Valuing a Private Annuity

Gladys Cook and her sister-in-law had a long-standing agreement to jointly purchase Texas lottery tickets. On July 8, 1995, they bought a winner—the prize was $17 million, payable in 20 annual installments. The state made the first payment of $858,648 on July 10, 1995. Texas law prohibits assignment of the winnings, except by court order, as well as collection of the amount in a lump sum. On July 12, Gladys and her sister-in-law created a formal partnership to receive the winnings. Gladys died on November 6, 1995. The partnership interest was included in her estate with a value based on an appraisal. The IRS disagreed with this method and revalued the interest based on the annuity tables in the regulations. The Tax Court held for the IRS, supporting its use of the annuity tables. The taxpayer appealed.

Result. For the IRS, with one dissent. Normally the appeals courts do not review questions of value since they are questions of fact. In this case the issue was the proper method of valuation, a question of law, which the appeals court can review.

The initial inquiry was the correct classification of the lottery winnings. The Tax Court held they were a private annuity based on a broad reading of the definition of an annuity. The Fifth Circuit agreed.

Unlike other assets, private annuities are valued using tables from the regulations. Attempting to determine the price a willing buyer and willing seller would agree upon is not an appropriate valuation method. Congress approved the use of these tables because they provide convenience and certainty and the loss of accuracy is minor. Prior court cases had permitted use of a method other than the tables if “the result is so unrealistic and unreasonable that either some modification in the prescribed method should be made, or departure from the method should be taken.” Specifically the courts allowed a departure from the tables when the actual yield was proven to be significantly less than the table rate and when the recipient’s life expectancy was only one year. In this case the taxpayer requested an exception for the annuity’s lack of marketability.

The Fifth Circuit rejected marketability as a factor for deviating from the tables. The court noted that prior cases deviated only if the tables’ underlying assumptions were incorrect. Marketability is not one of the tables’ assumptions, and, therefore, the court said that the table results were reasonable.

In reaching this conclusion, the court noted that the Second and Ninth circuit courts of appeal had accepted lack of marketability as a factor permitting an alternate valuation method. Therefore this decision establishes a split among the circuits on the question of when the table is inappropriate. This split also may affect taxpayers who are receiving annuities from sources other than lottery winnings.

Because of stipulations by the parties, the court did not consider whether the partnership interest’s lack of marketability allowed a discount from the value of the partnership assets. The IRS had agreed to allow this discount. The amount and availability of discounts when valuing partnership interests continues to be an area of dispute between some taxpayers and the IRS.

Gladys J. Cook v. Commissioner, CA-5.

Prepared by E dward J. Schnee, CPA, PhD, Hugh Culverhouse Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.