TAX COURT DETERMINES VALUE OF ESTATE'S PARTNERSHIP INTEREST; NO PENALTY APPLIED.

Kelley A. Blaine, for respondent.

(1) the value of the 41.128-percent limited partner interest in Giustina Land & Timber Co. Limited Partnership owned by Natale Giustina at his death on August 13, 2005 (the estate contends the value is $12,995,000, but the IRS contends the value is $33,515,000);² and

(2) whether the estate is liable for the section 6662 accuracy-related penalty.³ We find that the value of the partnership interest is $27,454,115 and that the estate is not liable for the penalty.

Natale Giustina was the trustee of the N.B. Giustina Revocable Trust.⁴ The trust owned a 41.128-percent limited partner interest in Giustina Land & Timber Co. Limited Partnership. This partnership is sometimes referred to here as "the partnership".

Until the 1960s the family timberlands were held by Giustina Bros., a partnership. In the 1960s the timberlands that contained young trees were transferred from Giustina Bros. to a newly formed partnership called Giustina Timber Co. The shares of Giustina Timber Co. were then transferred to heirs of the original four brothers. The mills, meanwhile, were owned by Giustina Bros. Lumber & Plywood, a corporation that employed 200 people.

For many years the family business was run by Natale Giustina and his brother, Ehrman Giustina. The Giustina family eventually sold all of its mills. By 1988 the Giustina family's business holdings consisted primarily of timberlands owned by Giustina Bros. and by Giustina Timber Co.

The first new partnership was Giustina Land & Timber Co. Limited Partnership. This partnership received 51.875 percent of the assets of (1) Giustina Bros. and (2) Giustina Timber Co. The parties have stipulated that this partnership was owned by "the Natale Giustina and Anselmo Giustina families, as well as another relative named Dolores Fruiht". The value of a 41.128-percent limited partner interest in this partnership is the major issue in this case.

The second new partnership was Giustina Resources. This partnership received 30.625 percent of the assets of (1) Giustina Bros. and (2) Giustina Timber Co. The parties have stipulated that this partnership was owned by "members of the Ehrman Giustina family". It was operated by Dan Giustina.

The third new partnership was Giustina Woodlands. It received 17.5 percent of the assets of (1) Giustina Bros. and (2) Giustina Timber Co. The parties have stipulated that this partnership was owned by "the Greg Giustina family".

The extended Giustina families made every effort to ensure not only that the assets were divided according to each family's proportionate ownership interests in Giustina Bros. and Giustina Timber Co., but also that the timber species, revenues, and income were divided in the same manner. Even though substantially all of its assets were distributed, the Giustina Bros. partnership remained in existence. All of the assets of Giustina Timber Co. were distributed.

The partnership agreement provides that the general partners have full control over the business of the partnership. The general partners have the power to sell the partnership's timber, land, and other property. The general partners also have the power to make distributions of cash or property to the partners in proportion to each partner's respective interest in the partnership. All decisions of the general partners must be made with the concurrence of a majority of the general partners.

The partnership agreement initially provided that the general partners were Larry Giustina and Ansel James Giustina, their survivors, and any other person admitted to the partnership as an additional general partner in accordance with the provisions of the agreement. Ansel James Giustina is the son of Anselmo Giustina. We refer to him as James Giustina.

The partnership agreement allows a general partner to voluntarily resign. A general partner can be removed by the concurrence of limited partners owning two-thirds of the interests in the partnership. If a general partner resigns or is removed, a successor general partner may be designated by the limited partners owning two-thirds of the interests in the partnership. An additional general partner can be admitted to the partnership if all the partners consent to the admission.

The partnership agreement allows a limited partner interest to be transferred to (1) another limited partner, (2) a trust for the benefit of a limited partner, or (3) any other person approved by the general partners. A limited partner may not withdraw from the partnership unless all of the limited partner's interests have been transferred.

The partnership agreement provides that the partnership will continue to exist until December 31, 2040, unless the partnership is terminated earlier pursuant to section 12.2 of the partnership agreement. Section 12.2 provides that the partnership shall be dissolved: (1) automatically on December 31, 2040, (2) if the limited partners fail to designate a successor general partner within 90 days after the resignation or removal of the sole general partner, or (3) if the limited partners owning two-thirds of the interests in the partnership vote to dissolve the partnership. If the partnership is dissolved, its affairs must be wound up, its assets may be sold, and its assets and any proceeds from the sale of assets must be distributed to its partners in accordance with their capital accounts.

Schedule A of the original partnership agreement listed the limited partners when the partnership was formed in 1990:

              Limited Partner                Number of Units

A buy-sell agreement, dated November 21, 1994, bars a limited partner from transferring a partnership interest unless (1) the transfer is to a member of the transferring partner's family group, or (2) the transferring partner offers the other limited partners the right of first refusal. For these purposes, there are three family groups:

• "Sylvia B. Giustina, A.J. Giustina, children of Sylvia B. Giustina, and children of A.J. Giustina."

