                        T.C. Memo. 2000-242



                      UNITED STATES TAX COURT



      ESTATE OF FRED O. GODLEY, DECEASED, FRED D. GODLEY,
                ADMINISTRATOR CTA, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 19880-94.                 Filed August 4, 2000.



     C. Wells Hall III, for petitioner.

     James E. Gray, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION

     GALE, Judge:   Respondent determined a deficiency of $696,554

in petitioner’s Federal estate tax.

     Unless otherwise noted, all section references are to the

Internal Revenue Code in effect for the date of decedent’s death,
                               - 2 -

and all Rule references are to the Tax Court Rules of Practice

and Procedure.

     After concessions, we must decide the fair market value of

decedent’s interest in five partnerships as of November 11, 1990.

                         FINDINGS OF FACT

     Some of the facts have been stipulated and are so found.    We

incorporate by this reference the stipulation of facts, the

supplemental stipulation of facts, and the attached exhibits.

     Decedent was a resident of Charlotte, North Carolina, when

he died testate on May 11, 1990.   Lisa G. Gilstrap, Gregory

Godley, and Kimberly E. Godley, all of whom are grandchildren of

decedent, were appointed coexecutors of the Estate of Fred O.

Godley (estate).   At the time of filing of the petition in this

case, the address of the coexecutors was in Charlotte, North

Carolina.   After the filing of the petition, the original

coexecutors of the estate resigned, and Fred D. Godley (Fred

Jr.), one of decedent’s sons, succeeded as administrator c.t.a.

of the estate.   A Federal estate tax return was timely filed,

under extension, on or about August 14, 1991.   The estate elected

to use the alternate valuation date of November 11, 1990.

     At the time of his death, decedent owned a 50-percent

interest in each of the five general partnerships in issue, with

the remaining 50-percent interest in each owned by Fred Jr.    Four

of these partnerships, which were formed in 1978, owned and

operated housing projects for elderly tenants known as:   Monroe
                              - 3 -

Housing for the Elderly (Monroe); Clinton Housing for the Elderly

(Clinton); Rocky Mount Housing for the Elderly (Rocky Mount); and

Charlotte Housing for the Elderly (Charlotte), collectively

referred to the housing partnerships.

     For each of the housing partnerships, Fred Jr. was

permanently established as the managing partner.   The partnership

agreements for the housing projects contained the following

provisions:

          Section 2.02 Management of Partnership. The
     overall management and control of the business and
     affairs of the Partnership shall be vested in the
     managing Partner (the “Managing Partner”) designated
     herein, provided, however, no act shall be taken or sum
     expended or obligation incurred by the Partnership, or
     any Partner, with respect to a matter within the scope
     of any major decision (“major decision”) affecting the
     Partnership, unless such major decision has been
     approved by Partners holding collectively a 75%
     interest in the Partnership. * * *

     “Major decisions” included the acquisition and sale of land

or partnership property, financing, expenditures in excess of

$2,500, entering into major contracts, or any other decision or

action “which materially affects the Partnership or the assets or

operation thereof.”

     Section 2.03 Day to Day Management.

          (a) Subject to the limitations set forth in this
     Article II, the day to day management of the
     Partnership’s business shall be conducted by the
     Managing Partner, Fred D. Godley, Jr., and his agents
     and designees. Such Managing Partner subject to the
     limitation set forth in Section 2.02 above shall
     implement the major decisions of the Partners. * * *
                               - 4 -

Day-to-day management included duties such as effecting property

acquisitions as decided by the partnership, protecting title,

paying debts, and setting aside reserves for replacement of

assets or to cover contingencies.

     Section 4.05 Distribution of Net Cash Flow.

          (a) The net cash flow of the Partnership shall be
     distributed to the Partners annually or at such more
     frequent intervals as the Managing Partner shall
     determine. The “net cash flow” of the Partnership as
     used herein shall mean the net profits derived from the
     property owned by the Partnership as computed in
     accordance with normal and accepted accounting
     principles except that (i) depreciation of buildings,
     improvements, furniture, fixtures, furnishings and
     equipment shall not be taken into account, (ii)
     mortgage amortization paid by the Partnership shall be
     considered a deduction; and (iii) any amounts expended
     by the Partnership in the discretion of the Partners
     for capital improvements or set aside by the Managing
     Partner as a reserve for the replacement of assets of
     the Partnership or other contingencies shall be
     considered a deduction. Borrowings of the Partnership
     shall be excluded in computing net cash flow.

     Although Fred Jr. was managing partner, decedent was

actively involved in the housing partnerships.   He regularly

visited the housing projects to inspect the property and to

attend to tenants’ concerns, maintenance, and the like.   He made

his own decisions, without consulting with Fred Jr., when such

issues arose.   Moreover, decedent had a long history as a

businessman in the field of construction and brought his sons

into the business.   Finally, when he was engaged in a business

enterprise, he was almost always the person in charge.
                               - 5 -

     Upon the formation of Monroe, Clinton, and Rocky Mount,

decedent and Fred Jr. each owned a 45-percent general partnership

interest and a third party, Frank M. McCool (McCool), owned the

remaining 10-percent general partnership interest.   McCool was an

engineer and worked as a general manager for a company that Fred

Jr. operated.   Decedent and Fred Jr. each owned 50 percent of

Charlotte from inception.   McCool predeceased decedent, and in

1985, decedent and Fred Jr. purchased McCool’s three 10-percent

general partnership interests from his widow for a total of

$65,000.   Thereafter and until decedent’s death, decedent and

Fred Jr. each owned a 50-percent general partnership interest in

each of the housing partnerships.

     The housing partnerships held multifamily rental housing

projects operated and maintained under Housing Assistance

Payments contracts (HAP contracts) with the U.S. Department of

Housing and Urban Development (HUD) pursuant to the United States

Housing Act of 1937, ch. 896, 50 Stat. 888, currently codified at

42 U.S.C. secs. 1437-1437x (1994), and the Department of Housing

and Urban Development Act, Pub. L. 89-174, 79 Stat. 667 (1965),

currently codified at 42 U.S.C. secs. 3531-3547 (1994).   The HAP

contracts were executed by HUD in order to provide, through local

public housing agencies, financial assistance to eligible

families of lower income in renting housing.   Pursuant to these

HAP contracts, the Government pledged to pay a certain annual

contribution to the applicable public housing agency on behalf of
                               - 6 -

the contracting housing partnership.   Housing assistance payments

made to the housing partnerships covered the difference between

the contract rental rates agreed to under the HAP contracts

(contract rents) and that portion of the rent payable by eligible

families determined in accordance with HUD-established schedules

and criteria.   The term of the HAP contracts for Monroe,

Charlotte, and Rocky Mount was 30 years and for Clinton was 20

years.

     Also, in general the HAP contracts entitled the owner to

housing assistance payments in the amount of 80 percent of the

contract rent for a period not exceeding 60 days (i) in the event

a unit covered under the HAP contract (covered unit) was not

leased within 15 days of the effective date of the HAP contract

or (ii) upon the vacancy of a covered unit by an eligible family.

In the event a covered unit remained vacant for a period

exceeding 60 days, the owner could, in general, request

additional payments in an amount equal to the principal and

interest payments required to amortize that portion of the debt

service attributable to the vacant unit for up to 12 additional

months.

     On March 1, 1980, after the formation of the housing

partnerships, a fifth general partnership, Godley Management

Association (GMA), which was owned 50 percent each by decedent

and Fred Jr., was formed for the purpose of managing the

operations of the housing partnerships.   The formation of GMA for
                               - 7 -

this purpose was required by HUD.   As of the valuation date, GMA

held no real estate or other fixed assets and served only as a

management company for the housing partnerships to oversee

leasing, maintenance, and repair in compliance with HUD

requirements.   GMA received a management fee from each of the

housing partnerships equal to 10 percent of rental income.

