Davis v . United States 04-CV-273-SM 12/19/05 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 .

United States of America, Defendant

O R D E R

Plaintiff, the executrix of the estate of Kenneth Freeman,

sues for a tax refund of approximately $506,000. The legal

question presented is how the decedent’s state lottery winnings

(in the form of 10 annual payments of approximately $209,000)

should be valued for estate taxation 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 of approximately

$1.6 million.

Plaintiff, on the other hand, notes that the estate’s right

to receive future lottery payments i s , by law, non-assignable and

argues that 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. Based on an expert’s appraisal,

plaintiff asserts that the asset should be valued at

approximately $800,000 for estate tax purposes.

Pending before the court are the parties’ cross motions for

summary judgment with respect to the method properly used to

value future lottery receipts for estate tax purposes.

Standard of Review

When ruling on a party’s motion for summary judgment, the

court must “view the entire record in the light most hospitable

to the party opposing summary judgment, indulging all reasonable

inferences in that party’s favor.” Griggs-Ryan v . Smith,

1 2 , 115 (1st Cir. 1990). Summary judgment is appropriate

when the record reveals “no genuine issue as to any material fact

and . . . the moving party is entitled to a judgment as a matter

of law.” Fed. R. Civ. P. 56(c). In this context, “a fact is

‘material’ if it potentially affects the outcome of the suit and

a dispute over it is ‘genuine’ if the parties’ positions on the

2 issue are supported by conflicting evidence.” Intern’l Ass’n of

Machinists and Aerospace Workers v . Winship Green Nursing Ctr.,

(1st Cir. 1996) (citations omitted).

Here, the parties agree to nearly all material facts

underlying this dispute and suggest that the case is appropriate

for summary disposition. As will be discussed below, however,

there is at least one fact that is both material and genuinely

disputed, precluding the entry of summary judgment in favor of

either party.

Background

In 1989, the decedent, Kenneth Freeman, won the

Massachusetts lottery and received the first of 20 annual

payments of $209,220 from the Commonwealth of Massachusetts.

Slightly more than nine years later (after receiving 10 annual

payments from the Commonwealth), the decedent died. Upon his

death, the remaining 10 annual payments became payable to

decedent’s estate. The Commonwealth of Massachusetts has

continued to make those annual payments to the estate.

3 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,

Item 12 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.

.

Subsequently, the Internal Revenue Service audited the

estate’s return and determined that the value of the 10 remaining

payments from the Commonwealth was 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

4 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 IRS auditor).

The estate explained the difference by pointing out that the

annuity tables (employed by the IRS and used by the estate when

it filed its initial return) fail to take into account the fact

that the estate’s right to receive the annual lottery payments is

a non-marketable asset. That is to say, the right to receive

those payments cannot be sold, assigned, pledged as collateral,

or otherwise transferred. Consequently, says the estate, that

asset has a significantly lower fair market value than the tables

establish.

5 The estate’s informal claim for a tax refund was denied on

November 2 1 , 2002. It 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. They also agree that the decedent’s interest

in those payments was an “ordinary annuity interest” within the

meaning of the Estate Tax Regulation set forth in

(b)(1)(i)(A). Finally, the parties agree that, at the

time of the decedent’s death, the remaining 10 lottery payments

due to him were neither marketable nor assignable.

Discussion

As noted above, the issue before the court is a legal one:

the proper means by which to determine the estate tax value of

the 10 remaining lottery payments due from the Commonwealth of

Massachusetts. See, e.g., Cook v . Comm’r of Internal Revenue,

5 0 , 853 (5th Cir. 2003) (“Mathematical computation of

6 fair market value is a factual issue; however, determination of

which is the proper valuation method is a question of law.”).

I. The Estate Tax in General.

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.”

(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.”

(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 or

relevant facts.”

(b).

The estate’s claim appears to be this: a well-informed buyer

would be willing to pay substantially less for an identical

annuity that he or she could not sell or assign than that same

buyer would be willing to pay for an identical annuity that could

7 be sold or assigned. In other words, that buyer (as well as the

broader market itself) would ascribe some value to the power to

sell, encumber, or otherwise transfer the annuity and, therefore,

would be willing to pay more for i t . And, critically, the estate

says the annuity tables in section 7520 of the IRC fail to take

into account the diminished market value of a non-marketable

annuity, as compared to a marketable one.

