By Espen Robak, CFA
Pluris Valuation Advisors LLC, New York, NY
As a waitress at the Waffle House in Grand Bay, Alabama, Tonda Lynn Dickerson had a regular customer, Edward Seward, who was known as a generous, albeit atypical, tipper. He liked to give lottery tickets. In fact, he liked it so much he would regularly drive from Alabama, which doesn't have a lottery, to Florida, to buy tickets he would give away. Whether the waffles were particularly good on March 7, 1999, is unknown, but at any rate on that day he gave Tonda a $10 million1 winning lottery ticket (the drawing had been the day before2). Which in turn set in motion a chain of events, recounted recently in Dickerson v. Comr., T.C. Memo 2012-60, involving Tonda's close-knit family, their various advisors, a family corporation, several disgruntled co-workers, and at least five court battles.
What piqued the IRS's interest in the winning ticket is what Tonda and her family did with it. They formed a family corporation and when Tonda eventually signed the back of the ticket to claim it at the Florida lottery headquarters she did so as president of the company. The corporation had been formed with Tonda and her husband as 49% shareholders and with Tonda's mother, brother, and sister (and their spouses) as 17% shareholders. No gift tax return was filed until 2009 and, when filed, claimed that no gift had been made. The IRS disagreed and determined a gift tax deficiency of $771,570. At issue in Tax Court were:
1. Did Tonda make an indirect gift by transferring the ticket to the family corporation?
2. If so, what was the value of the gift?
On the first question, petitioner argued that either (1) the family had a pre-existing agreement, in effect an enforceable contract under Alabama state law, to share all lottery winnings among its members or, alternatively, (2) the family members were all members of an existing partnership under federal tax law which was the true owner of the ticket. The court, in its opinion, disagrees for the following reasons:
1. "The `terms' of the so-called Reece family agreement consist solely of offhand statements made throughout the years about sharing and taking care of one another in the event someone came into a substantial amount of money."
2. There was no pooling of money, or pattern of regular purchases, or requirement that each family member buy tickets.
3. There were no predetermined sharing percentages and the allocation of the prize was in fact uneven, with Tonda taking more than the others.
4. In any case, an agreement to pool lottery winnings are likely void under Alabama state law, which frowns on what it calls "the vicious system of lottery schemes and the evil practice of gaming, in all their protean shapes."
Similarly, the court held that no valid partnership existed under federal tax law as that requires the parties to conduct some kind of business activity.3
Valuation of Contingent Claims
Having held that Tonda did in fact make a gift of 51% of the ticket left the court with task of arriving at its value. Luckily for the taxpayer, the respondent seems here not to have presented its own expert analysis,4 leaving the petitioner to (mostly) prevail on this point. The gift was made on March 12, 1999, which is several days after Tonda received it.5 This turns out to matter a great deal, because of what happened in the days after the drawing.
Mr. Seward had been generously giving lottery tickets before, including at the Waffle House. And shortly after hearing of Tonda's good fortune, several of her co-workers emerged alleging that the Waffle House employees too had an agreement, or partnership, involving lottery tickets: specifically, that they would share if any one of Mr. Seward's tickets ever came in a winner.6 The taxpayer argued that, as a result, anyone purchasing the ticket, or any portion of the ticket, on March 12, would have discovered that there were competing claims to as much as 80% of the ticket, or in the court's words, a "potential cloud on its title." The court held in favor of the taxpayer on this point.
Petitioner hired as its valuation expert - a lawyer at a law firm that exclusively works for plaintiffs on a contingency basis and that had substantial experience evaluating cases and claims for that purpose. He testified that, as of the valuation date, a discount in the 65% to 80% range was appropriate for the risk that the Waffle House claimants would prevail. Furthermore, assuming that Tonda had decided not to share with the other family members, there was the additional risk that the family would sue her claiming they had an agreement, or partnership, with respect to the winnings. For these two contingent claims, he took a total discount in the 80%-85% range. Finally, he deducted litigation costs of between 2% and 5%.
The court found the petitioner's expert very credible and knowledgeable about both Alabama law and the valuation of potential claims. While agreeing with the respondent that the family claims should be disregarded, the court held that there was substantial uncertainty about whether or not the Waffle House claimants would win their case. But because their case had not yet been filed as of the valuation date, the court found a discount in the low end of the range, or 65%. In addition, the court found that 2% is the appropriate discount for litigation expenses.
As support for its decision on the discount, and while recognizing the general rule against considering subsequent events, the court found significant support in the fact that the Waffle House claimants actually won in trial court, Alabama's strong anti-gaming statutes notwithstanding, and that there were two dissenting judges when the Alabama Supreme Court reversed.
The discount in Dickerson was a very healthy 67%. Could the IRS have done better? Does the Alabama legislature feel strongly about evils of gambling? We have said it before, we will say it again: you can not beat something with nothing. When the other side has a valuation expert, get your own. Or get two. The case is also yet another very helpful reminder that going into court with an analysis that ignores subsequent events is just unfortunate tactics. The court will virtually always sneak a peek at what really happened. You need to be prepared to discuss why, as of the valuation date, circumstances were so that the subsequent events were unexpected.
For more information, in the Tax Management Portfolios, see Hood, 830 T.M., Valuation: General and Real Estate, and in Tax Practice Series, see ¶6290, Valuation - Generally.
1 Specifically, the ticket paid out $354,000 per year for 30 years.
2 No kidding, and what Mr. Seward said when he found out he had given away an already winning ticket is not relayed by the Tax Court's opinion. (The court states that it was "unbeknownst to Mr. Seward at the time" of the gift that the ticket was a winning one).
3 Distinguishing Dickerson from Winkler Est v. Comr., T.C. Memo 1997-4, where the Winkler family had a pattern of purchases and joint decision making regarding lottery ticket purchases.
4 At least, none is mentioned in the opinion.
5 According to the petitioner. The respondent claims March 11. The court held it does not matter.
6 Mr. Seward also later sued the petitioner, claiming that since Tonda had backed out on her "commitment" to share with the others at the Waffle House, he was entitled to get the ticket back.
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