The consideration of contingent assets and liabilities represents one of the more unique and difficult issues encountered by companies and individuals for both financial and tax reporting purposes. Contingent assets and liabilities result from an existing condition, situation, or set of circumstances that involve uncertainty given their dependence upon the outcome of future events. These amounts often pertain to potential litigation settlements, environmental costs, product liability claims, earn-out payments, or other future uncertain events. By definition, the final calculation of the contingent asset or liability cannot be determined with certainty until the actual occurrence of a future event, thus rendering the valuation of these amounts prior to such event a particularly difficult challenge for taxpayers and their advisors.
A certain level of guidance may be derived from several cases in which the courts have addressed this issue, particularly when considered in conjunction with existing Treasury Regulations issued by the U.S. Department of the Treasury (the “Treasury”). At the same time, the Financial Accounting Standards Board has also attempted to address the issue from a financial reporting perspective. Despite these efforts, no uniform standards have definitively been established to govern the recognition and valuation of contingent items. Rather, the specific facts and circumstances of each particular case still require taxpayers and their advisors to address each situation from a unique perspective. The following article addresses certain relevant factors to be considered in determining both the recognition and valuation of contingent assets and liabilities.
Recognition of Contingent Assets and Liabilities
Part of the challenge historically encountered by taxpayers stemmed from the fact that the Internal Revenue Service (“IRS”), U.S. Tax Court, and accounting regulatory authorities had not adopted and presented a consistent message stipulating the factors requiring recognition, or lack thereof, of contingent assets and liabilities. Two recent decisions reached by the U.S. Tax Court, discussed below, again highlight this issue and provide a certain level of insight into the existing tendencies of the court. These decisions, considered in conjunction with existing Treasury Regulations, contain certain implications for taxpayers and their representatives.
Estate of Ellen D. Foster v. Commissioner1
This case required the court to separately consider both a contingent liability and asset that were reported by the estate. First, the estate reported a liability on its return solely to account for the hazards of litigation presented by an outstanding lawsuit. The IRS responded with a notice of deficiency that disallowed the discount, asserting that the amounts were not “sums certain” and “legally enforceable” at the date of death. The second issue in this case pertained to the amounts reported by the estate as a contingent asset related to potential receipts from a future settlement in a separate legal matter, to which the IRS also asserted a notice of deficiency.
With respect to the contingent liability, the court noted that the differences between the parties focused in part on the reasonableness of the valuation positions of each party in assessing the likely resolutions of litigation subsequent to the date of death. The estate cited numerous cases that it argued held that litigation, or the threat of litigation, concerning an asset in the gross estate justified discounting the value of the asset for estate tax purposes. The estate also noted Treas. Reg. §20.2053-1(b)(3), which provides that:
An item may be entered on the return for deduction though its exact amount is not then known, provided it is ascertainable with reasonable certainty, and will be paid. No deduction may be taken upon the basis of a vague or uncertain estimate.
The IRS, for its part, argued that the discount for a contingent claim should be disallowed as it involved vague and uncertain estimates that were not ascertainable with reasonable certainty.
In its opinion, the court noted that the cases cited by the estate were distinguishable since they involved litigation that affected the rights of a purchaser of the particular asset that was the subject of the litigation. Recognizing that its rights in the asset would have been subsequently impaired, a willing buyer in such a situation would have refused to pay full Fair Market Value. In the case at hand, however, the court determined that the lawsuit was asserted against the estate and not the particular assets. Thus, a willing buyer would not have insisted on a discount to the assets since the outstanding lawsuit would not have affected a buyer’s rights. Moreover, although it remained subject to appeal, the legal matter had been resolved just prior to the date of death in favor of the decedent, thus largely eliminating the potential for a large payment on behalf of the estate.
Additionally, in a decision that has implications for future estates, the court concluded that the estate’s experts did not and could not reasonably opine that any of the suggested amounts would be paid, and it further provided that simply stating and supporting a value is not equivalent to ascertaining a value with reasonable certainty. The court was assisted in this regard by the fact that the estate’s experts presented multiple values for the contingent claim that varied significantly, thereby providing prima facie evidence of the inability to determine a value with reasonable certainty in the view of the court. As a result, the court did not allow a discount to account for the hazards of litigation at the date of death.
