                        T.C. Memo. 2004-195



                      UNITED STATES TAX COURT



            GARWOOD IRRIGATION COMPANY, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 1459-03.              Filed August 30, 2004.


     Donald F. Wood, Benjamin M. Leff, and Karl S. Stern, for

petitioner.

     Richard T. Cummings, for respondent.



              MEMORANDUM FINDINGS OF FACT AND OPINION


     GOEKE, Judge:   Respondent determined a deficiency of

$15,819,650 in petitioner’s 1999 Federal income tax.    The issue

for decision is the value of petitioner’s primary asset, the

right to divert 168,000 acre feet of water from the Colorado
                               - 2 -

River, upon petitioner’s election to be treated as an S

corporation effective January 1, 1997.

     Our decision relies on the record, which is sufficient in

this case to make a decision based on a preponderance of the

evidence.   We do not rely on the burden of proof.   In addition,

there is cogent proof in the record that the value of

petitioner’s water right was less than that stated on

petitioner’s 1999 Federal income tax return.   Our decision that

the value was lower than that stated on petitioner’s return is

based on the factual circumstances surrounding an arm’s-length

sale of a portion of petitioner’s water right to the city of

Corpus Christi.   We conclude that as of January 1, 1997, the

value of petitioner’s water right was $22,532,519.

                          FINDINGS OF FACT

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

The stipulation of facts and the attached exhibits are

incorporated herein by this reference.   At the time the petition

was filed, petitioner’s principal place of business was in the

city of Garwood, Texas.

     Petitioner has been in the irrigation business in Texas

since 1900.   Petitioner existed as an S corporation from 1948

until 1978, when William K. Lehrer, one of petitioner’s

shareholders, died.   At his death, William K. Lehrer’s shares in

petitioner passed to two trusts.   At that time and until 1996,
                                - 3 -

trusts were ineligible to be S corporation shareholders.   As a

result, petitioner operated as a C corporation from 1978 until

1997.    William N. Lehrer (Mr. Lehrer), who is William K. Lehrer’s

son, was petitioner’s chairman of the board and chief executive

officer on the valuation date and for several years before the

valuation date.

     On March 19, 1997, petitioner filed Form 2553, Election By A

Small Business Corporation, to elect to be an S corporation under

section 13621 (the election).   The election was effective January

1, 1997.    At the time of the election, petitioner’s primary asset

was the right to divert 168,000 acre feet2 of water from the

Colorado River at a specified diversion point near Garwood,

Texas.    Petitioner also held an investment portfolio at the time

of the election, the value of which has been agreed upon by the

parties.

     On January 7 and 8, 1999, petitioner sold its water right

and related assets to the Lower Colorado River Authority (LCRA)

and the city of Corpus Christi, Texas (Corpus Christi).

Petitioner timely filed Form 1120S, U.S. Income Tax Return for an


     1
      Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the year in issue, and
all Rule references are to the Tax Court Rules of Practice and
Procedure.
     2
      An acre foot of water is the amount of water necessary to
cover an acre of land 1 foot deep and is equal to approximately
326,000 gallons.
                               - 4 -

S Corporation on September 16, 2000 (the 1999 return).   The 1999

return reported a built-in gains tax of $9,636,736 on the sale of

petitioner’s water right.   The built-in gains tax amount reported

by petitioner was based on a valuation of $31,410,000 as of

January 1, 1997 (valuation date) for the water right and the

investment portfolio.

     Respondent determined a deficiency in petitioner’s 1999

Federal income tax of $15,819,650, based on a valuation of

$76,609,000 for the water right and the investment portfolio.

1.   Petitioner’s Irrigation Business

     The State of Texas owns the water in its public waterways.

The right to divert and use or sell water from a waterway is

known as a “water right”.   The Texas Commission on Environmental

Quality, formerly known as the Texas Natural Resources

Conservation Commission (hereinafter, the TNRCC), is a State

agency that regulates the water rights in Texas and controls the

transfer and use of such rights.   The TNRCC formally recognized a

water right by issuing to the holder a Certificate of

Adjudication, which contained the limits of that right, its

priority date, and any special or unique conditions associated

with its use.

     On June 28, 1989, the TNRCC formally recognized petitioner’s

water right and issued to it Certificate of Adjudication No. 14-

5434 (certificate).   Petitioner’s certificate allowed it to
                                 - 5 -

withdraw 168,000 acre feet of water per year from the Colorado

River for irrigation of up to 32,000 acres of land within its

service area.   The Colorado River involved in this case begins in

southeastern New Mexico and flows approximately 600 miles from

northwestern Texas to southeastern Texas and empties into the

Matagorda Bay and the Gulf of Mexico.      For water allocation

purposes, Texas is divided into areas of watershed from its

rivers, called river basins.   The Colorado River Basin is the

third largest river basin in Texas.      Petitioner’s service area

was located in the lower Colorado River Basin, in Colorado and

Wharton counties, Texas.

