Valuing Interest in Tenancies by the Entirety Under Craft
In United States v. Craft, 535 U.S. 274 (2002), Mr. and Mrs. Craft owned Michigan real property as tenants by the entireties. During the marriage, Mr. Craft failed to pay federal income taxes for tax years 1979 through 1986 and in 1988, the Internal Revenue Service assessed the husband $482,446 of income tax, penalties, and interest. The IRS recorded a notice of federal tax lien1 and after the lien notice was filed, Mr. Craft transferred his interest in the property to his wife for $1 by quit-claim deed.
In 1992, Mrs. Craft sold the property. She reached an agreement with the IRS whereby the property was sold free of the tax lien, if Mrs. Craft placed half of the net proceeds in an escrow account pending a judicial determination of the government’s interest in the property. In an unusual ruling, the district court allowed the IRS to seize an interest in one half of the proceeds from the sale of tenancy by the entireties property. The district court stated that Mr. Craft enjoyed present “rights to the property” that the IRS lien attached to. On appeal to the Sixth Circuit, the court followed the majority of jurisdictions and held that no lien attached to the proceeds since the property was owned jointly, with each party owning an undivided interest in the whole. Since the joint owner possessed no individual and separate interest in the entireties property, the Sixth Circuit concluded that there was no individual property for the tax lien to attach to.2
On certiorari, the Supreme Court held that the state law recognized Mr. Craft had present rights to property, even though he owned it as a tenant by the entireties, and that federal law allowed the government to maintain a lien on the husband’s rights to property.3
Tenancy by the Entireties Ownership
Like Michigan and Florida, approximately 25 states recognize tenancy by the entireties ownership, and historically do not allow a creditor with a judgment against an individual owner to seize or encumber property that belongs to the individual as tenants by the entireties.4 In said jurisdictions, property owned as tenants by the entirety belongs to neither spouse individually, but to a separate fictional economic unity created by their marriage.5 Florida, like Michigan, characterizes tenancy by the entirety ownership as creating no individual rights whatsoever, but each owner “is vested with an entire title.”6 Accordingly, property held as tenants by the entirety can only be reached to satisfy a husband and wife’s joint debts and cannot be reached to satisfy the obligations of only one spouse.7
Despite the inability to separate the husband’s interest from that of the wife’s interest in jointly owned property, the Craft court noted that property ownership has been defined as a “bundle of sticks,” and includes both present and future interests. Despite the fact that under state law neither of the owners had the right to unilaterally alienate the other owner from the property, and that each party had to survive the other party to obtain total ownership, the court ignored that portion of the state law and found one party had present interests in the property. The present interests provided the husband with “a substantial degree of control over the entireties property” as found by the court and therefore were subject to the federal tax lien.
Once the court determined that each tenant individually possessed present rights under state law, the court held that under federal law, the federal tax lien attached to said property rights within the meaning of 26 U.S.C. §6321. The court selectively chose which part of the state law it applied to the federal law. It recognized the individual’s “present rights” under state law, but it ignored the state law’s finding that neither tenant owns a severable interest in the property.
Typically, Mr. Craft’s right of survivorship is considered a future interest and would be merely an expectancy. Expectancy interests are not vested rights which can be conveyed or transferred. The court said in Drye v. United States, 528 U.S. 49, 60, n.7 (1999), that an expectancy would not constitute “property” for the purposes of a federal tax lien. But Drye’s discussion of an “expectancy” did not decide the issue for the Craft court. The Craft court did not decide how many “sticks” were required for a tax lien, but it decided that it did not have to reach the issue of “expectancies” or whether survivorship alone would qualify as “property” or “rights to property” under §6321 since sufficient present possessory sticks existed for the tax lien to attach.8
The court expressed its concern that if it did not identify present “sticks” for the tax lien to attach to, that entireties property would belong to no one for §6321 purposes. Hence, if “the wife had no more interest in the property than her husband; if neither of them had a property interest in the entireties property, who did?”9 If neither the wife nor the husband had attachable lien rights in the present property, the decision would produce an absurd result that would allow spouses to shield their property from federal taxation by classifying it as entireties property.
