by

independent appraisals because LKHP was not recognized as a valid

partnership entity.

Value of the LKHP Properties as Agreed by the Parties

The parties have stipulated the undiscounted values of

decedent’s interest in the seven LKHP properties as follows:

Value

Property

West Collins

Enterprise

North Main

University property

Manzanita

Crescent Bay

Railroad

Total

$1,285,000

1,093,787

975,000

1,074,131

2,261

265,176

115,711

$4,811,066

OPINION

Burden of Proof

Generally, under section 7491(a), in any court proceeding,

if a taxpayer introduces credible evidence with respect to any

factual issue, the burden of proof is shifted to respondent.

The

burden shifts, however, only when the taxpayer has maintained all

records and has cooperated with reasonable requests by respondent

- 25 for witnesses, information, documents, meetings, and interviews.

Sec. 7491(a)(2)(B); see Higbee v. Commissioner, 116 T.C. 438,

440-441 (2001).

The parties dispute whether the burden shifts to respondent

in this case.

The estate argues that respondent has the burden

of proof because the estate has satisfied all of the conditions

under section 7491.

The estate contends that it responded by

fully cooperating with respondent’s requests for witness

interviews and by responding to numerous requests for information

and documents during audit.

Respondent, however, argues that the

estate did not comply with the substantiation and record-keeping

requirement under section 7491(a)(2)(A) and that the estate did

not cooperate as required under section 7491(a)(2)(B).

Respondent also argues that the estate failed to introduce

credible evidence, stating, instead, that the estate has

introduced “evidence that is internally contradictory and

inconsistent, and not worthy of belief.”

We agree with respondent that the estate’s evidence was

sometimes inconsistent and that Hillgren had made inaccurate and

misleading representations prior to trial.

There is no evidence,

however, that the testimony at trial was false or implausible.

Respondent often objected to the estate’s proposed findings of

fact on the ground that they are “biased and self-serving”.

This

obvious comment is insufficient, without more, to contradict the

- 26 estate’s testimony.

It is unnecessary, however, to prolong our

discussion of burden of proof.

We decide the issues based on the

preponderance of the evidence.

Section 2036

We must decide whether the existence of LKHP will be

recognized for estate tax purposes.

Respondent argues that the

value of the properties that were transferred to LKHP is

includable in decedent’s gross estate under section 2036(a).

The

estate argues, however, that LKHP was a valid partnership, formed

under California law and created as a premarital asset protection

device.

Under section 2036(a), a decedent’s gross estate includes

the value of property interests transferred by the decedent

during his or her lifetime if the decedent retained for life the

possession or enjoyment of the property, or the right to the

income from the property, or the right to designate the persons

who would possess or enjoy the property or the income from the

property.

The general purpose of section 2036(a) is to include

in a decedent’s gross estate transfers of property that are

“essentially testamentary in nature”.

Estate of Ray v. United

States, 762 F.2d 1361, 1362 (9th Cir. 1985) (quoting United

States v. Estate of Grace, 395 U.S. 316, 320 (1969)).

An asset

transferred by a decedent during his or her lifetime is included

in his or her gross estate unless he or she “absolutely,

- 27 unequivocally, irrevocably, and without possible reservations,

parts with all of his title and all of his possession and all of

his enjoyment of the transferred property.”

Commissioner v.

Estate of Church, 335 U.S. 632, 645 (1949).

Under section 2036(a), a transferor retains the enjoyment of

the property transferred if there is an express or implied

agreement at the time of the transfer that the transferor will

retain the present economic benefits of the property, even if the

retained right is not legally enforceable.

See Estate of

Reichardt v. Commissioner, 114 T.C. 144, 151 (2000); sec.

20.2036-1(a), Estate Tax Regs.

In deciding whether there was an

implied agreement, the Court considers all of the facts and

circumstances surrounding the transfer and the subsequent use of

the property.

151.