II. Differing Approaches to Valuing the Annuity.

Only a few courts have considered this narrow legal

question. The Court of Appeals for the First Circuit is not one

of them. Among those that have considered the issue, there is

disagreement over the proper way to value a non-transferable

right to receive lottery winnings (in the form of guaranteed

annual payments). The Courts of Appeals for both the Ninth and

Second circuits have concluded that the annuity tables do not

accurately reflect the fair market value of future lottery

payments to the extent they fail to account for the annuities’

lack of marketability. See Shackleford v . United States,

(9th Cir. 2001); Estate of Gribauskas v . Comm’r of

Internal Revenue,

(2d Cir. 2003).

8 The Court of Appeals for the Fifth Circuit (with one judge

dissenting from a panel opinion), joined by the district court in

Massachusetts (Woodlock, J . ) , have concluded that lottery annuity

payments are properly valued by reference to the IRC annuity

tables. See Cook, 349 F.3d at 855-57 (5th Cir. 2003); Estate of

Donovan v . United States,

(D. Mass. April 2 6 ,

2005). See also Anthony v . United States,

(M.D.

L a . June 1 7 , 2005) (concluding that, for estate tax purposes, a

non-marketable structured settlement annuity must be valued by

reference to the IRC annuity tables, without any discount to

account for the asset’s lack of marketability).

III. “Fair Market Value” v s . “Present Value”.

As noted above, the parties have stipulated that the “10

payments due the plaintiff on the date of his death from the

Commonwealth of Massachusetts constitute an annuity within the

meaning of Internal Revenue Code Section 2039 and 7520(a) and the

decedent’s interest in those payments was an ordinary annuity

interest within the meaning of Estate Tax Regulation § 20.7520-

3(b)(1)(i)(A).” Stipulation of Facts for Summary Judgment,

Exhibit 1 to plaintiff’s motion for partial summary judgment

9 (document n o . 7 ) . Accordingly, for estate tax purposes, the

general rule provides that the annuity must be valued by

reference to the IRC annuity tables. See

-

1(a) (“[I]n the case of estates of decedents with valuation dates

after April 3 0 , 1989, the fair market value of annuities . . . is

their present value determined under this section.”).

There i s , however, an exception to the general rule. As the

Court of Appeals for the Fifth Circuit has observed:

The applicability of the annuity tables is not, however, unassailable. They must be used to value annuities unless it is shown that the result is so unrealistic and unreasonable that either some modification in the prescribed method should be made, or complete departure from the method should be taken, and a more reasonable and realistic means of determining value is available.

Estate of Cook, 349 F.3d at 854 (citations and internal

punctuation omitted). S o , justify a departure from the annuity

tables, plaintiff bears the burden of demonstrating that: (1) the

value ascribed by the tables to the decedent’s annuity is

“unrealistic and unreasonable,” and (2) there is a more

reasonable and realistic means by which to determine its fair

market value.

10 The problem illustrated by cases of this sort - those

involving non-assignable annuities - is that the IRC annuity

tables take into consideration only two factors: time and a

discount interest rate. See Shackleford,

(“The

IRS has explained that the ‘valuation factors for determining the

present value of interests measured by a term certain are based

on two components: a term of years component and an interest rate

component.’”) (quoting Tax Notice 89-24, 1989-

6 0 ) .

Consequently, those tables provide what is generally known as the

“present value” of an annuity. That is to say, by using the

tables, one can determine the lump-sum amount that, if invested

today, together with interest earnings (at the 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. But, as noted above, for estate tax

purposes, the focus is necessarily on an asset’s “fair market

value,” rather than its “present value.”

In most cases an annuity’s “present value” is roughly

equivalent to its “fair market value.” That is to say, the

present value of a marketable annuity is close to the lump sum

11 that a well-informed buyer would be willing to pay for the right

to receive that periodic stream of payments. Presumably, that is

why the tax regulations equate present value with fair market

value. See

(a). Of course, routine use of

the annuity tables is also justified as a simple, cost-effective,

consistent, and, generally speaking, reliable means by which to

calculate an annuity’s fair market value, without the need to

call upon the opinion of valuation experts. See, e.g., Cook, 349

F.3d at 854 (“[F]or the property interests subject to § 7520 and

the accompanying regulations, the sometimes wide variation

produced by experts’ fair market valuation methods gives way to

certainty provided by the valuation tables.”).