Yet, this conclusion has been relied upon by attorneys for several decades and has assisted them in creating asset protection plans. Maybe it is time, in this court’s opinion, to change that planning option. Even though the fiction of owning the property as one economic unit has been used for several years by clients to avoid creditors, the court felt that such a position facilitated abuse of the federal tax system, and should therefore be changed. This change occurred, not pursuant to statute, but pursuant to the judiciaries’ interpretation. There were no congressional investigations, no hearings on the House floor, and no conference committees, but only a unilateral decision by the court that changed several years of law.
The Federal Tax Lien
The Internal Revenue Code that creates the federal tax lien does not create property rights, but establishes that the lien attaches to any and all property rights, or rights to property, belonging to the taxpayer. The courts have the responsibility to apply such rights to federal law to determine whether the government’s interest attaches to such rights.
The court recognized that the majority of jurisdictions prevent a creditor from attaching an individual’s interest in jointly owned property, but the court deviated from the majority opinion and disavowed the “single economic unit” theory as a fiction. The court found that the husband’s present rights gave him a substantial degree of control over the property and, therefore, such rights were sufficient to subject his entireties interest to the federal tax lien.
Open Door Against the State Law of Exemptions
The court’s decision in Craft opens a door that has previously been closed. Despite the fact that Mr. Craft lacked the right to unilaterally alienate the property, the court found that the right was not quintessential to the category of “property.” This interpretation is another example of how sweeping the court’s reach has become to remove property once considered exempt from the taxing authorities’ lien.
The dissent in Craft criticized the court’s expansive interpretation of the attachment of a tax lien when it considered that “partnership” property may now be subject to the individual’s tax lien.10 How broadly will the sweeping effects of the tax lien be? Will the decision affect the homestead exemption?11 Will the Craft holding expand to include other forms of business association property that is possessed and owned by multiple owners?
How Should the Rights be Valued?
The Craft court failed to value the lien or measure the husband’s interest in the entireties property, thus, leaving the measuring device to be determined on remand. Craft implied that the value of a severed interest in entirety property is exactly one half of the value of the total estate with no adjustment for various discounts that should be applicable.
There are several reasons why the ad hoc “one-half” figure utilized by the IRS yields a windfall to the taxing authority. Common sense indicates that in an arm’s length transaction, a bona fide purchaser would be reluctant to purchase a joint tenant’s interest in personal or homestead property for investment and speculation purposes at full value. One thing is certain, the value paid in an arm’s length transaction is not consistently 50 percent for similar interests.
Assuming such an interest were marketable, how should it be valued? Since value is unique, measuring value should be on a case-by-case basis.12
The IRS took a position in Craft similar to its position in Young v. Commissioner, 110 T.C. 297 (1998). In Young, the IRS refused to permit an “illiquidity” (lack of marketability) discount to a fractional interest in the case of multiple ownership in joint tenancy with the right to survivorship property. Despite the allowance of discounts in Propstra v. United States, 680 F.2d 1248 (9th Cir. 1982), the IRS argued against the Ninth Circuit’s position that fractional interest discounts were allowable for property owned as joint tenants. In Propstra, the Ninth Circuit allowed a fractional interest discount of 15 percent for valuation purposes under 26 U.S.C. §2033. The IRS successfully argued before the Tax Court that the fractional interest discount allowed by the Ninth Circuit in Propstra under 26 U.S.C. §2033 were inapplicable to §2040 valuations for jointly held property, despite the similarity in language between the two sections of the Code.
The position of the IRS in Craft therefore was consistent with its former position in Young, when it requested the court to refuse to permit valuation discounts for multiple party ownership if there is survivorship. Note, however, that §2040 as discussed in Young specifically includes “survivorship property” in valuing property, which is distinguishable from §6321 at issue in the Craft case. Section 6321 does not expressly limit valuation discounts for jointly held property.
When the courts and the taxing authority fail to recognize discounts for the present ownership restraints of multiple party ownership, they fail to reflect sound reasoning. Various valuation discounts are historically applied as they more accurately reflect market value, and not an artificial value, for valuing the present interests of jointly owned property. While the Craft court did not offer any guidance on the valuation of fractional interests, there is ample literature in the context of business asset valuation and estate asset valuation from which at least, rough guidelines for discounting can be gleaned.