See Estate of Reichardt v. Commissioner, supra at

Where the decedent conveys all or nearly all of his or her

assets to a trust or partnership, this may suggest an implied

agreement that the decedent can continue to use the assets.

id. at 153.

See

Section 2036 applies not only if a transferor

retains possession or enjoyment of property but also if a

transferor retains the right to income from the property.

See

sec. 2036(a)(1); Estate of Reichardt v. Commissioner, supra at

153.

Moreover, if a decedent’s relationship to the assets

transferred to a partnership remains the same after the transfer

as it was before the transfer, the value of the assets may be

- 28 included in the decedent’s gross estate.

See sec. 2036(a)(1);

Estate of Reichardt v. Commissioner, supra at 152.

Section 2036(a) does not apply if the transfer of property

was part of a bona fide sale in exchange for full and adequate

consideration.

A bona fide sale is an arm’s-length business

transaction between a willing buyer and a willing seller.

Estate

of Reichardt v. Commissioner, supra at 155.

The estate argues that there was no agreement, express or

implied, that decedent would retain the possession, control, or

enjoyment of, or the right to the income from, the partnership.

The estate contends that, because the partnership was in

existence for only 5 months at the time of decedent’s death,

there was not enough time to establish a pattern of history or

behavior from which respondent could imply an agreement.

Respondent contends that, shortly after decedent’s initial

suicide attempt, decedent executed her will, the amended trust,

and the LKHP agreement, thereby transferring substantially all of

her assets.

Respondent argues that the practical effect of the

partnership was minimal because decedent continued to be the sole

economic beneficiary of the property that was contributed to the

partnership.

- 29 1.

Formation of LKHP as a Premarital Asset Protection

Device

The estate contends that the creation of LKHP was motivated

by legitimate business concerns and for premarital asset

protection.

The estate further contends that decedent and

Hillgren negotiated the terms of the partnership agreement at

arm’s length under “adverse economic interests”.

First, with respect to the claim that the partnership served

as a premarital asset protection device, respondent notes that

decedent and her boyfriend broke up before her initial suicide

attempt and that it was unclear from the record whether they were

intending to get married.

Respondent also notes that the estate

made inconsistent representations during discovery and during

trial as to whether decedent’s boyfriend was even aware of the

partnership.

Respondent further argues that, as a premarital

asset protection device, the partnership agreement would fail

because decedent had the right to transfer her interest to a

spouse and had the power to approve a transfer to her spouse.

There is nothing in the language of the LKHP agreement

stating the reasoning behind the formation of the partnership.

The estate’s claim that the partnership served to protect

decedent’s assets from an impending marriage to O’Brien is

unsupported by the record.

Title to the properties remained

solely in decedent’s name, potentially within the reach of a

- 30 spouse.

There is no evidence that O’Brien knew of the existence

of LKHP.

The partnership was intended to be largely invisible.

Goldenberg testified that, during the examination of the

case, the estate did not mention that the partnership agreement

was intended as a “premarital tool”.

The estate told Goldenberg

that the partnership served as an asset protection vehicle.

Goldenberg further testified that, if he had known of the

premarital reason for the partnership agreement, he would have

identified O’Brien to interview him.

We are therefore not

persuaded by the testimony that LKHP was formed to provide

premarital asset protection.

Second, with respect to the estate’s claim that the

partnership was formed as a result of arm’s-length negotiations,

we are not persuaded that decedent and Hillgren acted at arm’s

length.

The estate contends that Hillgren made a significant

contribution to the partnership, to wit, the services that he was

to provide to the partnership as a general partner with a

25-percent profit interest.

The estate argues that decedent and

Hillgren bargained over what his profit interest would be in the

partnership.

The estate claims that the negotiation between

decedent and Hillgren distinguishes this case from that of Estate

of Harper v. Commissioner, T.C. Memo. 2002-121, where the

decedent stood on both sides of the transaction.

The record,

however, indicates that Hillgren was not only a general partner

- 31 in the partnership but was also cotrustee of the amended trust

and a “lender” to decedent regarding the same properties that

were transferred to the partnership.