     On the Federal estate tax return, decedent’s interests in

the five partnerships were reported at a fair market value of

$10,000 each.   At the time of decedent’s death, the partnership

agreement for each housing project contained a provision granting

Fred Jr., or his personal representatives, heirs or assigns, the

option to purchase decedent’s interest in said partnership for

the sum of $10,000.1   This option provision was contained in each

of the original partnership agreements.   On December 31, 1990,

Fred Jr. exercised these options to purchase decedent’s interests

in the four housing partnerships for the payment of the option

price of $10,000 for each partnership interest, or $40,000.   On

     1
         Sec. 5.02 of each partnership agreement provides:

                Notwithstanding any of the foregoing,
           Fred D. Godley, or his personal
           representative, heirs or assigns, shall have
           the option to purchase the Partnership
           interest of F.O. Godley from either F.O.
           Godley or his personal representative, heirs
           or assigns, for the sum of Ten Thousand
           $10,000. This option may be exercised at any
           time during the existence of the Partnership.
           Fred D. Godley shall notify all other
           Partners in writing of his intention to
           exercise this option to purchase.
                               - 8 -

March 12, 1990, decedent and Fred Jr. executed a similar option

with respect to decedent’s interest in GMA.    The estate also

accepted a cash payment in the amount of $10,000 from Fred Jr.

for decedent’s 50-percent interest in GMA.2

     From 1985 through 1994, Fred Jr. was the defendant in an

equitable distribution suit brought by his former spouse, Jean H.

Godley.   An Equitable Distribution Judgment was filed by the

District Court of Mecklenburg County, North Carolina, on

January 1, 1991.   In the equitable distribution proceedings, the

nature of the foregoing option provisions was in issue, and

testimony was presented concerning the same.    Also, depositions

were taken of Fred Jr. and decedent in connection with the

equitable distribution proceedings on the same issue.    Fred Jr.

testified by deposition and at trial that the options “[were]

done for the purpose of circumventing inheritance taxes” and

“[were] a gift”.   Decedent testified by deposition that the

options “would simplify at my death the closing of my estate, and

also would help establish to the government our worth whereby he

[i.e., Fred Jr.] could buy it * * * at a reasonable price”; and

in answer to the question whether the options “[were] a gift that

you made to him [i.e., Fred Jr.] at the time you signed the



     2
        Petitioner was unable to produce a copy of the
partnership agreement for GMA, but the testimony supports, and we
have found, that a similar option agreement existed in the case
of GMA.
                               - 9 -

contract”, decedent replied “That’s right.”    The Judgment of

Equitable Distribution held as follows:

          239. All of the evidence indicates and the Court
     finds that there was no consideration for Defendant’s
     father giving to Defendant options to acquire
     Defendant’s father’s interest in the five partnerships.
     Both Defendant and his father testified unequivocally
     that the options were gifts to Defendant from
     Defendant’s father. The Court finds such testimony to
     be credible and further finds that these options were
     gifts to Defendant from his father. [Emphasis added.]

     At issue in the equitable distribution litigation was the

value of Fred Jr.’s 50-percent general partnership interest in

the partnerships.   In this regard, Fred Jr. was asked whether the

idea of HUD-subsidized projects originated with him or decedent,

and he testified that he could not recall.    As part of the

litigation, both the plaintiff (Fred Jr.’s former spouse) and the

defendant (Fred Jr.) produced expert witnesses and reports

regarding the value of Fred Jr.’s 50-percent general partnership

interest in the partnerships as of December 1989.    The court

accepted the plaintiff’s expert appraisal of GMA prepared by

Mitchell Kaye (Kaye).   In his appraisal, Kaye estimated the net

fair market value of GMA as of December 31, 1989, to be $450,000

and concluded that Fred Jr.’s 50-percent interest in GMA had a

net fair market value of $225,000 as of December 31, 1989.     The

court also accepted the expert appraisals of Robert O. Beck III

(Beck), who relied on David A. Dvorak (Dvorak) in valuing the

improved real estate held by Monroe and Charlotte, and Tom J.

Keith (Keith) in valuing the improved real estate held by Clinton
                                   - 10 -

and Rocky Mount.    Beck valued decedent’s housing partnership

interests as follows:

                           Total Value of               Fred Jr.’s
           Entity          the Partnership             50% Interest

          Monroe                 $469,307                $234,653
          Clinton                 158,391                  79,196
          Rocky Mount             187,287                  93,643
          Charlotte               198,005                  99,003

Dvorak and Keith both qualify as experts on valuation of real

estate, and Kaye and Beck qualify as experts on the valuation of

businesses.

     On August 2, 1994, respondent mailed a notice of deficiency

for Federal estate tax.    The values of decedent’s 50-percent

partnership interests determined by respondent in the notice were

derived by averaging values of decedent’s interests as determined

under a net asset approach and an income approach after applying

a 10-percent discount for lack of marketability to each.3             The

values were as follows:


Partnership         Income Value        Asset Value            Average

Monroe                $577,689              $337,125          $457,407
Clinton                186,039                72,933           129,484
Rocky Mount            439,960               320,782           380,371
Charlotte              390,087               309,692           349,890
GMA                    431,356               230,020           330,688

In calculating income value, respondent applied a capitalization

rate of 10 percent.


     3
        No lack of marketability discount was applied to the net
asset value of GMA.
                             - 11 -

     In a report prepared for this Court in valuing decedent’s

interests, Beck concluded that a lack of marketability discount

of 25 percent and a lack of control discount of 15 percent should

apply to the values derived in his valuation of Fred Jr.’s

interests in the housing partnerships, which would result4 in

values as follows:

          Partnership                       Value

          Monroe                          $149,591
          Clinton                           50,487
          Rocky Mount                       59,697
          Charlotte                         63,114

     In addition to the partnerships in issue, at the time of his

death, decedent and Fred Jr. each owned 50 percent of the stock

of Godley Realty, Inc. (Godley Realty), and decedent owned a 25-

percent interest and Fred Jr. owned a 75-percent interest in

Concrete Panel Systems, Inc., of North Carolina (CPSI).     In the

notice of deficiency, respondent determined that the value of

decedent’s interest in Godley Realty was $225,048 as of the

valuation date and the value of decedent’s interest in CPSI was

$34,271 as of the valuation date.5    Respondent’s valuations of

Godley Realty and CPSI were based, in part, upon the November 11,

1990, balance sheets, which reflect accounts payable to the five


     4
        In his trial testimony, Beck clarified that the
compounding of these two discounts would produce a total discount
of 36.25 percent.
     5
        The parties have stipulated that these values are
correct.
                             - 12 -

partnerships in issue at full face value as of that date as

follows:


     Partnership        Godley Realty          CPSI

     Monroe               $376,078            $38,750
     Charlotte             237,753             16,500
     Rocky Mount           278,528              9,000
     Clinton                75,399              None
     GMA                     None               1,550

       Total               967,758             65,800

As of December 31, 1989, adjusted balance sheets of Godley Realty

and CPSI showed accounts receivable of the housing partnerships,

with Godley Realty and CPSI as payors, as follows:




     Project           Godley Realty           CPSI

     Monroe              $359,487             $32,750
     Charlotte            241,222              11,500
     Rocky Mount          284,103               None
     Clinton               81,049               None

      Total               965,861              44,250


     In order to finance the acquisition and construction of

Charlotte, Monroe, and Rocky Mount, bonds were issued by the

local public housing agency as the construction lender.   To

secure the payment of the bonds, the housing partnerships, the

local nonprofit housing development corporation, and a trustee
                             - 13 -

entered into trust indentures requiring the creation of various

trust funds, including:

          (a) The Mortgage Acquisition Fund, which shall be
     disbursed for the purpose of paying in full the
     Construction Note and acquiring an assignment of or
     satisfying and releasing the Construction Deed of Trust
     * * * or which shall be applied to the redemption of
     the Bonds * * * in the event of the failure to satisfy
     those requirements.