Importantly, however, the attributes of predictability,

consistency, and efficiency must give way when the prescribed

valuation method produces a result that is “unrealistic and

unreasonable.” And, the accuracy and reliability of the IRC

annuity tables falls into some question when dealing with non-

assignable, non-marketable annuities. The present value of a

non-marketable annuity is not necessarily representative of its

fair market value because the tables have, by virtue of their

12 very structure and assumptions, failed to take into consideration

the fact that the annuity is non-marketable. A hypothetical

buyer would naturally be willing to pay less for a non-marketable

annuity than he or she would be willing to pay for a marketable

one. “The right to transfer is one of the most essential sticks

in the bundle of rights that are commonly characterized as

property. It is axiomatic that if an asset’s marketability is

restricted, it is less valuable than an identical marketable

asset.” Shackleford,

(citations and internal

punctuation omitted).

The Donovan court acknowledged as much, noting that, “Surely

if one could receive a lump sum payment for a freely assignable

right to the future payments, it potentially would have greater

worth than it does as an unassignable right to payments which may

not be accelerated [or assigned, or sold].” Donovan, at * 5 .

This court cannot agree, however, with the conclusion the Donovan

court derived from that statement: “But these factors do not make

the interest less valuable (at least to the decedent) than the

sum of the guaranteed payments discounted for the time value of

money as embraced by the annuity tables.”

That view, it

13 seems, mistakenly equates the “present value” of a non-marketable

asset with its “fair market value,” something that, at least at

this juncture, this court is unwilling to do. 1

In this case, the nonmarketable right to receive 10 future

payments from the Lottery Commission is less valuable than if the

right were freely alienable. O r , stated differently, it’s fair

1 As noted above, the Court of Appeals for the Fifth Circuit concluded that the “non-marketability” of an annuity is not a relevant factor when determining its fair market value and, therefore, reference to the annuity tables is appropriate. The court bolstered its conclusion that use of the annuity tables is appropriate in cases such as this by observing that “the non- marketability of a private annuity is an assumption underlying the annuity tables.” Cook, 349 F.3d at 856 (emphasis supplied). That view was shared by the Donovan court. Donovan,

at * 5 . I disagree. The tables are not designed to account for whether an annuity is marketable or not marketable. They take into account only two factors: an assumed interest rate and the length of time over which the annuity payments will be made. Thus, it is incorrect to say that the tables “assume” the non-marketability of the underlying assets. They do not. Marketability is simply not relevant to the function of the annuity tables (though it would be closer to the mark to suggest that if the tables “assume” anything on the subject, they assume marketability of annuities). The “present value” of an annuity, as calculated by those tables, will closely approximate its “fair market value” when the annuity happens to be marketable. And, contrary to what is suggested by Cook, those tables are less accurate in gauging fair market value when an annuity is non- marketable. That the tax regulations provide that certain non- marketable assets should be valued by reference to the IRC annuity tables, see defendant’s memorandum (document n o . 9 ) at 1 6 , does not alter economic reality: non-marketable assets have an inherently lower fair market value than marketable ones.

14 market value is less than its present value, as determined by the

IRC tables. First, as noted by the Gribauskas and Shackleford

courts, the annuity’s lack of marketability makes it inherently

less valuable because the right to receive annual payments cannot

be converted into, say, an immediate lump sum payment, which sum

could then be put to any number of uses. To deny that the

annuity’s lack of marketability has an effect on its fair market

value (as distinguished from its “present value”) is to ignore

one of its essential characteristics; the non-marketability of

that annuity has an unquestionable (and potentially material)

impact on its fair market value.

The annuity’s lack of marketability has another, perhaps

more tangible, negative effect on the estate. Because the estate

cannot simply sell the annuity to a third party for its fair

market value and then distribute that lump sum to the estate’s

beneficiaries, it might well be forced to remain open to

administer the annual receipts from the Lottery Commission. See,

e.g., N.H. Rev. Stat. Ann. 564:19. As a result, the estate will

likely incur additional administrative and legal expenses that it

could otherwise avoid. Plainly, the estate would be forced to

15 incur those additional continuing expenses because of the

annuity’s non-marketable character.