At various times, Hillgren

signed his name on documents as trustee of both the original and

amended trusts, as vice president of Sea Shell, as an officer of

Seaward, and as general partner of LKHP.

As a result, Hillgren

stood on every side of the transaction.

The same lawyer

represented decedent and Hillgren with respect to the formation

of the partnership.

In addition, the estate provided no

corroboration of the negotiation between decedent and Hillgren

regarding Hillgren’s interest.

Hillgren ignored the terms of the

partnership agreement as it suited him.

Further, because the

management functions did not change and were still performed by

MSL after the formation of the partnership, it is hard to believe

that Hillgren contributed sufficient services at the formation of

the partnership to warrant his 25-percent profits interest.

(This case is further indistinguishable from Estate of Harper v.

Commissioner, supra, as discussed below because of the

commingling of funds, the “egregious” disregard for the

partnership form, and the existence of post mortem accounting

manipulations.)

2.

How Formation of LKHP Failed To Alter Decedent’s

Interest

In this case, neither decedent’s interest in the properties

that were transferred to the partnership nor legal title changed

- 32 once the partnership was established.

MSL provided the day-to-

day management services for the properties both before and after

the creation of the partnership.

The tenants of the LKHP

properties were unaware of the supposed change in ownership.

Decedent continued to use Sea Shell’s bank account for the

partnership income, contracts and leases that were executed after

the formation of the partnership remained under Sea Shell’s name,

and bills remained in Sea Shell’s name.

Representations were

made to third parties, including to a mortgage broker and a

lender during the Nordica refinancing, that decedent owned and

remained in control of the LKHP properties.

Hays also testified that decedent did not expect that the

partnership would change the relationship between decedent and

Hillgren or change decedent’s role in the management

responsibility for her property.

Moreover, Hillgren told

Goldenberg during the examination that he took over management

control of the properties subject to the BLA and that he also

controlled the day-to-day functions of decedent’s other

properties.

This arrangement did not change as a result of the

partnership agreement.

Respondent notes an apparent initial intent to transfer

decedent’s personal residence as shown in the partnership’s

financial statements, which were adjusted after decedent’s death.

The later adjustment was an attempt to reverse the initial

- 33 commingling of funds between the partnership and decedent.

See,

e.g., Estate of Reichardt v. Commissioner, 114 T.C. at 155.

Gates testified that she tracked the financial statements and

kept the accounting books for the partnership exactly as she had

for Sea Shell.

death.

No changes were made until after decedent’s

This testimony does not explain how the personal

residence was not a partnership asset.

Instead, it demonstrates

the estate’s complete disregard for the formalities of financial

statements.

Based on the record as a whole, we reject the estate’s

claims that the partnership agreement changed any real

relationship between Hillgren and decedent or that it changed

decedent’s interest in the properties.

3.

Distributions From LKHP

The estate admits that decedent received all of the income

distributed from the partnership in the 5 months preceding her

death.

The estate further admits that decedent was dependent on

the cashflow from the partnership for her living expenses.

The

estate claims that, presumably, Hillgren would have received cash

distributions as well if decedent had remained alive through the

end of the year.

In addition, the estate claims that there was

no history of disproportionate distributions because the 5 months

of partnership distributions was too short to create a pattern.

Respondent argues that there was an implied agreement, as

- 34 demonstrated by the record, relating to the funding, operations,

and distributions of the partnership so that decedent retained

the right to the income of the partnership.

During 1997, decedent received $99,363 in distributions from

the partnership, and Hillgren received no distributions.

When

questioned by the estate’s counsel, Hillgren described the

situation surrounding the disproportionate distributions as

follows:

Q

Would you tell us about those cash distributions?

Were they disproportionate, and if so, why?

A

To date, to her date of death, they were, in fact,

disproportionate. I took no distributions. She took

all of them.

Q

And why did you distribute entirely to her, and

nothing to you?