          (b) The Revenue Fund, into which all Revenues
     shall be paid, except as otherwise provided * * *

          (c) The Principal and Interest Fund, to be funded
     monthly, and which shall be held by the Trustee for
     disbursal by the Trustee * * * from time to time solely
     for the purpose of paying the principal of an interest
     on the Bonds * * * and * * * to pay the Trustee’s fees
     from earnings thereon;

          (d) The Debt Service Reserve Fund, which shall be
     funded upon Completion of Construction from the
     Mortgage Acquisition Fund, in an amount equal to the
     Debt Service Reserve Requirement ($167,100), and shall,
     subsequent to the Completion of Construction, be
     disbursed by the Trustee solely to pay the principal
     of, premium, if any, and interest on the Bonds. * * *

          (e) The Insurance and Tax Escrow Fund, to be
     funded monthly, from which the Trustee shall pay the
     premiums of all insurance on the Project required by
     this Indenture and all taxes, assessments or
     governmental charges except utility services * * *

          (f) The Maintenance Fund, to be used upon the
     written request of the Owner, with the concurrence of
     the Trustee, for extraordinary maintenance * * *

          (g) The Replacement Fund, to be used upon written
     request of the Owner with the concurrence of the
     Trustee, for extraordinary repair and replacement * * *

          (h) The Operating Fund, to be funded monthly,
     which shall be disbursed to make monthly payments to
     the Owner for operation of the Project pursuant to the
     requirements of its then current Budget. * * *
                              - 14 -

           (i) The Project Reserve and Surplus Fund, to
      receive any monies not required to be disbursed to any
      other fund or account * * *

           (j) The Bond Redemption Fund, which shall be held
      in escrow and disbursed by the Trustee solely for the
      purpose of paying the principal of and interest and
      redemption prices or premiums, if any, on the Bonds
      called for redemption in advance of maturity * * *

      As of December 31, 1989, the balances of these trust funds

were as follows:

1. Monroe

      Current trust funds1                    $49,360
      Noncurrent trust funds
           Debt service fund                  138,862
           Maintenance and replacements        55,970

      Total trust fund accounts               244,192

2. Charlotte

      Current trust funds2                    $68,108
      Noncurrent trust funds
           Debt service fund                  170,684
           Maintenance and replacements        33,170
           Project reserves                    35,851

      Total trust fund accounts               307,813

3.   Rocky Mount

      Current trust funds3                    $70,073
      Noncurrent trust funds
           Debt service fund                  135,043
           Maintenance and replacements        72,988

      Total trust fund accounts               278,104
            1
            The 1990 audited financial statements for Monroe
      identify the current trust funds as consisting of the
      Principal and Interest Fund, the Investment Interest Fund,
      and the Revenue Fund.
                              - 15 -
          2
           The 1990 financial statement for Charlotte identifies
     the current trust funds as the Principal and Interest Fund,
     the Tax & Insurance Escrow, and the Depository Fund.
          3
           The 1990 financial statement for Rocky Mount
     identifies the current trust funds as the Principal and
     Interest Fund, the Insurance and Tax Escrow Fund, and the
     Surplus Fund.

     Clinton was not financed by bond issuance and is not subject

to these same reserve requirements.     However, Clinton was

financed by a loan issued by the Farmers Home Administration of

the U.S. Department of Agriculture, and the loan agreement

required a maintenance and replacements reserve, which as of

December 1989 contained $8,920.

                              OPINION

     The issue in this case is the fair market value for Federal

estate tax purposes of decedent’s interests in the five

partnerships.   Under the regulations, the value of property

includable in decedent’s gross estate is its fair market value at

the alternate valuation date with adjustments prescribed under

section 2032.   See sec. 20.2031-1(b), Estate Tax Regs.   Fair

market value is defined for these purposes as “the net amount

which a willing purchaser * * * would pay for the interest to a

willing seller, neither being under any compulsion to buy or to

sell and both having reasonable knowledge of relevant facts.”

Sec. 20.2031-3, Estate Tax Regs.   Fair market value is determined

on the basis of the interest that passes at death.    See Ahmanson
                               - 16 -

Found. v. United States, 674 F.2d 761 (9th Cir. 1981); United

States v. Land, 303 F.2d 170 (5th Cir. 1962).

     Petitioner introduced the expert report of Beck prepared for

purposes of the present proceeding.     In addition, the parties

stipulated into evidence the expert reports that were prepared

for the equitable distribution proceedings.     Finally, Beck,

Dvorak, Kaye, and Keith all testified as expert witnesses at

trial.    Expert opinion sometimes aids the Court in determining

valuation; other times, it does not.     See Laureys v.

Commissioner, 92 T.C. 101, 129 (1989).     We evaluate such opinions

in light of the demonstrated qualifications of the expert and all

other evidence of value in the record.     See Estate of Newhouse v.

Commissioner, 94 T.C. 193, 217 (1990).     We are not bound,

however, by the opinion of any expert witness when that opinion

contravenes our judgment.    See id.    We may accept the opinion of

an expert in its entirety, see Buffalo Tool & Die Manufacturing

Co. v. Commissioner, 74 T.C. 441, 452 (1980), or we may be

selective in the use of any portion thereof, see Parker v.

Commissioner, 86 T.C. 547, 562 (1986).

Options

     We must first decide whether the value of each interest is

limited by the option provision contained in each partnership

agreement.    Petitioner claims that the fair market value of each

partnership interest is limited to the $10,000 option price, or

in the alternative, that the option provision otherwise affects
                              - 17 -

the value to some degree.   Respondent takes the position that the

option provision should be disregarded in determining the fair

market values of decedent’s interests.

     It is well settled that an option agreement may fix the

value of a business interest for Federal estate tax purposes if

the following conditions are met:   (i) The price must be fixed

and determinable under the agreement; (ii) the agreement must be

binding on the parties both during life and after death; and

(iii) the agreement must have a bona fide business purpose and

must not be a substitute for a testamentary disposition.   See

Estate of Bischoff v. Commissioner, 69 T.C. 32, 39 (1977); see

also sec. 20.2031-2(h), Estate Tax Regs.6   Respondent does not

dispute that petitioner meets the first two conditions but

challenges whether the option provision had a bona fide business

purpose and whether it was a substitute for testamentary

disposition.   According to petitioner, the option provision was

inserted in each of the partnership agreements for the purpose of

allowing Fred Jr. to maintain control of the businesses without

the possibility of interference from other family members.   The

maintenance of family ownership and control constitutes a bona


     6
        Sec. 2703, relating to the valuation of property subject
to options, is not applicable to an agreement entered into before
Oct. 9, 1990, unless there has been substantial modification
since Oct. 8, 1990. See Omnibus Budget Reconciliation Act of
1990, Pub. L. 101-508, sec. 11602(e)(1)(A)(ii)(I), 104 Stat.
1388-500. The options in issue were executed before Oct. 9,
1990, and were not substantially modified thereafter.
                               - 18 -

fide business purpose.    See Estate of Bischoff v. Commissioner,

supra at 39-40.    However, even if we find that the option had a

bona fide business purpose, it will be disregarded if it served

as a device to pass decedent’s interest to the natural objects of

his bounty and to convey that interest for less than full and

adequate consideration.    See Bommer Revocable Trust v.

Commissioner, T.C. Memo. 1997-380; Estate of Lauder v.