IV. The Estate’s Burden: Unrealistic and Unreasonable Valuation.

Having determined that the annuity tables (1) do not take

into account a “lack-of-marketability” factor in calculating an

annuity’s present value, (2) that the fair market value of a non-

marketable annuity is necessarily less, to some degree, than its

present value, and (3) that the IRC annuity tables are not

necessarily an accurate measure of a non-marketable annuity’s

fair market value, the court must next determine whether the

estate has carried its burden of demonstrating, as a matter of

law, that an alternate means of valuing the annuity must be used.

It has not.

Although the parties have agreed to the correct value of the

annuity if determined by applying the annuity tables, they have

not agreed upon a taxable value if a different valuation method

is used. And, while the estate’s expert has opined that the

annuity’s fair market value is $800,000, that opinion is

presumably contested by the government. Until that disputed

16 factual question is resolved - the correct tax value under

alternate valuation methods - the court cannot determine whether

plaintiff has carried her burden of demonstrating that the value

yielded by the IRC tax tables is “unreasonable and unrealistic.”

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

17 court cannot determine the proper valuation method as a matter of

law.

Conclusion

As the disagreement among respected courts illustrates,

resolution of this legal issue is difficult. In many respects

one’s view on the subject is a function of the perspective taken.

One might consider the annuity as simply the right to receive an

ongoing stream of fixed payments over a specified time. It is

difficult to conceive of such a right as having a “fair market

value.” It is what it i s : a right to receive defined cash

payments over a defined period. Consequently, its “present

value” can be readily (and accurately) expressed as a lump sum

value by reference to the tables. This is not unlike reducing an

individual’s projected earnings over the course of his or her

career to a lump sum or present value. And, it is not at all

unreasonable to say that an individual’s projected earnings o f ,

say, $1.5 million over his working life is “worth” a fixed amount

in current dollars. A “marketability” factor simply has no place

in that kind of calculation. Yet, we accept that the two assets

- the lump sum payment and the stream of periodic payments over

18 time - are equal in value. This appears to be the view embraced

by the Cook and Donovan courts.

I f , on the other hand, the court takes a different

perspective and views the asset as an “annuity” (rather than

simply the right to receive periodic payments), its

“marketability” becomes relevant in determining “fair market

value.” Annuities are, generally speaking, marketable assets.

There are, of course, exceptions (e.g., some structured

settlement annuities, lottery winnings, and survivor annuities

under ERISA-qualified plans), but the existence of those

exceptions highlights the difference in “value” between one and

the other. Though they might well be assets of identical present

value, marketable and non-marketable annuities are not assets of

identical fair market value.

Here, the parties have stipulated that the asset in question

is an annuity. Accordingly, it should be valued as such. This

court agrees with those that have concluded that: (1) by their

very nature, the IRC annuity tables fail to take into account a

“marketability” factor when determining an annuity’s present

19 value; (2) whether an annuity is marketable or not influences

(perhaps substantially, perhaps not) its fair market value (as

distinguished from its present value); and (3) when an annuity is

non-marketable, that factor should be taken into account when

determining its fair market value for estate taxation purposes.

Nevertheless, based on the record presently before i t , the

court cannot conclude, as a matter of law, that it is either

appropriate or inappropriate to use the IRC tables to determine

an approximate measure of the fair market value of the annuity in

question. Consequently, the government’s motion for partial

summary judgment (document n o . 8 ) , in which it seeks a judicial

determination that, as a matter of law, the IRC annuity tables

must be used to determine the value of the annuity at issue here,

is necessarily denied. But, on the other hand, because both the

sufficiency of the proposed alternate valuation method and the

“true” fair market value of the annuity are genuinely disputed

material facts, the court cannot conclude, as a matter of law,

that use of the IRC annuity tables is inappropriate in this case.

Plaintiff’s motion for partial summary judgment (document n o . 7 )

i s , therefore, denied as well.

20 SO ORDERED.

Steven J./McAuliffe lief Judge

December 1 9 , 2005

cc: Peter S . Black, Esq. Valerie Wright, Esq. William C . Knowles, Esq. Stephen T . Lyons, Esq.

21