• "N.B. Giustina, Natalie Giustina Newlove, L.M. Giustina, Irene Giustina Goldbeck, and children of Natalie Giustina Newlove, L.M. Giustina, and Irene Giustina Goldbeck."

• "Dolores Giustina Fruiht, her children, and grandchildren."

On January 1, 2002, Larry and James Giustina resigned as general partners. Each was replaced by a limited liability company. LMG, LLC, is controlled by Larry Giustina. AJG, LLC is controlled by James Giustina.

Some transfers of limited partner interests occurred after formation of the partnership. The parties stipulated that as of August 13, 2005, the partnership had the following owners:

                 Ownership of Giustina Land & Timber Co.

By August 13, 2005, Giustina Land & Timber Co. owned 47,939 acres of timberland in the area of Eugene, Oregon. It employed approximately 12 to 15 people. Three or four worked in forestry; four worked on the roads crew; and six worked at administrative tasks. Although James Giustina and Larry Giustina both controlled general partners of the partnership (their respective LLCs), the primary decisions regarding the management of the timber were made by Larry Giustina. James Giustina provided assistance to Larry Giustina in the decisionmaking.

One problem with Reilly's computations is that he reduced each year's predicted cashflows by 25 percent to account for the income taxes that would be owed by the owner of the partnership interest on that owner's share of the partnership's income. The 25-percent reduction is inappropriate because the rate at which Reilly discounted the cashflows to present value was a pretax rate of return, not a posttax rate of return. An appraiser should not reduce cashflows by income tax while simultaneously using a pretax rate of return to discount the cashflows to present value. Gross v. Commissioner, T.C. Memo. 1999-254, 78 T.C.M. (CCH) 201, 209, affd. 272 F.3d 333 (6th Cir. 2001). Thus, Reilly's cashflow estimates must be recomputed to eliminate the 25-percent discount for income tax liability.

Reilly's 18-percent discount rate had four components. Only the fourth needs to be corrected. The first component was the risk-free rate. Reilly assumed that the risk-free rate was the 4.5-percent rate of return earned by owners of 20-year U.S. Treasury bonds.

The second component of Reilly's discount rate was a beta-adjusted equity risk premium. According to Reilly, beta is a "measure of the systematic risk (i.e., risk relative to returns in a measure of the overall equity market, such as the S&P 500 index) inherent in a company's investment returns." Reilly determined that the risk premium for an equity investment in the S&P 500 common stock index was 7.2 percent. Reilly estimated that the beta for an investment in companies in the timber industry was 0.56. He then estimated that a beta of 0.5 was appropriate for the partnership because it had less debt than other timber companies. He therefore calculated a beta-adjusted risk premium of 3.6 percent (7.2 percent x 0.5).

The third component of Reilly's discount rate was a small stock equity risk premium. Reilly estimated that this component was 6.4 percent. Reilly calculated that an investment in a small company, defined as a company with a total equity capitalization between $1.4 million and $263 million, had an annual return of 6.4 percent above the overall equity risk premium exhibited by the S&P 500 common stock index.

The fourth component of Reilly's 18-percent discount rate was a partnership-specific risk premium of 3.5 percent. Reilly explained that this risk premium was justified because the partnership's timberlands were not geographically dispersed. All were in Oregon. He also explained that the partnership's operations were nondiversified. The partnership's sole source of revenue was timber harvesting. Thus, it is apparent that a portion of the 3.5-percent premium reflects the unique risks of the partnership. But unique risk does not justify a higher rate of return. Investors can eliminate such risks by holding a diversified portfolio of assets.⁵ We conclude that the partnership-specific risk premium should be only 1.75 percent.

After this adjustment is made, the correct discount rate is 16.25 percent. This is equal to the sum of 4.5 percent, 3.6 percent, 6.4 percent, and 1.75 percent.⁶

Reilly reduced his 18-percent discount rate by 4 percent to reflect his assumption that cashflows would increase by 4 percent each year. After making this reduction, his "direct capitalization rate" was 14 percent. We have no dispute with the 4-percent assumption. Therefore, the 16.25-percent discount rate should be reduced by 4 percent, resulting in a direct capitalization rate of 12.25 percent.