Commissioner, T.C. Memo. 1992-736; see also sec. 20.2031-2(h),

Estate Tax Regs.    We find that the option provision in each of

the partnership agreements represents a testamentary device to

convey decedent’s interest to his son for less than full and

adequate consideration, and therefore we disregard it in

determining the value of those interests.

     Petitioner argues that the options were not a testamentary

device because they were exchanged for full and adequate

consideration.    Petitioner claims that the options were granted

in exchange for allowing decedent to participate as a 45- or 50-

percent partner in the partnerships without a substantial

contribution, either of cash or in kind, and that, therefore,

decedent’s agreement to concede to Fred Jr. all future

appreciation exceeding $10,000 was the product of a bona fide,

arm’s-length transaction.    That is, Fred Jr. testified at trial,

and petitioner argues on brief, that Fred Jr.’s contribution to

the partnerships substantially outweighed decedent’s; namely,

that Fred Jr. had the original idea of seeking HUD contracts;
                               - 19 -

that Fred Jr. mastered the HUD bureaucracy and regulations

encountered in the undertaking; and that, as managing partner,

Fred Jr. did the lion’s share of the work in developing and

managing the housing projects, whereas decedent served merely as

a “sounding board”.    Thus, petitioner’s argument goes, decedent’s

agreement to give the options to Fred Jr.–-in which decedent

effectively gave up any future appreciation in the value of his

interests exceeding the $10,000 option price and settled for a

share of each partnership’s current operating income-–was arm’s

length and bona fide, given the vastly unequal contributions of

father and son.

     When both parties to the agreement are members of the same

family and circumstances indicate that testamentary

considerations influenced the creation of the option agreement,

we do not assume that the price as stated in the agreement was a

fair one.   See Bommer Revocable Trust v. Commissioner, supra;

Estate of Lauder v. Commissioner, supra.    We first note that the

fixed price of the option, without any adjustment mechanism to

reflect changing conditions, invites close scrutiny.   If decedent

and Fred Jr. really engaged in an arm’s-length transaction in

which it was decided that Fred Jr.’s greater contribution

required decedent to give an option, we believe the price of the

option would have included an adjustment mechanism to account for

future appreciation.    See Bommer Revocable Trust v. Commissioner,

supra.   The fact that the price was set at $10,000, combined with
                              - 20 -

the fact that the agreement was between a father and son,

strongly suggests that there was no arm’s-length bargain for the

option price, but rather that the option was a testamentary

device designed to pass decedent’s interest for less than

adequate consideration.

     Moreover, the foregoing picture of the partners’ relative

contributions is based almost entirely on Fred Jr.’s self-serving

testimony at trial.7   In contrast to Fred Jr.’s efforts to

portray the options in the instant proceeding as the product of

an arm’s-length bargain, in their sworn testimony in the

equitable distribution proceedings, Fred Jr. and decedent both

characterized the options as “gifts”, suggesting that both

thought it was decedent who was giving something of value to Fred

Jr., not the other way around.   We note also that decedent’s

second wife provided detailed, credible testimony concerning

decedent’s frequent trips (on which she accompanied him) to

inspect each partnership property and attend to problems thereby

discovered; that decedent had an entire career’s worth of

     7
        Petitioner also called as a witness a HUD official who
corroborated Fred Jr.’s assertion that he was primarily
responsible for the partnership’s dealings with HUD. However, we
note that, in contrast to Fred Jr.’s emphasis in his testimony at
trial in this case that the idea of developing HUD-assisted
housing projects was entirely his own, when asked under oath 6
years earlier in connection with the equitable distribution
proceedings whose idea it had been, Fred Jr. testified that he
could not recall. The subsequent improvement in Fred Jr.’s
recollection on this point in the instant proceeding--in a manner
which serves his financial interests--casts doubt on the
credibility of his other testimony in this proceeding.
                             - 21 -

experience in the construction business; and that Fred Jr.’s

brother testified credibly that when decedent entered into a

business venture, he was almost always in charge--all of which

tend to rebut Fred Jr.’s characterization of decedent’s role in

the enterprise as minimal.

     On balance, we believe the evidence that the options were a

substitute for a testamentary device outweighs any evidence of

their bona fide business purpose.   In an unusual circumstance, we

have the sworn testimony of the grantor-decedent himself as to

the options’ essentially testamentary purpose, as well as the

sworn testimony of the grantee to the same effect, albeit a

grantee who now testifies in changed circumstances that the

options had a bona fide business purpose.

     Alternatively, petitioner argues that even if the option

provisions do not control the values of the partnership

interests, they nonetheless should be given “significant weight”

in determining the values of decedent’s interests.   The

regulations state that the option price shall be “disregarded” in

determining the value of a business interest unless it is

determined that the option represents a bona fide business

arrangement and not a substitute for testamentary disposition.

Sec. 20.2031-2(h), Estate Tax Regs.   Because we have determined

that the option provision represents a substitute for

testamentary disposition, the provision will be disregarded and
                             - 22 -

shall have no effect on the valuation of decedent’s interest for

purposes of the Federal estate tax.

Valuation of the Housing Partnerships

     Petitioner offered into evidence the expert report and

testimony of Beck regarding the fair market value of decedent’s

interests in the housing partnerships.    Beck applied a net asset

approach under which the value of each partnership was estimated

to equal each partnership’s equity in its real estate assets,

plus cash and accounts receivable, net of liabilities.    Beck

adopted the valuations of Keith and Dvorak of the real estate and

subtracted the mortgage balances as of December 1989 to determine

each partnership’s equity in the real property it held.

     Respondent did not present any expert testimony as to the

value of the housing partnerships.    Instead, respondent called as

a fact witness David Archer (Archer), the revenue agent who had

calculated the values used in respondent’s determination in the

notice of deficiency, to testify regarding his calculations.

There is no expert testimony in the record to support Archer’s

method of computing the asset and income values of the

partnerships or his decision to average the two approaches in

reaching his valuation conclusion.    Respondent also called Dvorak

and Keith, the real estate appraisers who valued the partnerships

for the equitable distribution proceedings and who were relied

upon by Beck, to testify as to their valuations of each
                               - 23 -

partnership’s real property.   On brief, respondent challenges

certain aspects of Dvorak’s appraisal and argues for adjustments

that would increase the value of the real estate.    Keith’s real

estate valuations are not challenged.   Finally, respondent

challenges, and proposes adjustments to, various aspects of

Beck’s appraisal of the partnership entities.

Value of the Housing Partnerships’ Real Estate

     Keith’s valuation estimates for the real estate held by

Clinton ($665,000) and Rocky Mount ($1,400,000) are not disputed,

and we accept them for purposes of this case.    Respondent does

challenge various aspects of the approach used by Dvorak to value

the real property held by Monroe and Charlotte.    We consider

each.

Dvorak’s Report

     Dvorak applied three general approaches in valuing the

improved real estate:   (i) The cost approach, (ii) the direct

sales comparison (market) approach, and (iii) the income

approach.   The cost approach consisted of valuing the land of the

subject property by examining comparable sales and valuing the

improvements on the land by considering cost of construction,

taking into account depreciation and obsolescence.    The market

approach consisted of examining sales of comparable properties to

estimate the cost of the subject property.   The income approach

consisted of discounting to present value the future income

stream of the subject property for a number of years into the
                                   - 24 -

future and then capitalizing the residual or reversionary value,

using appropriately derived discount and capitalization rates.

The values determined by Dvorak with respect to Charlotte and

Monroe were as follows:

     Housing              Cost          Market       Income
     Project            Approach       Approach1    Approach

     Charlotte         $1,070,000     $1,137,500   $1,480,000
     Monroe             1,240,000      1,337,500    1,370,000
          1
           The determinations under the market approach
     represent the average of a range estimated by Dvorak.
     The estimated range for Charlotte was from $1,050,000
     to $1,225,000 and the estimated range for Monroe was
     from $1,275,000 to $1,400,000.