A

Well, in that I had a 25 percent--it was a

calculated number, and we didn’t have--obviously, the

books--we were only five months into the or six months

into the accounting year. We had no information as to

what my 25 percent would be.

Q

Why didn’t you then withhold distributions to

either of you until those numbers could be calculated?

A

Well, the distributions were discretionary on my

part. If we had erred, and distributed too much, for

example, it would have just gone against he--or would

gone into my--added to my capital account. So it would

have worked out in the end eventually, if we had made

that mistake, and overdistributed.

Q

Well, let’s see if I understand it.

distribute anything to her?

Why did you

A

All of the--all of her income producing assets

were in the partnership. So her--that’s what she

- 35 needed to live on. She wanted the income, or those

monies for living expenses * * *.

Hillgren’s explanation only underscores the intention to use

the partnership assets to support decedent.

Further, it is not

apparent from the record that Hillgren would ever have received a

distribution from LKHP.

Overall, the record shows that the

partnership distributions were intended to provide decedent with

her living expenses, further demonstrating that her relationship

to the LKHP properties remained the same after formation of the

partnership and that LKHP should be disregarded for estate tax

purposes.

4.

Formality of the LKHP Agreement

Hillgren did not file a certificate of limited partnership

until respondent began examination of the estate’s return.

Striking features of LKHP were the lack of formality surrounding

the partnership, the intention of the parties to keep the

agreement largely invisible, the apparent disregard of the

agreement as situations arose, and the restatements of the

financial affairs by Hillgren and representatives of the estate.

Hillgren and Albrecht took advantage of apparent

inconsistencies in the partnership agreement regarding Hillgren’s

interest when reporting Hillgren’s interest on the estate tax

return and on the partnership tax returns.

On the estate tax

return, the estate reported that Hillgren had a 25-percent profit

interest to increase the discount on the estate tax.

On the

- 36 other hand, on the partnership tax return, Hillgren reported a

.05-percent profit interest so more income from the partnership

could bypass him and go to the trust that provided for his

children.

The discrepancy was not fixed until after the

examination of the estate tax return had begun.

Hillgren then

caused amended partnership tax returns to be filed for 1997,

1998, and 1999.

During trial, Albrecht was questioned by respondent as to

why he took inconsistent positions on the estate tax return and

on the partnership return regarding Hillgren’s interest in the

partnership.

Albrecht testified that, because decedent had died

and because the amended trust provided for disposition of her

estate to Hillgren’s children, the estate could essentially

disregard the provisions of the partnership agreement by

interpreting Hillgren’s partnership interest in a way that would

benefit his children and beneficiaries of decedent’s estate.

The

income not allocated to Hillgren would not flow through the

partnership or subject him to income tax on the distributions and

ultimately would not pass through Hillgren’s estate.

Hillgren testified regarding the discrepancy on the returns

as follows:

Q

Now, you heard counsel for respondent in his

opening statement mention the fact that in the 1997 tax

return for the partnership, your sister’s profit

interest was shown at 99.95 percent and yours was shown

at either zero, or .05 percent, instead of 25/75. Why

was that?

- 37 A

That was based on a misinterpretation of the

agreement by Rick Albrecht.

*

*

*

*

*

*

*

A

He (Albrecht) advised me that he thought the

agreement could be read either way, that it was

confused.

Q

Either way being what?

A

With 25 percent of profits, and 25 percent of the

increased profits as one way. The other way was just

25 percent of increased profits.

Q

But you knew better, didn’t you?

A

Well, I had negotiated better, yes.

Q

What did you know it to be?

A

Well, that there was 25 percent, both 25 percents

apply. The 25 percent of operational profits, and the

25 percent of increased profits.

Q

So that when Mr. Albrecht told you that in his

opinion it could be interpreted differently, why didn’t

you object?

A

Well, he pointed out that the difference basically

goes--the 25 percent of operation profits would go to

my children. There’s an estate tax benefit in

interpreting it that way.

Q

And so you accepted that?