As noted, the court also considered the issue regarding the amount reported by the estate as a contingent asset. In its opinion, the court did not find the conclusions reached by either expert reliable or compelling. It particularly noted that the “relatively minimal value” placed on the claims by the estate was not reasonable under the premise that the estate and its attorneys would not even have pursued the claims if the ultimate values of such amounts were consistent with those reported on the return.
Estate of Gertrude H. Saunders v. Commissioner2
This case also involved a deduction claimed by the taxpayer for litigation pending against the estate at the date of death. Similar to the aforementioned case, this matter also required a determination by the court as to whether the claim against the estate satisfied the requirements of Treas. Reg. §20.2053-1(b)(3), stipulating that such claim must be ascertainable with reasonable certainty.
The court first opined that stricter provisions apply to valuing contingent liabilities as a deduction against an estate relative to valuing contingent assets in favor of an estate. Additionally, as mentioned in Foster the court referenced, among others, Propstra v. United States, which stated that “the law is clear that post-death events are relevant when computing the deduction to be taken for disputed or contingent claims”. Additionally, the court cited the Estate of Van Horne v. Commissioner, which concluded that post-death events are considered “in cases where the decedent’s creditor has only a potential, unmatured, contingent, or contested claim that requires further action before it becomes a fixed obligation of the estate, but not where a claim is valid and fully enforceable on the date of death”. These cases were particularly relevant, as the litigation pending against the Estate of Saunders was ultimately resolved post-death with no damages awarded against the estate, and its actual liability was limited to attorney’s fees.
The court ultimately decided that the value of the contingent liability could not be determined with reasonable certainty and thus was not allowed as a deduction based on estimates provided as of the date of death. Rather, only the amount actually paid, which consisted solely of legal fees and not determined until after the date of death, was allowed as a deduction.
Guidance from Treasury Regulations
Neither of the cases mentioned involved favorable outcomes from the perspective of the taxpayer. Although these cases in and of themselves did not necessarily establish any binding precedent or regulations, particularly given that each involved an effective valuation date that preceded the current updates to the Treasury Regulations, some level of guidance is provided to legal and valuation experts. In particular, each case indicated the tendency of the U.S. Tax Court to only allow deductions to an estate for amounts actually paid, even if the final determination and realization of such amounts does not occur until post-death. Additionally, the court also applied a strict standard allowing deductions only in situations whereby the amounts could be ascertained with reasonable certainty. In this regard, the decisions of the U.S. Tax Court are fairly consistent with the existing Treasury Regulations.
Specifically, in October 2009 the Treasury finalized the Treasury Regulations with respect to IRC §2053 in an attempt both to clarify what it conceded has historically been “a highly litigious issue” and to further the goal of effective and fair administration of the tax laws. The most salient points addressed in the finalized regulations were 1) the underlying premise that an estate may deduct only amounts actually paid in settlement of claims against the estate, and 2) post-death events shall be considered in doing so. The regulations stemmed from the Treasury’s concerns regarding the date-of-death valuation approach, including a) the inefficient use of resources, b) the requirement that substantive issues underlying the claims be re-tried in a tax controversy setting, c) a deduction amount that differs from the amount actually paid in disputed claims, and d) the possibility of contradictory positions taken by the taxpayer on the estate tax return and in court proceedings.
Several notable issues addressed in the Treasury Regulations are outlined below.
- Deductions for contingent claims are limited to the amounts of bona fide claims that are enforceable against the decedent’s estate and claims that are actually paid by the estate in satisfaction of the claim (Treas. Reg. §20.2053-4(a)(1)).
- Events occurring after the date of death shall be considered in determining whether and to what extent a deduction is allowable (Treas. Reg. §20.2053-4(a)(2)).
- Based on the foregoing, the Treasury Regulations essentially provide that no estate tax deduction may be taken for a claim against an estate while it remains a potential or unmatured claim. An estate does, however, maintain the right to file a protective claim for refund with respect to claims that mature and become deductible after the period of limitation for filing a claim for refund (Treas. Reg. §20.2053-4(d)(1)).