Dvorak believed that the income approach was the correct method

for valuing the real estate in question and relied on the other

approaches only to confirm his income-based value.       Thus, his

final appraised values for Charlotte and Monroe were $1,480,000

and $1,370,000, respectively.

Respondent’s Challenges

     (a) Vacancy Rate

     In calculating cash-flow, Dvorak reduced gross income of the

housing partnerships by 3 percent as a vacancy allowance.

Respondent challenges Dvorak’s use of a 3-percent vacancy

allowance, arguing that in light of the HUD guaranty to pay 80

percent of the contract rent for 2 months after a tenant vacates,

the 3-percent vacancy allowance is too high and that 1 percent is

appropriate.     We agree.   According to Dvorak’s appraisals, a

vacancy allowance represents a reduction in potential rental
                               - 25 -

income due to vacancies or uncollectibility.    Dvorak normally

would have used a 5-percent rate, but he reduced it to 3 percent

because the risk of uncollectibility was low, given that the

Federal Government was the obligor with respect to most of the

rent.    However, although Dvorak testified that he understood the

actual vacancy rates were low and that there were usually waiting

lists of tenants at Monroe and Charlotte, he admitted that he was

unaware of the HUD guaranty to pay 80 percent of the rent for 2

months following a vacancy when he made the determination to use

a 3-percent vacancy rate.8   In light of Dvorak’s view that the

reduced risk of uncollectibility required a 2-percent adjustment

to the vacancy rate, we believe that the reduced risk of loss

from short-term vacancies provided by the HUD guaranty requires

another 2-percent reduction in the vacancy rate assumption,

resulting in a vacancy rate adjustment of 1 percent.    We note

that a vacancy rate assumption of 1 percent was used by Keith,

whose expert reports are not disputed by either party in this

proceeding.

     (b)   Rental Rates

     Respondent disputes Dvorak’s use of an estimated figure for

1989 rental receipts, on the grounds that it is less than actual

1989 rents.    Because actual 1989 figures were not available to

him when he did his appraisal (originally for use in the

     8
        Indeed, the owner could apply for additional payments
beyond the first 2 months.
                               - 26 -

equitable distribution proceedings), Dvorak used actual rental

income from 1985, and estimated expenses for the same period, and

then inflated his net income amounts at 1.5 percent per year to

produce estimates for 1989.    This resulted in 1989 net operating

income for Charlotte of $187,531 and for Monroe of $176,350.     The

record in the instant case contains 1989 income statements for

Charlotte and Monroe, including actual rents and expenses.     Using

actual rents, as respondent urges, but also using actual

expenses–-since both would presumably have been available to a

hypothetical buyer and seller on the November 11, 1990, valuation

date--results in 1989 net operating income of $189,319 for

Charlotte and $175,905 for Monroe.      In comparison with Dvorak’s

estimated amounts, the difference is negligible, and we see no

need to modify Dvorak’s results on the basis of this factor.

     (c) Capitalization Rate

     Finally, respondent contends that net income multipliers9

applied by Dvorak are erroneous because they exceed the range of

multipliers identified from comparable sales.     We first note that

Dvorak’s method did not consist of a simple application of net

income multipliers.   Dvorak calculated a discount rate to apply

to cash-flow year by year for 4 years, and a capitalization rate

to apply to cash-flow in the fifth year, which he termed a


     9
        Dvorak actually used discount and capitalization rates.
A capitalization rate is the reciprocal of a net income
multiplier.
                               - 27 -

reversionary value.   He first calculated the reversionary value,

using the reversionary capitalization rate.   He then subtracted

costs of sale, then added this result to the cash-flow figure for

year 4.    He then discounted to present value the cash-flow figure

for each of 4 years following the date of valuation, using the

discount rate.

     Dvorak applied different discount and capitalization rates

depending on whether he was assuming the existence of HUD

subsidies.   For Charlotte, the discount rate without the HUD

subsidies was 13 percent, and with the HUD subsidies was 15

percent.   The capitalization rate for the reversionary interest

was 11 percent without, and 12 percent with, HUD subsidies.     For

Monroe, the discount rate was 13 percent without, and 14 percent

with, the HUD subsidies.   The capitalization rate for the

reversionary interest was 11.25 percent without, and 11.75

percent with, HUD subsidies.   He used higher rates for the HUD-

subsidized housing because he believed an investor would demand a

greater rate of return due to the risk of losing the HUD

subsidies.

     Rather than attacking the specific method by which Dvorak

generated his discount and capitalization rates, respondent

argues that the rates should match the rates of the properties

that Dvorak used as comparables for his market method value.    In

other words, respondent looks at the market comparables, examines

their rates of return, and criticizes Dvorak’s income method
                              - 28 -

because his rate does not fall within the range of these amounts.

Using net income multipliers rather than discount or

capitalization rates, respondent calculates Dvorak’s net income

multiplier for Charlotte to be 7.78 and argues that the correct

net income multiplier would fall in the range of 9.22 to 9.6.

For Monroe, respondent calculates Dvorak’s net income multiplier

to be 7.77 and argues that the correct net income multiplier

would fall in the range of 9.31 to 9.84.

     There is no evidence in the record suggesting that the small

sample of comparables used in Dvorak’s market approach could be

used to generate a reliable net income multiplier, or

capitalization rate, for purposes of an income valuation of the

subject properties.   Indeed, the evidence shows just the

opposite.   In his market approach, Dvorak found virtually all of

the comparables to be superior to the subject.   In his income

approach, Dvorak himself used a broad-based survey of investors

to derive the required rate of return for an investor in the

subject properties, rather than simply looking at the rates of

return for the very small sample of actual sales relied on by
                                - 29 -

respondent.    In addition, the dates of the sales used in the

market approach ranged from 1983 to 1989.10

       For the foregoing reasons, we do not believe respondent’s

criticisms of Dvorak’s capitalization rates are well taken.

However, our review of Dvorak’s analysis causes us to question

whether Dvorak was justified in his use of higher discount and

capitalization rates for HUD-subsidized properties than for

properties operating without HUD subsidies.    We do not believe he

was.    In Dvorak’s view, an investor in the subject properties

would require a higher rate of return because of the risk of loss

of the HUD subsidies and the above-market rental income stream

that such subsidies produced.    However, Dvorak offered no

evidence or analysis to support the existence of, or quantify the

extent of any, risk that HUD subsidies on properties of this type

might be lost.    The HUD contracts covering the subject properties

were generally for 30 years, yet Dvorak asserted the purported

risk only in conclusory fashion.    Even if we were to accord some

weight to his unsupported opinion regarding this risk, we believe

any such increase in risk would be offset by the decreased risk

(in comparison to non-HUD-subsidized rental properties) provided

by (i) the status of the Federal Government as obligor for most

of the contract rents, and (ii) the mandated trust fund accounts,


       10
        Dvorak was valuing the subject property as of two dates,
1985 and 1989, for purposes of the equitable distribution
proceedings.
                              - 30 -

which provided for reserves for a broad range of project

expenditures, including routine and extraordinary maintenance,

insurance, taxes, debt service, etc.    Dvorak acknowledged that he

did not consider the trust funds in his valuation analysis.         On

balance, we believe the Federal Government’s liability for the

rents and the existence of the trust funds provide support for a

lower, not a higher, capitalization rate.       On this record,

therefore, we conclude that the most appropriate capitalization

rate is the lower one used by Dvorak for the subject properties

in the absence of HUD subsidies.11

Final Values Based on Adjustments to Dvorak’s Report

     Incorporating the adjustments above, we find that the value

of the real estate held by Charlotte was $1,720,000, and the

value of the real estate held by Monroe was $1,690,000.       The

following tables show the derivation of these values:

Charlotte

     Dvorak’s Report

               Year 1     Year 2       Year 3      Year 4    Year 5
Net operating
  income      $190,344   $193,199    $196,097 $199,039 $202,024
Cash-flow      190,344    193,199     196,097 11,815,235
Present value2 165,517    146,086     128,937 1,037,867


     11
        Even the lower of Dvorak’s two capitalization rates is
arguably too high, since it takes no account of the HUD subsidies
(which tended to reduce the risk perceived by an investor, in our
view). Nevertheless, in the absence of an evidentiary basis on
which to compute the extent to which the capitalization rate
should be adjusted downward, we adopt the lower of the two
computed by Dvorak.
                               - 31 -

Sum of present values: $1,478,407
Estimated value: $1,480,000
          1
            This figure equals the reversionary value of
     $1,616,196 plus the net operating income from year 4 of
     $199,039. The reversionary value equals the net operating
     income from year 5, $202,024, divided by Dvorak’s terminal
     capitalization rate of 12 percent, minus costs of sale of
     $67,341.
          2
           Dvorak discounted to present value using a 15-percent
     discount rate.

     Court’s Adjustments

                Year 1      Year 2      Year 3   Year 4   Year 5
Net operating
  income1      $195,948    $198,887   $201,871 $204,899 $207,972
Cash-flow       195,948     198,887    201,871 22,028,313
Present value3 173,405      155,758    139,907 1,243,941

Sum of present values: $1,713,011
Estimated value: $1,710,000
          1
           These figures include the adjustment to the vacancy
     rate that we have concluded is appropriate, from 3 percent
     down to 1 percent. This caused an increase of $5,202 (2
     percent of the rental income figure of $259,200) each year
     in 1985 dollars. The figures in the table are inflated to
     1989 dollars using Dvorak’s inflation rate of 1.5 percent
     per year.
          2
           This figure equals the reversionary value of
     $1,823,313 plus the net operating income from year 4 of
     $204,899. The reversionary value equals the net operating
     income from year 5, $207,972, divided by our adjusted
     terminal capitalization rate of 11 percent, minus costs of
     sale of $67,341.
              3
            We discount to present value using our adjusted 13-
    percent discount rate.
                               - 32 -

Monroe

     Dvorak’s Report

                Year 1      Year 2      Year 3   Year 4    Year 5
Net operating
 income1       $176,350    $176,350   $176,350   $176,350 $176,350
Cash-flow       176,350     176,350    176,350 21,617,165
Present value3 154,693      135,696    119,031    957,491

Sum of present values: $1,366,910
Estimated value: $1,370,000
          1
           In contrast to his computations for Charlotte, Dvorak
     did not inflate the net operating income figures for Monroe
     by 1.5 percent from year to year, nor did he adjust the
     starting net operating income figure for inflation to state
     it in 1989 dollars. Dvorak gives no reason for failing to
     make these adjustments, and for consistency we make them in
     the table that follows.
          2
           This figure equals the reversionary value of
     $1,440,815 plus the net operating income from year 4 of
     $176,350. The reversionary value equals the net operating
     income from year 5, $176,350, divided by Dvorak’s terminal
     capitalization rate of 11.75 percent, minus costs of sale of
     $60,034.
          3
           Dvorak discounted to present value using a 14-percent
     discount rate.

     Court’s Adjustments

                Year 1      Year 2      Year 3   Year 4    Year 5
Net operating
  income1      $195,386    $198,317   $201,292   $204,311 $207,376
                                               2
Cash-flow       195,386     198,317    201,292 1,987,619
Present value3 172,909      155,311    139,505 1,219,044

Sum of present values: $1,686,769
Estimated value: $1,690,000
          1
           These figures include an adjustment to the vacancy
     rate that we have concluded is appropriate, from 3 percent
     down to 1 percent. This caused an increase of $5,019 (2
     percent of the rental income figure of $250,080) each year
     in 1985 dollars. The figures in the table are inflated to
     1989 dollars using Dvorak’s inflation rate of 1.5 percent
     per year and inflated at the same rate year by year.
                               - 33 -
          2
           This figure equals the reversionary value of
     $1,783,308 plus the net operating income from year 4 of
     $204,311. The reversionary value equals the net operating
     income from year 5, $207,376, divided by our adjusted
     terminal capitalization rate of 11.25 percent, minus costs
     of sale of $60,034.
          3
            We discount to present value using our adjusted 13-
     percent discount rate.

Value of Decedent’s Interest in the Housing Partnerships

     Beck valued decedent’s partnership interests using only the

net asset approach under the theory that rental real estate was

the primary asset of the housing partnerships and the income-

producing value of the partnerships is contained in the net asset

value.   We agree.   The hypothetical investor would seek the

income stream from the partnerships as going concerns, but,

because the partnerships hold rental properties, the income

stream of the partnerships is reflected in the net asset value,

or income stream, of the underlying properties.    See, e.g.,

Estate of Andrews v. Commissioner, 79 T.C. 938, 944 (1982);

Estate of Smith v. Commissioner, T.C. Memo. 1999-368.    A value

based principally on the income stream is especially appropriate

in this case, we believe, because the HUD subsidies produced

above-market rents and also, in our view, affect the

capitalization rate that should be used to value the properties.

The impact of the subsidies is thus only captured in an income-

based approach to valuation.    Accordingly, we find that an

income-based value, which takes into account the HUD subsidies,

is the most appropriate method to value the housing partnerships.
                             - 34 -

We therefore believe that Beck’s reliance on Dvorak’s appraisals,

which used an income approach to value the real estate, was, in

general, proper.

Beck’s Report

     As earlier noted, under Beck’s net-asset approach, the value

of the partnerships was estimated to equal each partnership’s

equity in its real estate assets (as appraised by Dvorak and

Keith), plus cash and accounts receivable, net of liabilities.12

Beck’s appraisals of decedent’s interests in the housing

partnerships, before discounts, were as follows:

Charlotte

Real estate value
  (per Dvorak appraisal)            $1,480,000
Less outstanding mortgage balance    1,380,000
Real estate equity                                 100,000
Plus cash and accounts receivable                  259,343
Less (nonmortgage) liabilities                     161,338
Partnership value                                  198,005
Value of 50% interest                               99,003




     12
        The valuations of the accounts receivable and accrued
liabilities were based on audited financial statements dated
Dec. 31, 1988.   The 1989 financial statements were not yet
prepared as of the performance of the appraisals, and thus the
reconstructed market income statements for 1989 were used for
both the market analysis and the operational analysis.
                             - 35 -

Monroe

Real estate value
  (per Dvorak appraisal)            $1,370,000
Less outstanding mortgage balance    1,220,000
Real estate equity                                    150,000
Plus cash and accounts receivable                     436,751
Less (nonmortgage) liabilities                        117,444
Partnership value                                     469,307
Value of 50% interest                                 234,653

Rocky Mount

Real estate value
  (per Keith appraisal)             $1,400,000
Less outstanding mortgage balance    1,380,000
Real estate equity                                     20,000
Plus cash and accounts receivable                     339,952
Less (nonmortgage) liabilities                        172,665
Partnership value                                     187,287
Value of 50% interest                                  93,643

Clinton

Real estate value
  (per Keith appraisal)                 $665,000
Less outstanding mortgage balance        587,500
Real estate equity                                     77,500
Plus cash and accounts receivable                     113,709
Less (nonmortgage) liabilities                         32,818
Partnership value                                     158,391
Value of 50% interest                                  79,196

Beck then applied discounts to the values of the 50-percent

interests in the housing partnerships for lack of control (15

percent) and for lack of marketability (25 percent), which would

result in discounted values as follows:

                           Value Before          Discounted
           Project           Discounts             Value

          Charlotte           $99,003              $63,114
          Monroe              234,653              149,591
          Clinton              79,196               50,487
          Rocky Mount          93,643               59,697
                                  - 36 -

     There are disputes concerning various aspects of Beck’s

analysis, which we consider in turn.