A

Yes, that was his advice at the time, and I

accepted it.

Hillgren further testified during cross-examination by

respondent’s counsel as follows:

Q

Now, let’s talk about your meeting with

Mr. Albrecht. I think we said--I think you testified

in direct examination that when Mr. Albrecht told you

of his interpretation of the agreement, that there was

a conflict, and that the agreement was susceptible of

- 38 an interpretation whereby your profits interest was

limited to what the Section 3.4 provision said, i.e.,

25 of any post-‘96 increases, did you agree with that

interpretation?

A

That was not how I had understood the document to

be, but he told me that that--it could be interpreted

that way, and that the benefits of using that

interpretation would be because basically that

25 percent would belong to my children, it would be

beneficial.

Q

If Lea were still alive, and Mr. Albrecht had told

you that that was his interpretation, what would have

been your response?

A

Oh, absolutely not.

cheating money from Lea.

I mean, that would be

Q

That would be what?

A

That would be cheating her of money, of--

Q

Cheating her, or cheating you?

A

Well, it would be--yeah, I’m sorry, cheating me of

money.

*

*

*

*

*

*

*

Q

So why did you go along with Mr. Albrecht’s

interpretation?

A

He--well, first of all, Lea was dead, so it was

not an issue between she and I, it was basically an

issue between my children and I, and it would be

beneficial for my children to have that 25 percent, not

me.

The estate contends that Hillgren received “faulty legal

advice” that induced him to take advantage of an ambiguity in the

partnership agreement for a tax benefit.

The estate further

contends that the faulty advice created the inconsistency between

the estate tax return and the partnership tax returns.

Hillgren,

- 39 however, was sophisticated in real estate and business matters

and was aware that Albrecht was interpreting the partnership

agreement in a way that was incorrect.

During trial, Hillgren

admitted that he knew better and that he had negotiated better,

yet he was willing to take the inconsistent positions on the

returns knowing that it would benefit his children and,

implicitly, that he would avoid or reduce tax on the

distributions.

Respondent also questioned why Albrecht instructed

M. Higgins to appraise the limited partnership interest as though

Hillgren had a 25-percent profit interest, although the

partnership tax returns were filed with a .05-percent interest.

Respondent’s questions related to a letter written by Albrecht to

Higgins, Marcus & Lovett, Inc., regarding how to appraise

Hillgren’s interest.

Albrecht testified as follows:

Q

You advised Mark Higgins to appraise the

partnership interest as though Mark Hillgren had a

25 percent profits interest in the partnership,

correct?

A

Well, I don’t know if I did or not, or whether

I’m-Q

You can take a minute and look at the letter if

you need to.

A

Well, I don’t know--I just don’t recall, I--this

letter is obviously written as a response to the report

that they had written and I would have to compare it to

the report to see what I actually recommended by this.

I--it’s obviously something that I had my office

type up, and I signed the letter, but I would have to

- 40 look at the report to compare it to what I was really

trying to accomplish here.

Albrecht’s explanation of his instructions was evasive at best

and further demonstrates the estate’s inconsistency with regard

to the partnership overall.

In addition, Hillgren and decedent had a history of

producing incorrect or incomplete financial records.

Hillgren

and Gates both testified that Sea Shell’s balance sheets and

financial records had arbitrary and imperfect numbers.

Hillgren

described financial statements that were produced by MSL in 1994

as follows:

They are strictly an arbitrary--they’re not based on

appraisal, they’re not based on cost, they’re not based

on anything other than an arbitrary--well, a

guesstimate, per foot value times the number of feet

for each location.

As the market collapsed in the early ‘90s, we did

not adjust these down. * * * [T]hey had been used for

external purposes.

Despite their inaccuracies, the balance sheets were used for

external purposes.

They were provided to the lender during the

refinancing of the Nordica properties to show that decedent had

equity in the University property.

For example, Sea Shell’s

balance sheet as of July 31, 1994, as provided to respondent

during the audit, represented that the value of the University

property was $4,287,500.