- The Treasury Regulations do provide several exceptions to the deduct-when-paid approach, including an exception for claims against an estate in the event there is an asset or claim includible in the gross estate that pertains to the same or a substantially related matter as the claim against the estate (Treas. Reg. §20.2053-4(b)(1)). In this case, the claim’s value must be determined based on a “qualified appraisal” by a “qualified appraiser”, yet still remains subject to adjustment for post-death events. Additionally, the current value of an unpaid claim may also be deducted to the extent that the total amount deducted does not exceed $500,000 (Treas. Reg. §20.2053-4(c)(1)).
Valuation of Contingent Assets and Liabilities
Given the interpretations presented in the Treasury Regulations, the allowable deduction for any contingent liabilities against estates subsequent to October 2009 will typically be limited to the actual amounts paid, even if not determined until after the date of death. However, the Treasury Regulations do provide for certain exceptions in which a valuation of the contingent liability at the date of death may be deducted. At the same time, a more likely scenario in which a valuation analysis may be required pertains to contingent assets of an estate. The valuation of these items is subject to IRC §2031, which maintains a different standard relative to IRC §2053. As a result, the amounts reported for contingent assets of an estate generally reflect a contemporaneous valuation based on information known as of the date of death, rather than the actual amounts ultimately realized post-death. In fact, the court in Saunders specifically opined that the provisions governing the valuation of contingent assets in favor of an estate are not as strict as those that apply to valuing contingent liabilities as a deduction against an estate. Outside the estate and gift tax realm, it is noted that the valuation of both contingent assets and liabilities is often required equally for financial reporting purposes, pursuant to FASB ASC 805.
Contingent assets and liabilities exist in many forms and generally maintain significantly different risks, payout streams, and timing requirements. As a result, the unique facts and circumstances of each particular situation warrant consideration of multiple valuation methodologies. A few of these methodologies are outlined.
Discounted Cash Flow Method
The Discounted Cash Flow (“DCF”) Method is a valuation technique in which the value of an asset or liability is estimated based on the present value of its expected future cash inflows or outflows. To perform a DCF analysis, the expected cash flows are projected into the future. Each period’s cash flow is then discounted to the valuation date at a rate of return commensurate with the risk involved in realizing those cash flows. An investor would accept a rate of return no lower than that available from other investments with equivalent risk, and would value the investment accordingly. A potential limitation of the DCF Method is that it typically involves modeling only the most likely or representative outcomes. This limitation may be addressed, in part, by preparing multiple iterations of the DCF Method by adjusting the anticipated cash flows, discount factors, and time requirements, and then applying a probability weighting to each scenario. However, in general, given the number of scenarios often required in this type of analysis, a DCF Method on its own may not provide the level of flexibility required to handle the complex nature of many contingent items.
Binomial Option Pricing Method
Contingent assets and liabilities inherently maintain a significant degree of uncertainty, as they involve a number of potential outcomes dependent upon the resolution of multiple factors. As a result, the uncertainty inherent in contingent assets and liabilities may be more appropriately addressed through valuation methodologies applied for financial options, such as the Binomial Option Pricing Method (“BOPM”), which provides a greater degree of flexibility.
From a financial point of view, the BOPM is an arbitrage-pricing model that is premised on the concept that if two assets have identical payoffs, they must have identical values to prevent arbitrage (i.e., riskless profit). The BOPM utilizes a “decision tree” framework whereby movement in future contingent cash flows is estimated based on a volatility factor. The application of the BOPM may generally be performed in several steps. First, the amounts and timing of the future contingent cash flows are estimated under multiple scenarios. For each time period, the model assumes that at least two price movements are possible. The resulting lattice model represents the evolution of the cash flows attributable to a particular contingent asset or liability. These amounts are then discounted to their present value equivalent utilizing a rate of return consistent with the risk of the cash flows. The resulting present values of the contingent payments under each scenario are then weighted in accordance with the likelihood of each scenario.
The BOPM provides a greater level of flexibility relative to the DCF Method by allowing for incorporation of multiple scenarios. However, this method is limited given that it requires an increased number of assumptions that are difficult to accurately quantify, in particular with respect to the volatility in the cash flows and the probabilities assigned to each scenario. Further, although it does provide increased flexibility, it remains limited by the number of scenarios that can practically be modeled.
