Restricted lottery payments not valued under IRS actuarial tables.

P and his wife won a $15,807,307 Connecticut Lotto prize, to be paid out in 20 annual installments of $790,365. After the first installment, they divorced. Thereafter, each was entitled to receive $395,183 annually. P died intestate on June 4, 1994, with 18 installments remaining.

On P's Form 706, United States Estate (and Generation Skipping Transfer) Tax Return, the value of the remaining prize installments was discounted to account for Connecticut's restrictions on Lotto winnings: (1) all prizes in excess of $1 million were payable in 20 equal annual payments, which could not be accelerated and (2) winners were forbidden from assigning or transferring their right to future installments to third parties. These bans severely restricted a winner's ability to exchange his or her rights to future payments for a lump sum. However, the parties stipulated a market for such unassignable winnings did exist, albeit at a significant discount, at the time that the estate filed its return. P's estate factored in this risk-based market discount and valued the prize at $2,603,661.

The IRS determined that the prize constituted an annuity that should have been valued under the Sec. 7520 actuarial tables. It determined that the present value of the award was, in fact, $3,528,058 and assessed a $403,167 deficiency. The estate filed a Tax Court petition; the parties stipulated that (1) a market for the Lotto winnings did exist at the time the return was filed, (2) the prize's fair market value (FMV) was diminished considerably due to transfer restrictions and (3) if departure from the Sec. 7520 tables was warranted, the estate's valuation of the prize was correct. The Tax Court held, as a matter of law, that marketability restrictions, per se, did not justify departure from tabular valuation; see Est. of Gribauskas, ll6TC 142 (2001).

Analysis

Generally, the value of an annuity, or of any interest for a term of years, is derived from standardized valuation tables set forth in Sec. 7520(a). However, departure from the tables is appropriate when adherence to them "would produce an obviously erroneous result," Berzon, 534 F2d 528 (2d Cir. 1976) or would "produce a substantially unrealistic and unreasonable result," O'Reilly, 973 F2d 1403 (8th Cir. 1992). A party challenging application of the tables "bears the 'considerable burden of proving that the tables produce such an unrealistic and unreasonable result that they should not be used,'" Shackleford, 262 F3d 1028 (9th Cir. 2001) (quoting O'Reilly).

Shackleford is a useful guidepost. In that case, the Ninth Circuit ruled on a virtually identical issue. The court held that departure from the tables was appropriate when the taxpayer provided a more realistic and reasonable valuation method, because the tables did not reasonably approximate the FMV of a California lottery prize subject to anti-assignment restrictions. In arriving at its holding, the court correctly observed that the "right to transfer is 'one of the most essential sticks in the bundle of rights that are commonly characterized as property,'" and that, as a rule, an asset subject to marketability restrictions is worth less than an identical item not so burdened.

The parties stipulated that the transferability restrictions had an adverse effect on FMV and the Service agreed that the estate's valuation accurately reflected the market discount attributable to those restrictions. Thus, application of the tables would clearly "produce a substantially unrealistic and unreasanable result;" O'Reilly, 973 F2d at 1408. Thus, valuing the winnings under the tables was erroneus.

The Tax court had held that adherence to the tables was proper because no priorcase had held that marketably restrictions alone could justify departure; see Gribauskas, 116 TC at 163. The Service argues for a similarly narrow interpretation, despite the broad language in cases such as O'Reilley, that departures from the proponent can show a substantial inconsistency between the actual facts and the assumptions underlying the tables (e.g., when the rate of return is actually lower than the assumed rate of return in the tables, or when the death of the measuring life is imminent due to terminal illness).

The governing principle is that a departure is allowed if the tables produce a substantially unrealistc and unreasonable result. The need for efficiency and consistency does not justify the application of the standardized tables in the instant case. The law sufficiently accounts for such policy concerns by placing the burden on the party challenging the application of the tables to prove that they yield a substantially unreasonable or unrealistic result. This high burden has been met by the stipulations in the record.

EST OF PAUL C. GRIBBAUSKAS, 2D CIR., 8/26/03