The Safeco and Huettner loans were

shown on the balance sheet in the amounts of $1,260,419.03 and

$1,481,567.95, respectively.

The balance sheet therefore

- 41 indicated that the University property had approximately

$1.5 million in equity.

Hillgren represented in the BLA and

during trial, however, that the University property was

“underwater” because the debt exceeded the equity at the time

that Hillgren and decedent entered into the BLA.

5.

Conclusion

The estate claims that decedent was “in excellent physical

health, on new antidepressant medication, and not contemplating

suicide” and that, therefore, the partnership was not an

alternate testamentary vehicle.

claim.

The evidence contradicts this

Shortly before her death, decedent attempted suicide, was

on various medications, was under the care of a psychiatrist, and

suffered from severe pain due to degenerative disc disease.

After her initial suicide attempt, LKHP was formed.

Decedent and Hillgren started many businesses over the years

and disregarded entities as they saw fit, making various

“situational representations”, i.e., statements about their

property ownership and values to support a then existing purpose,

without regard to accuracy.

Even the stipulated facts contain

inconsistencies regarding entity names and dates of creation and

dissolution.

The stipulations of the parties were often

contradicted by the documents that were provided by Hillgren.

Hillgren and the estate’s representatives continued to disregard

the LKHP agreement both prior to and after decedent’s death.

- 42 The value of the properties that were transferred to the

partnership is includable in decedent’s gross estate under

section 2036(a).

The properties are included in the estate at

the fair market value on the date of decedent’s death, subject to

the effect of the BLA.

Valuation of the Properties

The parties have stipulated the undiscounted values of all

seven properties in which decedent had an interest.

Three of the

properties, Manzanita, Crescent Bay, and Railroad, are not

subject to the BLA.

The three properties will therefore be

included in the value of the estate at stipulated values of

$2,261, $265,176, and $115,711, respectively.

Property is included in the gross estate at its fair market

value, which is “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.”

Sec. 20.2031-1(b), Estate Tax

Regs.; Estate of Newhouse v. Commissioner, 94 T.C. 193, 217

(1990).

fact.

The determination of fair market value is a question of

Estate of Newhouse v. Commissioner, supra at 217.

During

trial, we received reports and testimony from expert witnesses.

We evaluate the opinions of the experts based on the

qualifications and reasoning of each expert and on all other

credible evidence in the record.

See Estate of Jones v.

- 43 Commissioner, 116 T.C. 121, 131 (2001).

We are not bound by the

expert opinions, and we may determine value based on our own

examination of the record.

It is the responsibility of the

parties to instruct the experts of all the relevant facts that

might affect the valuation.

T.C. 312, 338 (1989).

Estate of Hall v. Commissioner, 92

If the parties fail to provide the experts

with complete information concerning material facts or reasonable

assumptions to be made, the reliability of the experts is

undermined.

Prior to trial, respondent instructed his experts to

value the LKHP properties as if the BLA encumbered only the

University property.

At the conclusion of testimony in this

case, the Court agreed with the estate’s contention that the

exhibits to the BLA were inadvertently switched and that the BLA

encumbered the Orange County properties as well as the University

property.

The Court further concluded that the BLA did not

terminate at decedent’s death.

Nonetheless, in the briefs,

respondent argues that the BLA should be disregarded, that the

BLA terminated at the death of decedent, that the exhibits to the

BLA were not mistakenly switched, and that the BLA encumbered

only the University property.

The estate contends that the BLA was:

(1) A contract for

services provided by Hillgren who would facilitate the

forbearance and extensions of the Puccio, Huettner, and Safeco

loans; (2) a loan guaranty agreement where Hillgren agreed

- 44 personally to guarantee the Puccio and Safeco loans; (3) a loan

agreement where Hillgren extended a $1 million line of credit to

decedent; and (4) a security agreement encumbering the three

Orange County properties, giving Hillgren the authority, for

29 years, to determine whether to sell any of the four properties

subject to the BLA and to grant an irrevocable power of attorney

to Hillgren for the duration of the ownership of the properties.