     Petitioner’s certificate gave it a priority date of November

1, 1900.   In the event of a shortage of water, priority dates

determine which rights holders will receive their allocated share

of the water that is available.    Holders of water rights with

later, or junior, priority dates must let water flow past them

until a senior holder receives the full amount of water

authorized by its certificate.    At the time the certificate was

issued and at the valuation date, petitioner’s priority date was

the most senior in the Colorado River Basin.

     As of the valuation date, petitioner’s water right had been

used only for irrigation for rice farming.      Petitioner’s only

customers were rice farmers, and petitioner’s service of its

rice-farming customers had never required petitioner to use all
                                 - 6 -

of the water allotted by its certificate.       In the several years

leading up to the valuation date, an average of 100,000 acre feet

per year were used for irrigation purposes.       In each year, the

difference between the amount of water petitioner was entitled to

withdraw (168,000 acre feet) and the amount of water needed to

serve its irrigation customers (100,000 acre feet) was

approximately 68,000 acre feet.    The 68,000 acre feet of extra

water flowed unused past petitioner’s diversion point and into

the Matagorda Bay every year.

2.   Events Before the Valuation Date

     A.     Regulatory Climate

     The TNRCC regulated the use, transfer, and management of

Texas water, and no transfer of water rights in Texas could occur

without the TNRCC’s approval.    If a transfer would result in the

subject water being put to a different type of use than that

listed on its certificate, or the movement of the subject water

to a different area or basin, the seller was required to apply to

the TNRCC to amend its certificate to reflect the new use or

location.    As of the valuation date, the TNRCC had broad

discretion to grant or deny amendments, and evaluated each

application based on six criteria:       Availability of additional

requested water, environmental impacts, injury to existing

rights, beneficial use (including need), public welfare, and

water conservation.    The TNRCC also conducted technical reviews
                                - 7 -

of hydrology, environmental factors, and water conservation.     If

a change in use would cause harm to other in-basin users, the

requested amendment could be denied.     A request for a transfer of

water to another basin, or an “interbasin transfer”, required

additional consideration of the benefits and detriments to each

basin.    In addition, when an application was made, the TNRCC

would notify interested persons and give them an opportunity to

present evidence and be heard on the matter.     If an interested

party objected to the TNRCC’s determination, it had the option of

filing suit in a district court of Travis County, Texas, for

review of the TNRCC’s determination.     The district court’s

decision was appealable to the Texas Courts of Appeal and the

Texas Supreme Court.    Around the valuation date, the TNRCC

generally granted or denied uncontested applications within 12 to

18 months of their filing.    The amendment process for contested

applications generally took between 2 and 5 years at the TNRCC

level excluding any time spent in the Texas courts.

     B.     Corpus Christi Transaction

     In 1992, petitioner granted the city of Corpus Christi an

option to purchase the right to a 35,000 acre-foot portion of

petitioner’s water right for $400 per acre foot.     The agreement

was for 2 years and required Corpus Christi to pay petitioner

$20,000 per month to keep the option open.     The monthly payments

would be credited to the purchase price if Corpus Christi
                               - 8 -

exercised the option.   On March 18, 1993, the TNRCC granted an

amendment to petitioner’s certificate, authorizing the change of

use for the 35,000 acre feet subject to the option from

agricultural to municipal and industrial use.   In February 1994,

the option agreement was amended to extend the period in which

Corpus Christi could exercise the option for 2 additional years,

to increase the monthly payments to $25,000, and to increase the

option payment to $450 per acre foot.    In November 1996, Corpus

Christi notified petitioner that it intended to exercise the

option.   Upon notification of Corpus Christi’s exercise, the

option agreement required petitioner to obtain amendments to its

certificate from the TNRCC authorizing an interbasin transfer of

the 35,000 acre-foot portion of petitioner’s water to various

other basins for Corpus Christi’s use.   The option agreement

provided that Corpus Christi could either close the sale or

withdraw from the transaction upon petitioner’s acquisition of

the amendment to its certificate.

     As of the valuation date, petitioner had not yet submitted

an application for an amendment authorizing the interbasin

transfer.   However, the LCRA had made it known by the valuation

date that it planned to oppose the Corpus Christi transaction.

In fact, at that time the LCRA had a policy of vigorously

opposing any transfer of water out of the Colorado River Basin

and was a politically influential organization.   Its mission was
                               - 9 -

to steward water resources and protect users in the Colorado

River Basin.   The transfer of petitioner’s water out of the

Colorado River Basin would have diminished the amount of water

consistently available for future use within the Colorado River

Basin.