     (a)    Accounts Receivable

     The first issue to decide is whether it is appropriate to

discount intercompany accounts receivable.      Petitioner argues

that the value of certain accounts receivable from Godley Realty

and CPSI should be discounted in valuing the underlying assets of

the housing partnerships.    Petitioner’s theory is that

discounting is required to reflect the risk of nonpayment, in

particular because there were no promissory notes or collateral

for the partnerships’ receivables.

     We believe petitioner’s argument for discounting the

accounts receivable is unpersuasive.       The accounts receivable in

question were not secured because they were from related parties.

Generally speaking, accounts receivable and payable between

related parties are disregarded in a valuation of the commonly

controlled entities; that is, they are either all counted at face

value or all eliminated, producing in either case a wash.      Beck,

petitioner’s own expert on valuation of business entities, so

testified.    Moreover, Beck valued the accounts receivable of each

housing partnership at face value in his expert report, which

petitioner has submitted under Rule 143(f) in support of its

position.    In conformance with the general rule, respondent

allowed the corresponding accounts payable of Godley Realty and

CPSI at full face value in reaching an agreement with petitioner
                                  - 37 -

as to the valuations of those entities for Federal estate tax

purposes, which valuations the parties have stipulated are

correct.    Accordingly, we conclude that the accounts receivable

of the housing partnerships should be valued at face value, and

we make no adjustment to Beck’s report in this respect.13

     (b)    Trust Fund Accounts

     Beck assigned no value to the trust funds established and

maintained under the financing arrangements of the housing

partnerships, on the grounds that maintenance of the funds was

essentially a prerequisite for the HUD subsidies and therefore

the funds were not available to a purchaser of decedent’s

interest.    It is respondent’s contention that the trust funds are

includable in the net asset value of the partnerships at their

full face value as of December 31, 1989.   Although we disagree

with respondent’s approach, we also do not believe that Beck has

fully accounted for the value supplied by the trust funds.   We


     13
        Petitioner also argues with respect to Godley Realty
that its accounts receivable were not actually accounts
receivable; that is, petitioner argues that they were not amounts
owed by Godley Realty to each housing partnership but rather were
distributions from Godley Realty, before it was incorporated, to
decedent and Fred Jr. and were incorrectly recorded as
receivables held by the housing partnerships. We reject this
argument for a number of reasons. First, the supporting evidence
is at best vague and imprecise. Second, in contradiction to this
position, petitioner submitted an expert report that treated
these amounts as accounts receivable. Finally, petitioner
allowed respondent to treat the corresponding amounts as accounts
payable in the hands of Godley Realty, which resulted in their
treatment as liabilities at face value when respondent and
petitioner reached agreement on the valuation of Godley Realty.
                              - 38 -

believe respondent is correct in arguing that the trust funds

would have some value to a purchaser of an interest in the

housing partnerships, as the existing funds could eventually be

used to defray expenses that the partnerships would otherwise

incur.   However, viewed from this perspective, the funds would

have to be discounted to present value, because the circumstances

and timing for their use are subject to strict controls.    The

appropriate discounting would vary with each fund, depending upon

the terms governing its use; and the record in this case provides

an insufficient basis on which to estimate such discounting.

     In these circumstances, we think the trust funds are best

viewed as analogous to working capital.   The trust funds had to

be maintained by the partnerships in order to retain the HUD

subsidies.   The funds were thus essential to producing the above-

market rental income stream earned by the partnerships, not

unlike the working capital necessary for any going concern to

produce an income stream.   Since we are valuing the partnerships

as operating businesses, we consider the trust accounts not as

liquid assets (which might be proper if we were considering

liquidation value), but rather as components of working capital,

necessary to continue the income stream of the partnerships, but

otherwise unavailable to an investor in the partnerships.

However, the trust funds have some value to an investor; as

reserves, they make the housing partnerships less risky than

other partnerships similarly situated that do not have such trust
                                 - 39 -

funds.     Thus, we believe an investor would require a lower rate

of return from the partnerships with the trust funds.     For this

reason, we believe the trust funds are best accounted for by

means of a reduction in the otherwise applicable capitalization

rate.     We have done so earlier in this analysis, where we

rejected Dvorak’s position that an increase in the capitalization

rate was warranted by the risk of loss of the HUD subsidies.       We

concluded there that any such risk was offset by a reduction in

risk produced by the trust funds.     On this record, we believe

such an adjustment to the capitalization rate is the best means

to account for the effect that the trust funds would have on the

price that a hypothetical buyer would pay for decedent’s interest

in the housing partnerships.14

     14
       We have considered whether a similar adjustment to take
into account the trust funds is warranted in the case of Keith’s
appraisals of the Clinton and Rocky Mount properties and conclude
that it is not. First, in the case of Clinton, that partnership
held only a maintenance reserve of $8,920, which we believe would
not have been a material consideration in a hypothetical sale.
The Rocky Mount partnership, however, did not hold trust funds of
a magnitude similar to those of Charlotte and Monroe.
Nonetheless, we note that Keith ultimately relied on his market-
based value rather than his income-based value in reaching his
conclusion regarding Rocky Mount. Keith’s market-based value for
Rocky Mount was $1,400,000, while his income-based value was
$1,325,000. In calculating his income-based value Keith used a
discount rate of 15 percent. If we adjust this rate to 13
percent, as we did in the case of Dvorak’s Charlotte report, the
value under Keith’s income approach would be $1,400,901, rounded
to $1,400,000, equal to the value under Keith’s market-based
approach and to Keith’s final value. We note again that
respondent has accepted this value and find that any adjustment
to Keith’s discount rate to reflect the existence of the trust
funds would not alter the final value of Keith’s Rocky Mount
                                                   (continued...)
                               - 40 -

     (c)   Discounts

     The final issue we must resolve is the extent to which

discounts may apply to the interests being valued.   Beck applied

a lack of control discount of 15 percent to decedent’s interests

in the housing partnerships because of the irrevocable

designation of Fred Jr. as managing partner thereof.   In Beck’s

opinion, this irrevocable designation effectively surrenders a

degree of control which would otherwise be held by a 50-percent

general partner, and therefore places decedent’s interest in the

position of a minority partner interest.   We disagree.

     A minority discount will apply where a partner lacks

control, indicated by such factors as the inability to

participate in management, to direct distributions, or to compel

liquidation or withdraw from the partnership without the consent

of the controlling interest.   See Estate of Bischoff v.

Commissioner, 69 T.C. 32, 49 (1977).    Degree of control is the

critical factor in deciding whether the minority discount applies

and the amount of the discount, if any.    See id.

     We find that the terms of the partnership agreements do not

reduce decedent’s interests to the level of minority interests.

The partnership agreements for the housing partnerships contain

restrictions on a partner’s right of liquidation, termination,

and withdrawal, but the restrictions apply equally to all

     14
      (...continued)
appraisal.
                              - 41 -

partners.   Day-to-day management decisions are in the hands of

the managing partner, but major decisions require approval of

partners owning 75 percent of the partnership’s interests.    The

term “major decisions” is broadly defined under the partnership

agreements so as to include nearly any decision other than

routine daily operational matters, including the acquisition and

sale of partnership property, financing, expenditures in excess

of $2,500, entering major contracts, or any other decision or

action “which materially affects the Partnership or the assets or

operation thereof.”   Also, annual distributions of net cash-flow

are required under the partnership agreements, giving the holder

of decedent’s interest the right to require distributions.    Beck

argues that the partnership agreements give the managing partner,

Fred Jr., “absolute discretion in establishing ‘reserves for

replacement of assets or to cover contingencies’”, essentially

allowing him to nullify the provision requiring annual

distributions of cash.   We believe Beck gives an overly expansive

reading of the managing partner’s discretion regarding reserves.