Rationales for Discounts
Multiple ownership naturally restrains free alienation and marketability and, ultimately, value. Should the courts decide to allow discounts when valuing a federal tax lien, valuation discounts on account of illiquidity, i.e., lack of marketability and lack of control, enjoy considerable vintage in the literature on asset valuation.13 There are several other rationales for recognizing discounts:14
1) Control. Just as “control” is not dependent upon an absolute majority of interest held (more than 50 percent), and may not even be sufficient, a minority stake of less than 50 percent need not strip the interest holder of control and therefore warrant a discount.
Other factors such as regulation or contractual conditions may also limit the power of the majority. For example, bond covenants imposed by creditors may sharply circumscribe the ability of the entity to engage in certain activities or procure additional financing, irrespective of the majority position of certain interest holders. In cases where there is state or other regulation (for instance, zoning restrictions), the freedom of the majority interest holder to engage in certain activities or acquisitions unimpeded is similarly curtailed. The presence of nonvoting (preferred) stock similarly strips the ability of the plurality interest holder from exercising full control. In addition, the distribution of ownership interests and the possibility of formation of coalitions between groups of minority stakeholders can also serve as a check on majority power. In some cases, courts and appraisers have recognized a “swing vote premium.”
For several “fundamental changes” such as mergers or liquidations, corporate charters or other membership agreements may require “super-majority” approval and a simple majority interest may not be able to engineer the desired change without at least some minority participation. Finally, the premium attached to a majority interest may be diluted by the presence of “key person” (the “key man discount”).15 However “control” is limited, and the reasons for such limitations, control has to be considered for valuing interests. Hence, one tenant owner in tenancy by the entireties property lacks control. The lack of control restraint should include valuation discounts when valuing lien interests in tenancy by the entireties property.
2) Marketability. An illiquidity discount is appropriate when there is no active market for resale, when resale requires expenditures for partitioning the property, when there is discord among existing interest holders, or when there are similar marketing restraints. In cases where there is a restraint on marketability, the availability of bank financing may be limited, and the value of the interests is correspondently reduced. Such marketability factors, or lack thereof, are similarly found in joint ownership of tenancy by the entireties property where there is no active market for resale of a partial interest. This is one reason partition suit litigation is prevalent in dissolution of marriage cases.
The IRS has frequently opposed discounts in valuation of fractional interests in tenancies in common (at least without strong evidence of discord among the remaining tenants). Several court cases, however, have ruled against the IRS in this context, especially in the presence of careful expert testimony by appraisers, real estate brokers, real estate attorneys, bank loan officers, and other financial experts.
Quantifying the Discounts
Because there may be multiple sources of discounts, a preliminary question that arises is whether the discounts are additive. For example, if it were the case that discounts for illiquidity and lack of control were each 20 percent, is the total discount to be applied 40 percent or 36 percent? This issue has not been fully resolved in the asset valuation literature yet; however, most analysts seem to opt for a layered approach.
When adapting discounts to valuation of fractional interests in real property, the first step is of course, to determine the initial, unadjusted fair market value (FMV) of the asset. In principle, and in the existence of organized markets with willing buyers and sellers, this unadjusted value of the asset may be readily observed from market data. When such market data is readily observable, financial valuation professionals utilize a number of valuation techniques. In cases of both financial and real assets, the intrinsic value of the asset may be determined, in principle, by its income producing potential (including its terminal value at the time of a liquidity event). Unfortunately, if the property in question is personal in nature, its income producing potential information may not be available. Nonetheless, even though personal property is owned without producing a source of income, income principles may still apply. For example, homes increase in value and replacement costs and obligations are similar in effect as to income producing property. Additionally, comparable rental values for similar property includes an income stream. In Craft, the property in question was not identified as having an income stream, i.e., personal, business, or investment.16 However, comparable replacement costs could be analogized as income streams.