     The city of Austin (Austin), the Colorado River Municipal

Water District, and property owners around five reservoirs

created and owned by the LCRA also expressed their intention to

oppose the granting of an amendment to petitioner’s certificate

necessary for the Corpus Christi transaction.    Nevertheless, the

LCRA was not confident that it would be successful in blocking

the transfer to Corpus Christi.

     C.   Anticipation of the 1997 Legislative Session

     Texas experienced a severe drought in the summer of 1996,

which was alleviated as of the valuation date.   As a result of

the drought, on August 30, 1996, the TNRCC issued a report

recommending legislative guidance on the criteria to be used in

making determinations regarding applications for interbasin

transfers.   In addition, other interested parties were lobbying

the Texas legislature to make the rules regarding interbasin

transfers both more and less restrictive.   The interbasin

transfer issue was expected to be considered at the 1997

legislative session, which was to convene on January 14, 1997.

Within the Texas legislature there was support for expanding the
                               - 10 -

ability to move water throughout the State to spur growth.    There

was also opposition to interbasin transfers because of the

potential for restraint of economic growth within certain areas.

As a result, before the 1997 session began, it was unknown what

the legislature would do regarding water rights.

     D.   Petitioner’s Unused Water

     As of the valuation date, 68,000 acre feet of water flowed

unused past petitioner’s diversion point into the Matagorda Bay

each year and did not generate any income for petitioner.    A

35,000 acre-foot portion of this was involved in the Corpus

Christi transaction.   This left 33,000 acre feet of petitioner’s

water right unused.    Under petitioner’s certificate, the 33,000

acre feet of unused water, as well as the 100,000 acre feet of

irrigation water, were authorized to be used only for

agricultural use, and only in petitioner’s service area.    There

was a reasonable probability that at some point in the future,

the unused water could be converted to municipal or industrial

use, inside or outside the Colorado River Basin, which would make

the water more valuable, but such a conversion would have

required time, money, and regulatory approval.   A transfer of

petitioner’s unused water out of the Colorado River Basin, after

the transfer of 35,000 acre feet to Corpus Christi, would have

increased the likelihood that inbasin users would be impaired and

that inbasin development would be impeded.   If petitioner applied
                              - 11 -

for a transfer of the unused water out of the Colorado River

Basin, it would likely have faced greater regulatory hurdles than

it faced with the Corpus Christi transaction.

     No prospective buyers, other than Corpus Christi, had made

an offer or was actively pursuing the purchase of any portion of

petitioner’s water right as of the valuation date.   Austin is

located in the Colorado River Basin and might have been a

potential customer for petitioner’s water, but Austin had a long-

standing agreement with the LCRA that entitled it to free water.

Austin did not predict that it would exceed its allotted free

water until at least 2030.   Similarly, the city of San Antonio

had discussions with petitioner in 1991 about purchasing a

portion of its water right, but those discussions had ended by

the end of 1991.   Neither city was actively pursuing a purchase

of any part of petitioner’s water right as of the valuation date.

     Petitioner’s shareholders had discussions with the LCRA in

1967, 1972, and 1992 regarding the possibility of the LCRA’s

purchase of petitioner’s water right.   None of these discussions

resulted in a sale, and the LCRA did not even make an offer

during the most recent discussions in 1992.   The LCRA had

expressed interest in purchasing petitioner’s entire water right.

Mr. Lehrer was willing to sell only a portion of the water right.

As of the valuation date, the LCRA had not made any recent offers

or initiated any serious discussions regarding the sale of
                               - 12 -

petitioner’s water right.   At the beginning of 1997, it opposed

any transfer of petitioner’s water outside the Colorado River

Basin, including the proposed sale to Corpus Christi.

3.   Events After the Valuation Date

     A.   The 1997 Legislative Session

     During the 1997 Texas legislative session, legislators and

interest groups with opposing interests rewrote the laws

regulating water planning and usage in Texas.     The result of this

collaboration was Senate Bill 1 (SB1).     SB1 included an amendment

known as the Junior Water Rights Provision.     Under the amendment,

the water rights involved in any interbasin transfer approved

under the new law would lose their priority date and be assigned

the date of the transfer as a new priority date.     SB1 became

effective September 1, 1997.   All interbasin transfers for which

applications were made before March 1, 1997, including

petitioner’s application for an interbasin transfer to Corpus

Christi, were exempted from the amendment.

     A loss of priority date would be significant to petitioner

because of the nature of its water right.     Petitioner’s water

right was a run-of-the-river right.     A run-of-the-river right

entitles the holder to divert water only if the flow is available

on the day the holder needs to use it, and compels upstream

holders of water rights with junior priority dates to allow

available water to flow past them, without diverting or storing
                              - 13 -

it, in order to meet the senior right holder’s need.    A holder

of a run-of-the-river right does not have the right to call water

that has been stored in a reservoir upstream, despite a junior

priority date of the upstream holder.   As a result, a run-of-the-

river right is not as dependable as rights to stored water during

a drought and is less valuable.   Petitioner’s certificate allowed

it to store only 86 acre feet of water, which was sufficient to

enable its intake pumps to function properly at normal stream

flows.   Consequently, petitioner’s early priority date was

important in that it determined the availability of water to

petitioner in times of drought.