Because Hillgren had performed under the agreement, he was

entitled to be compensated under it, regardless of the death of

decedent.

We agree with the estate’s analysis.

Respondent contends that the BLA was superseded by the LKHP

partnership agreement, and the estate argues that the subject

matter of each agreement was separate.

We have decided that the

partnership agreement was not respected by decedent or Hillgren

and will be disregarded.

purposes.

The BLA, however, had apparent business

Moreover, a hypothetical buyer would not disregard or

ignore the BLA.

See Estate of Newhouse v. Commissioner, supra at

231; Estate of Hall v. Commissioner, supra at 338-339.

As a

result, we value the University property and the Orange County

properties subject to the effect of the BLA.

The Higgins appraisal attached to the estate tax return

assumed, based on Albrecht’s erroneous instructions, that

Hillgren held a 25-percent operational interest and a .05-percent

profit interest.

The Higgins appraisal essentially used the

- 45 existence of the BLA as a factor in determining the discounts to

apply to decedent’s partnership interest.

Carsten Hoffman, senior vice president of FMV Opinions,

Inc., of Irvine, California, prepared three appraisals for the

estate during trial preparation.

The Hoffman appraisal relied on

information that was provided by Hillgren and by the estate’s

representatives and relied on the property values that were used

in the Higgins appraisal.

The first report, dated February 22,

2002, appraised the value on June 5, 1997, of the Orange County

and University properties as subject to the BLA (Hoffman

appraisal).

The other two appraisals valued partnership

interests that are irrelevant at this point in our analysis.

The Hoffman appraisal determined that, because of the BLA,

an investor in the real estate lacked control of and

marketability of the investments in the real estate.

The report

compared these restrictions to those based on limited partnership

interests in real estate holding partnerships.

The report also

applied additional discounts for lack of voting rights.

The

Hoffman appraisal made the assumption that the BLA was “fully

transferable to a third-party upon giving notice and that the

* * * [BLA] remains in full force and effect upon such transfer”.

The Hoffman appraisal took into consideration that the exhibits

to the BLA were transposed.

In addition, the Hoffman appraisal

- 46 considered that a hypothetical willing buyer would know of the

existence of the BLA.

Raynor Klaris (Klaris) and John A. Thomson (Thomson) of

Klaris, Thomson & Schroeder, Inc., prepared two appraisal reports

for respondent (respondent’s appraisal).

Klaris has been in the

appraisal business since 1961 and is a Senior Accredited Member

of the American Society of Appraisers with a specialty in

business valuations.

Thomson has been an appraiser since 1976

and received his Accredited Senior Appraiser designation in

business valuations and intangible properties in 1982.

is also a real estate appraiser.

Thomson

Both of respondent’s appraisals

assumed that the BLA affected only the University property and

not the Orange County properties.

As in Estate of Hall v.

Commissioner, supra, although respondent’s experts were

qualified, they were hindered in their valuation by respondent’s

incorrect instructions regarding the effect of the BLA.

1.

The University Property

The parties agree that the undiscounted value of decedent’s

interest in the University property is $1,074,131.

Based on the

terms of the BLA, Hillgren held a 25-percent lender interest in

the net proceeds from sale or refinancing of the University

property.

The Hoffman appraisal therefore reduced the value of

the University property by 25 percent to represent Hillgren’s

interest.

Respondent’s appraisal also reduced the value of the

- 47 University property representing the 25-percent lender interest.

As a result, the value of the University property becomes

$805,598, the value to which the parties agree.

The issue then

becomes whether any additional discounts should be applied for

lack of marketability, lack of control, or lack of voting rights.

The Hoffman appraisal compared the University property to

real property limited partnerships (comparable partnerships) with

revenues less than $3 million and with debt to total adjusted

capital greater than 20 percent.

The discounts of the comparable

partnerships ranged from 24.7 percent to 57.8 percent and had a

median of 41.5 percent.