Although Fred Jr. had discretion, we do not believe the other

partners would lack recourse if this discretion were used to cut

off otherwise available cash distributions.   Moreover, the

discretion to establish such reserves was listed as an item of

day-to-day management, suggesting a limited scope to that right.

When read in the context of the entire partnership agreement, we

do not believe the managing partner’s discretion to establish
                              - 42 -

reserves confers the absolute power suggested by Beck.    Thus, we

conclude that the terms of the agreements do not restrict control

to the extent of a minority interest.

     Petitioner argues, in the alternative, that Fred Jr. had

virtual control over the housing partnerships because of his

options to buy decedent’s interests.    As previously discussed,

the options must be disregarded in valuing those interests.

     Beck also determined that a lack of marketability discount

of 25 percent should apply because there was no ready market for

the housing partnership interests and a seller would necessarily

suffer a period of illiquidity.   Respondent concedes on brief

that a lack of marketability discount of 15 to 20 percent is

appropriate, but only where the income approach to valuation is

employed.   However, as previously discussed, in this case the

income and net asset values are intertwined.    Moreover, to

calculate the values in the notice of deficiency, Archer used a

lack of marketability discount for both asset and income-based

values of the housing partnerships.    Further, we believe that

Beck makes a persuasive case that decedent’s interests would not

be readily marketable.   He notes that they would be subject to

the irrevocable designation of Fred Jr. as managing partner.

Beck also cited the provisions in the partnership agreements that

grant a right of first refusal to nonselling partners and give

them 60 days to accept or reject the offer to sell, which he

interpreted as forcing a period of illiquidity on every selling
                               - 43 -

partner.    In light of all the facts and circumstances and

respondent’s concession, we find that a 20-percent lack of

marketability discount is appropriate.

     For the reasons previously outlined, we believe Beck’s

analysis should be modified:    (i) To include our adjustments to

Dvorak’s appraisals of the Charlotte and Monroe real estate; (ii)

to eliminate his 15-percent minority discount; and (iii) to apply

a 20- rather than 25-percent marketability discount.   Using

Beck’s methodology, as modified, results in the following values,

which we find are correct:

Charlotte

Real estate value
  (per modified Dvorak appraisal)         $1,710,000
Less outstanding mortgage balance          1,380,000
Real estate equity                                      $330,000
Plus cash and accounts receivable                        259,343
Less (nonmortgage) liabilities                           161,338
Partnership value                                        428,005
Value of 50% interest                                    214,003
Less 20% marketability discount                           42,801
Correct value                                            171,202

Monroe

Real estate value
  (per modified Dvorak appraisal)         $1,690,000
Less outstanding mortgage balance          1,220,000
Real estate equity                                      $470,000
Plus cash and accounts receivable                        436,751
Less (nonmortgage) liabilities                           117,444
Partnership value                                        789,307
Value of 50% interest                                    394,654
Less 20% marketability discount                           78,931
Correct value                                            315,723

Rocky Mount

Real estate value
                              - 44 -

  (per Keith appraisal)                  $1,400,000
Less outstanding mortgage balance         1,380,000
Real estate equity                                      $20,000
Plus cash and accounts receivable                       339,952
Less (nonmortgage) liabilities                          172,665
Partnership value                                       187,287
Value of 50% interest                                    93,643
Less 20% marketability discount                          18,729
Correct value                                            74,914

Clinton

Real estate value
  (per Keith appraisal)                     $665,000
Less outstanding mortgage balance            587,500
Real estate equity                                      $77,500
Plus cash and accounts receivable                       113,709
Less (nonmortgage) liabilities                           32,818
Partnership value                                       158,391
Value of 50% interest                                    79,196
Less 20% marketability discount                          15,839
Correct value                                            63,357

GMA

      The fifth partnership at issue is GMA, which is different

from the housing partnerships.   Decedent and Fred Jr. formed GMA

because HUD required a separate partnership to manage the housing

partnerships.   GMA received a management fee from each of the

housing partnerships equal to 10 percent of rental income.    GMA

held no fixed assets, and its only significant expense was salary

it paid to decedent and Fred Jr.

      In valuing GMA, respondent introduced the report of Kaye,

who valued GMA for Fred Jr.’s former spouse in the equitable

distribution proceedings.   Petitioner introduced the report of

Beck, who valued GMA for Fred Jr. in the earlier proceedings.

Kaye used an income approach, under which he capitalized an
                               - 45 -

after-tax income figure using a capitalization rate derived from

comparisons with large, publicly traded real estate management

companies.    He found the value of GMA as a whole to be

$450,000.15   Beck, on the other hand, believed that the value of

GMA was intrinsically tied to the value of the four housing

partnerships.   Further, he argued that because GMA had no fixed

assets and its only assets were accounts receivable from the

housing partnerships, its value was simply equal to the net

realizable accounts receivable as of December 1989 (the time

closest to the valuation date for which figures were available).

     We agree with Beck’s assertion that the value of GMA was

tied to the value of the housing partnerships, but we disagree

with his conclusions as to the value of GMA.    He failed to

recognize that the hypothetical buyer investing in GMA would not

merely be buying the accounts receivable on a particular date,

but instead would be buying the income stream attributable to 10

percent of the rental income of each of the four housing

partnerships, minus expenses associated with managing the housing

partnerships.   Thus, we reject Beck’s approach altogether.

     Petitioner makes no specific challenges to the income

approach used by Kaye.   Rather, petitioner makes two arguments:


     15
        We note that in the notice of deficiency respondent
determined the value of decedent’s 50-percent interest in GMA to
be $330,688. By proffering Kaye’s report, respondent has
apparently abandoned the position that decedent’s interest in GMA
has a value any greater than $225,000 (50 percent of $450,000).
                               - 46 -

(i) That Kaye valued the partnership as a whole, rather than

decedent’s interest, and that discounts for lack of control and

lack of marketability apply; and (ii) that the fact that GMA’s

value depended on the value of the housing partnerships should be

taken into consideration.   With respect to discounts, we apply

the same discounts, and for the same reasons, that we applied in

the case of the housing partnerships.     Respondent concedes a lack

of marketability discount of 15 to 20 percent with respect to

GMA, petitioner has not demonstrated that a greater discount

applies, and we accordingly apply a discount of 20 percent for

lack of marketability.   Further, petitioner has not demonstrated

that a minority interest discount applies, given that Fred Jr.

and decedent each held 50-percent partnership interests, and

there is no evidence that Fred Jr. controlled GMA to a greater

extent than the housing partnerships.16

     With respect to whether Kaye’s valuation approach took into

account the relationships between GMA and the housing

partnerships, we believe it did.   Kaye was aware of the

relationship, and he knew that GMA’s income consisted of accounts

receivable generated by the management fees, equal to 10 percent

of rental income, paid by the housing partnerships.    Moreover,

Kaye’s approach used actual income figures of GMA.    We believe




     16
          The partnership agreement of GMA is not in the record.
                             - 47 -

Kaye sufficiently considered the value of GMA in relation to the

housing partnerships.

     Using Kaye’s value of $450,000, and applying a discount of

20 percent for lack of marketability, we find that decedent’s 50-

percent interest in GMA was worth $180,000.

     To reflect the foregoing,

                                      Decision will be entered

                                 under Rule 155.