Monte Carlo Method
Given the limitations of the DCF and BOPM methodologies, a Monte Carlo Method often is considered to provide the maximum level of flexibility required to address the significant degree of uncertainty inherent in many contingent assets and liabilities. As a result, a Monte Carlo analysis is often applied in lieu of, or at least as a supplement to, the more traditional income-based valuation approaches, including the DCF Method and the BOPM. Monte Carlo methods are probabilistic in nature and involve statistical random sampling techniques that simulate the various sources of uncertainty and calculate an average or expected value over a range of thousands of resultant outcomes. In other words, since the analysis provides a range of possible outcomes and the probabilities that they will occur for any particular action, it more accurately accounts for claims with several sources of uncertainty and those with complicated features.
A Monte Carlo analysis essentially allows for the simulation of multiple inputs and outcomes in an income-based analysis specifically modeled to incorporate the unique characteristics of the particular asset or liability. Thus, the application of a Monte Carlo analysis involves first developing an analytical model similar to the DCF Method that incorporates many of the same drivers of value. The key assumptions revolve around the assumed probability distributions and distribution parameters for a particular action. A Monte Carlo simulation analysis can then be performed on the model by running multiple scenarios incorporating a range of random values for the key value drivers. The Monte Carlo simulation ultimately returns an expected value based on the outcomes for the numerous scenarios and, in this regard, provides a more comprehensive and robust analysis. Thus, the valuation professional should have experience with statistical modeling in general and Monte Carlo analyses in particular.
Given the nature of certain claims, a more straightforward analysis may be applicable and practical. In particular, the incremental cost to obtain adequate insurance coverage sufficient to satisfy any potential liability may provide a reasonable benchmark from a valuation perspective. In the Estate of Klauss v. Commissioner, decided prior to the final Treasury Regulations, the taxpayer determined a deduction in part by estimating the cost to increase the subject company’s product liability insurance. The court agreed with this methodology as a more accurate indication of the effects of the contingent claims on the value of the subject company.3 One caveat to this approach is the importance of considering the availability of insurance products for a particular liability. For example, insurance products generally exist in some form for liabilities such as environmental remediation costs, medical claims, and product liabilities. However, insurance products for various types of litigation may not necessarily be available in the marketplace, thus limiting or precluding the usefulness of this method as a reliable indication of value.
To the extent that they can be reasonably estimated, the anticipated costs to be incurred in remediating, settling, or litigating a claim may provide a compelling proxy of value. Similar to above, the taxpayer in Klauss estimated a deduction for a contingent environmental liability based on the anticipated fines and remediation costs, including excavation, transportation, and capping costs, and lab analysis, disposal, and environmental engineer and attorney fees required to resolve an enforcement action. The court favored this approach of directly estimating the anticipated costs to be incurred.
The finalized Treasury Regulations were issued by the Treasury in an attempt to reduce the significant amount of litigation surrounding the valuation of contingent liabilities for deduction purposes. As a result, it appears that, absent certain exceptions, the amounts deducted for contingent liabilities will be limited to the amounts actually paid in resolving or settling the claim, and that post-death events will necessarily be utilized for purposes of determining such amounts. In fact, although the Foster and Saunders cases both involved valuation dates prior to October 2009, the decisions were each consistent with the finalized Treasury Regulations. Notwithstanding these developments, there will continue to be circumstances in which the valuation of contingent liabilities, and certainly contingent assets, will be required. Thus, although additional guidance has been provided by the U.S. Tax Court and the Treasury in recent periods, taxpayers’ legal advisors and valuation experts will still need to consider the specific facts and circumstances of each particular case. In so doing, as always, it is important to ensure that appropriate valuation methodologies are applied and supportable reasoning is provided.
1 Estate of Ellen D. Foster, Deceased, Ashley Bradley and Tara Shapiro, Co-Executors v. Commissioner, T.C. Memo. 2011-95, Docket No. 16839-08 (28 April 2011).
2 Estate of Gertrude H. Saunders, Deceased, William W. Saunders, Jr., and Richard B. Riegels, Co-Executors v. Commissioner, 136 T.C. No. 18, Docket No. 10957-09 (28 April 2011).
3 Estate of Emily F. Klauss, Deceased, John G. Klauss, Independent Executor v. Commissioner, T.C. Memo. 2000-191, 79 T.C.M. 2177 (2000).