          Valuation of All Partnership Interests on a Marketable Basis

We believe that there was a 75-percent probability that the partnership would have continued its operations rather than liquidating its assets. The Giustina family had a long history of acquiring and retaining timberlands. We take this into account, but we also assume that the owner of the 41.128-percent limited partner interest is a hypothetical third party, see sec. 25.2512-1, Gift Tax Regs., who seeks the maximum economic advantage from the asset.⁹ As Reilly testified, the optimal strategy to maximize the value of the partnership would be to sell the timberland and "get $143 million today." Selling the timberlands would generate about $143 million; continuing to operate the partnership would generate only about $52 million. Reilly opined that the value of the timberlands is irrelevant because a holder of Natale Giustina's interest could not unilaterally force the sale of the partnership's assets. It is true that the owner of a 41.128-percent limited partner interest could not alone cause the partnership to sell the timberlands. However, there are various ways in which a voting block of limited partners with a two-thirds interest in the partnership could cause the sale. The members of such a voting block could replace the two general partners, who have the power to sell assets and make distributions. Alternatively, a two-thirds voting block could dissolve the partnership, an act that must be followed by the distribution of the partnership's assets. We are uncertain how many partners would share the view that the timberland should be sold. The uncertainty does not prevent us from estimating the probability of the sale:

Conversely, there was a 75-percent probability the timberlands would not be sold. We assign a weight of 75 percent to the value of the partnership as measured by the cashflow from its continued operations.

           Valuation of the 41.128-Percent Limited Partner Interest:

Like Reilly, Thomson used the value of other businesses to value the interest in the partnership. He relied on four businesses: Plum Creek Timber Co., Inc., Pope Resources LP, Deltic Timber Corp., and Potlatch Corp. Both Deltic and Potlatch have substantial operations other than owning timberland and selling timber.

In our view, neither expert appropriately considered that the other companies have assets other than timberland assets and that they earn income from sources other than timber sales. Because of this failure, and because other methods are available, we accord no weight to the "guideline publicly traded company" method used by Reilly or the similar method used by Thomson.

However, no penalty is imposed with respect to an underpayment if there was reasonable cause for the underpayment and the taxpayer acted in good faith. Sec. 6664(c)(1). Whether an underpayment of tax is made in good faith and due to reasonable cause will depend upon the facts and circumstances of each case. Sec. 1.6664-4(b)(1), Income Tax Regs. In determining whether a taxpayer acted reasonably and in good faith with regard to the valuation of property, factors to be considered include: (1) the methodology and assumptions underlying the appraisal; (2) the appraised value; (3) the circumstances under which the appraisal was obtained; and (4) the appraiser's relationship to the taxpayer. Id. Although the IRS bears the burden of production under section 7491(c) that the section 6662 penalty is appropriate, the taxpayer bears the burden of proof in demonstrating reasonable cause. See Higbee v. Commissioner, 116 T.C. 438, 446-448 (2001).

The executor of the estate is the decedent's son, Larry Giustina. Larry Giustina hired a lawyer, Steven Lane, to prepare the estate-tax return. Lane hired Columbia Financial Advisors to appraise the 41.128-percent limited partner interest. Larry Giustina relied on the Columbia appraisal in filing the return.

The Columbia appraisal, like the Reilly report, valued the limited partner interest on the basis of capitalized cashflows, capitalized distributions, and the market values of other companies. Even though the Columbia appraisal did not incorporate the asset method, it was reasonable for the executor to rely on the Columbia appraisal. The partnership had been in operation for 15 years. It was reasonable to conclude that the partnership would continue to maintain its timberland assets without liquidating them.

The underpayment of tax on the estate's tax return resulted from its valuation of the 41.128-percent limited partner interest. The valuation was made in good faith and with reasonable cause. The estate is not liable for the section 6662 penalty.

To reflect the foregoing,

Decision will be entered under Rule 155.

² Although the 41.128-percent limited partner interest was owned by a trust, rather than by Natale Giustina directly, the estate concedes that the value of the partnership interest must be included in the gross estate. For convenience, we sometimes discuss the partnership interest as if it was held by Natale Giustina rather than through the trust.

³ The parties have stipulated that the marital deduction at issue is a computational issue and that the amount of the allowable marital deduction will depend on the value of the 41.128-percent limited partner interest in Giustina Land & Timber Co. owned by Natale Giustina at his death on Aug. 13, 2005. The parties also stipulated that administrative expenses incurred by the estate shall be allowable to the extent substantiated.

⁴ Natale Giustina's middle initial was "B".

⁵ Richard A. Brealey and Stewart C. Myers explain:

⁶ The discount rate Thomson used in his cashflow method, 16.22 percent, is almost equal to the 16.25-percent rate that we find to be the appropriate discount rate. Thomson's discount rate was equal to: (1) a 4.52-percent risk-free rate, plus (2) an 11.7-percent equity risk premium paid for small stocks (i.e., stocks in the fifth capitalization quintile of companies traded on the New York Stock Exchange for 1926-2004). We did not use Thomson's method of determining a discount rate.

⁷ Reilly testified that 25 percent was also reasonable.

⁸ Reilly referred to the cashflow method as the direct capitalization method.

⁹ As we said in Estate of Davis v. Commissioner, 110 T.C. 530, 535 (1998) (citations omitted):

¹¹ As Reilly testified: "The concept of investment marketability relates to the liquidity of an investment -- that is, how quickly and certainly the investment can be converted into cash at the owner's discretion."

¹² Undistributed cash that is used by the partnership to increase the value of the partnership assets increases the value of the limited partner interests.