Essentially, an earnings multiples approach is rule of thumb computation arrived at by multiplying earnings before taxes (EBIT) by a multiple that is judged to be reflective of value in the particular industry being considered. Discounted cash flow methods have a more venerable vintage in academic circles, but are more difficult to apply. In part, this is because free cash flows must be first forecast over the relevant horizon, and then the resulting sum of flows is discounted to present value by the weighted average cost of capital.
Option pricing methods may also shed light in the value of an asset. As various authors recognized, the value of an option derives in large part from the ability of the option holder to exercise a call or put option. A parallel in the field of intellectual property may readily be found. If a revision of prior estimates upon receipt of additional information is relevant, Bayesian inference or conditional probabilities may apply. Just as options may be valued, “survivorship” and the ability to sever tenancy by the entireties property may be valued. The present value of a future expectancy, i.e., survivorship, may be predicted as with life expectancy calculations found in the government’s actuarial tables.
Adaptation of this approach to valuation of real property with contingent discounts to entireties property can readily be imagined. For instance, deeper discounts for lack of control may be appropriate if the equal interests of entireties property faces an increasingly hostile partner or if the partner engages in self-dealing over time. Because these events are probabilistic, it should be possible to assign conditional probabilities to a set of varying discounts.
A lack of marketability discount can theoretically, be incorporated in the valuation of an asset when using the discounted cash flow method. As discussed above, the reduction to present value with this method involves the use of an appropriate discount rate. The probability of surviving may be measured against life expectancy. The probability percentage creates lack of liquidity (or lack of access to financing). Hence, the cost of capital would be expected to be higher; correspondingly, the discount rate in this method can be adjusted upward, based upon competent expert testimony.
Several empirical studies in the finance literature point to an attempt to measure a lack of liquidity discount, as well as the minority discount. SEC studies have compared the prices at sale of restricted shares with comparable prices during an initial public offering (IPO) of the same company. The difference in share prices in these event studies have indicated the presence of a lack of marketability discount in the range of 20 to 40 percent. There is also a voluminous literature on the measurement of minority discounts and control premiums. The Mergerstat Review indicates the presence of a median minority discount of 27 percent and median control premium of around 30 percent.
Courts that apply the principles outlined in Craft will be confronted with whether to consider different discounting for valuing the federal tax lien. There is a wealth of history and application of discounting used in estate valuation, individual asset valuation, business asset valuation, and in other disciplines that make discounting a credible variable for courts to consider when valuing a lien.
1 26 U.S.C. §§6321 (2000).
2 Craft v. United States, 233 F.3d 358 (6th Cir. 2000), reh’g denied and suggestion for reh’g en banc denied, 2001 U.S. App. LEXIS 4111 (Mar. 16, 2001).
3 United States. v. Craft, 533 U.S. 976 (2001) rev’d, 535 U.S. 274 (2002).
4 Richard I. Aaron, Bankruptcy Law Fundamentals §7:6 (1984 & Supp. 2004).
5 When a married couple holds property as a tenancy by the entireties, each spouse holds the whole or the entirety, and not a share or divisible part. Beal Bank, SSB v. Almand & Assocs., 780 So. 2d 45 (Fla. 2001).
6 Long v. Earle, 277 Mich. 505, 517, 269 N.W. 577, 581 (1936). Compare a partial listing of Florida cases including United States v. Gurley, 415 F.2d 144 (5th Cir. 1969); United States v. American Nat’l Bank, 255 F.2d 504 (5th Cir. 1958), cert. denied 358 U.S. 835 (1958), reh’g denied 359 U.S. 1006 (1959); Baldwin v. United States, 805 F. Supp. 1026 (S.D. Fla. 1992); In re Daniels, 309 B.R. 54 (Bankr. M.D. Fla. 2004); and Meyer v. Faust, 83 So. 2d 847 (Fla. 1955); Vaughn v. Mandis, 53 So. 2d 704 (Fla. 1951); Allardice & Allardice, Inc. v. Weatherlow, 124 So. 38 (Fla. 1929).