The Hoffman appraisal also compared the

University property to comparable partnerships with net asset

values less than $10 million and with debt to total adjusted

capital greater than 20 percent.

The discounts that were applied

for the comparable partnerships ranged from 28.3 percent to

56.9 percent and had a median discount of 43.9 percent.

The

Hoffman appraisal also compared the University property to

comparable partnerships based on performance as measured by

distributions.

The discounts for the comparable partnerships

ranged from 24.7 percent to 62.3 percent and had a median of

42.4 percent.

In each of the three comparisons, the Hoffman

appraisal concluded that the University property was a less

attractive investment than the comparable partnerships.

- 48 Taking into account the comparable partnerships, as well as

other factors regarding the University property’s marketability,

the Hoffman appraisal applied a combined discount for lack of

control and lack of marketability of 50 percent.

The Hoffman

appraisal also applied a 5-percent discount for lack of voting

rights.

The Hoffman appraisal therefore applied a total combined

discount of 55 percent to the University property in addition to

the discount representing the 25-percent lender interest.

The

significant discount that was applied to the University property

was due in part to the high level of debt on the property.

Respondent’s appraisal used a discounted net asset value

approach and reduced the value of the University property by a

10-percent minority interest discount and a 35-percent discount

for lack of marketability.

The minority discount was determined

by comparing the University property to closed-end equity funds

and real estate investment trusts and by taking into

consideration the effect of the BLA.

The lack of marketability

discount was determined by comparing six separate independent

studies of restricted stock transactions.

The discounts that

were applied by respondent’s appraisal allowed for an overall

combined discount of 41.5 percent.

The estate’s brief points out

that respondent’s appraisal contains incorrect assumptions about

cashflow and the effect of the BLA.

- 49 The estate’s suggested 50-percent discount for lack of

control and lack of marketability would not reduce the value of

the properties below the value reported on the estate tax return.

The estate is not seeking to establish a value less than that

reported on the estate tax return.

The Hoffman opinion on

discounts is reasonable and is not contradicted by reliable

evidence.

Thus we adopt it.

See, e.g., Estate of Hall v.

Commissioner, 92 T.C. at 342.

2.

The Orange County Properties

The Hoffman appraisal used a similar analysis for the Orange

County properties as it used for the University property, looking

to discounts for comparable partnerships.

Therefore, the Hoffman

appraisal applied a 35-percent combined discount for lack of

marketability and lack of control on the West Collins property, a

35-percent combined discount on the Enterprise property, and a

40-percent combined discount on the North Main property.

The

Hoffman appraisal also used an additional 5-percent discount for

lack of voting rights on each of the three properties.

Respondent’s appraisal did not discount the three Orange

County properties based on the effect of the BLA.

Thomson

testified that, had he assumed that the BLA also encumbered the

Orange County properties, the Orange County properties would also

be discounted but at a different discount than that determined

for the University property.

Thomson estimated discounts of

- 50 30 percent on West Collins, 35 percent on North Main, and

30 percent on Enterprise.

Because the difference between the

parties’ discounts on the Orange County properties is

insubstantial, we accept the estate’s discounts of 35 percent,

40 percent, and 35 percent for West Collins, North Main, and

Enterprise, respectively.

The estate’s experts suggest an additional discount of

5 percent for lack of voting rights.

Thomson testified that an

additional lack of voting rights discount would be appropriate

between 2.5 percent and 5 percent and thus did not disagree with

the estate’s experts.

Thus, we accept the 5-percent discount for

lack of voting rights.

Conclusion

We conclude that the properties in which decedent had an

interest should be valued and discounted in accordance with this

opinion, but not reduced below the value reported on the estate

tax return.

We have considered all of the remaining arguments made by

both parties for a result contrary to that expressed herein, and,

to the extent not discussed above, they are irrelevant or without

merit.

To reflect the foregoing and to give effect to the

stipulations by the parties,

Decision will be entered

under Rule 155.