7 If the spouses are jointly obligated on a debt, however, the joint creditor may seize the entireties property.
8 Some of the sticks or rights that the Court considered under state law that belonged to the husband, as a joint tenant, included the right to use the entireties property, to exclude others from it, to survive, to become a tenant in common with equal shares upon divorce, to sell the property with the spouse’s consent and to receive half the proceeds from such a sale, and to block the spouse from selling or encumbering the property unilaterally.
9 Craft, 535 U.S. at 285.
10 Note that the Revised Uniform Partnership Act of 1995 provides that joint tenancy, tenancy in common, tenancy by the entireties does not, by itself, establish a partnership, even if the co-owners share profits made by the use of the property. Fla. Stat. §620.8202(3)(a) (2004).
11 The Court has previously ruled that the taxing authority is not prohibited from seizing exempt assets, such as the homestead property. See United States v. Rodgers, 461 U.S. 677 (1983). Therefore, due to the Craft decision, Florida homestead may no longer protect joint homeowners if one party has individual tax liabilities. Is Florida congressional intent frustrated when no property is protected from tax creditors? Will the tax authority next seek the partition the homestead property and force the removal of the surviving spouse and minor children? State law does not limit the federal government and since §6321’s interpretation is a federal question, the taxing authority is not restricted by the state courts’ answers to similar questions involving state homestead law.
12 Compare, Spears v. Boyd (In Re Spears), 313 B.R. 212, 217 (Bankr. W.D. Mich. 2004), the bankruptcy court found the trustee’s position to value the debtor’s interest in tenancy by the entireties property on a case-by-case method “hardly intelligible and without justification.” Without guidance, how is a court supposed to value or measure a tenant’s interest? The Spears court stated that “even if Congress did intend a homespun remedy to value severed entireties exemptions, the above recipe is not the right one. It muddles the distinction between severed and unsevered interests and invites only confusion and unworkable valuations.” Id. at 218.
13 Occasionally, courts and others have inappropriately confused the two concepts. A lack of marketability discount applies because the market is “thin” and this may be the case for both minority and majority interests. contrast, a minority discount (inverse of a control premium) may apply regardless of the “depth” of the market for the asset in question. Control premiums (and their converse) have, of course, been well recognized in asset valuation in the corporate context. Similarly, a thin market or illiquidity discount is easily analogized to share transfer restrictions in closely held corporations.
14 A lack of control or minority discount is appropriate when the entity does not have the right to a) determine distribution of earnings (set dividend policy in case of corporations or for REITs in case of real property assets); b) appoint management and directors; c) determine management compensation; d) determine if and whether other assets will be acquired; e) determine the timing and terms of liquidation, dissolution, or recapitalization (e.g., refinancing of mortgages); f) change internal operating procedures; g) determine the identity of future business partners and co-venturers; and h) register stock in instances where a public stock offering is to be made. It is easy to conceptualize the creation of a minority interest in the context of real property. Once the unity of a joint tenancy or a tenancy by the entirety is severed, two equal sized shares are left, neither one of which is a majority interest. Alienation of one of these shares to others thus produce fractional shares in a tenancy in common.
15 The dependence on a “key person” may affect both the total valuation of the enterprise and its marketability.
16 Common methods of valuing income producing assets include a) examining comparable companies; b) “earnings multiple methods”; c) discounted cash flow methods (using either free cash flows or equity cash flows); d) option valuation techniques; and e) others. This note is not the forum to discuss these methods in any detail and the reader is referred to one of several books in the area.
Jagdeep S. Bhandari is a professor of law at Florida Coastal Law School. He holds degrees in law from Duquesne University and Georgetown University. He also holds a Ph.D. in economics. Professor Bhandari has published widely in the areas of business and law, and has also had considerable practice experience.
Mike E. Jorgensen is an associate professor at the Florida Coastal School of Law. He holds an LL.M. in taxation from the University of Florida and a J.D. from the University of Idaho. Mr. Jorgensen commenced his legal career by serving as a trial attorney with the Internal Revenue Service, then as a special assistant U.S. attorney in Bankruptcy Court for the Middle District of Florida.
This column is submitted on behalf of the Tax Section, William D. Townsend, chair, and Michael D. Miller, Benjamin Jablow, and Normarie Segurola, editors.