     On August 29, 1997, petitioner filed an application with the

TNRCC for the right to change the use of and to transfer out of

the Colorado River Basin the 133,000 acre-foot portion of its

water right not being sold to Corpus Christi.   The requested

amendment would allow petitioner to sell all or a part of its

water right for municipal, industrial, or commercial purposes

outside of the Colorado River Basin.    Petitioner made the August

27, 1997, application in order to preserve an argument that its

remaining water would be exempt from the Junior Water Rights

Provision of SB1 because the application was filed before the

effective date of SB1 (September 1, 1997).   The argument was

supported by letters from Texas State senators.   Since the
                                - 14 -

passage of SB1, there have been no major interbasin transfers

that were subject to the Junior Water Rights Provision.

     B.   The Corpus Christi Transaction

     On January 30, 1997, petitioner filed an application with

the TNRCC for an amendment to its certificate approving an

interbasin transfer of a 35,000 acre-foot portion of petitioner’s

water right to Corpus Christi.    In September 1997, the TNRCC gave

public notice of the filing of petitioner’s application.     Fifteen

parties, including the LCRA and Austin, filed protests to the

proposed transfer to Corpus Christi.     The LCRA did not hold a

public hearing regarding petitioner’s application.     As of the end

of 1997, petitioner’s application was still pending with the

TNRCC.

     C.   LCRA’s Purchase of Petitioner’s Water Right

     At the valuation date, the LCRA showed no interest in

acquiring petitioner’s water.    The LCRA’s interest was protected

if it could effectively block the approval of an interbasin

transfer of the water by petitioner.     In late 1997, after the

enactment of SB1, the LCRA began to analyze a possible

acquisition of the remaining 133,000 acre-foot portion of

petitioner’s water right, as well as petitioner’s dam, pumps,

canals, and other irrigation assets.     On December 12, 1997, Mark

Rose, the general manager of the LCRA, met with Mr. Lehrer to

discuss a possible acquisition of petitioner’s assets.     On
                               - 15 -

February 18, 1998, Mr. Lehrer and Mr. Rose signed a letter

agreement in which the LCRA agreed to purchase the portion of

petitioner’s water right not involved in the Corpus Christi

transaction and petitioner’s irrigation assets for $75 million.

The purchase price was proposed by Mr. Lehrer and accepted by the

LCRA without negotiation or counteroffer.   As a condition to the

sale, the LCRA agreed to withdraw its opposition to the Corpus

Christi transaction and to assist petitioner in obtaining

approval for the Corpus Christi transaction from the TNRCC.

Petitioner had the right to cancel the sale if the TNRCC did not

approve the Corpus Christi transaction.   Petitioner also agreed

not to negotiate with anyone else during the pendency of the sale

to the LCRA.

     On July 20, 1998, petitioner and the LCRA signed a purchase

agreement for the sale of the remaining 133,000 acre-foot portion

of petitioner’s water right.   On July 22, 1998, petitioner filed

an application with the TNRCC for authorization to use the

133,000 acre-foot portion of its water for municipal or

industrial purposes, but only to the extent the water was not

needed within petitioner’s service area for irrigation.   The

application also requested an expansion of the service area in

which petitioner’s water right could be used, to four additional

counties within the Colorado River Basin, but again, only to the

extent the water was not needed within petitioner’s service area
                              - 16 -

for irrigation.   As part of its commitment to assist petitioner

in securing approval for the Corpus Christi transaction, the LCRA

tried to induce opponents to withdraw their protests.   Some

opponents did withdraw their protests.

     In 1998, the LCRA had discussions with Austin regarding the

possibility of a long-term water supply contract that would

substantially increase Austin’s water supply in the future.     On

September 17, 1998, Austin and the LCRA signed an agreement that

assured Austin adequate future water supply.   On the same day,

after reaching this agreement, Austin withdrew its protest to the

Corpus Christi transaction.   The 1998 discussions marked the

first time Austin clearly signified its interest in being a

customer for petitioner’s water, and the LCRA had no assurance

that Austin would sign the water supply agreement with the LCRA

until the agreement was executed.

     On October 7, 1998, effective as of October 3, 1998, the

TNRCC approved petitioner’s applications for the Corpus Christi

and LCRA transactions.   On January 7, 1999, the Corpus Christi

transaction for 35,000 acre feet closed, and on January 8, 1999,

the LCRA transaction for the remaining 133,000 acre feet closed.

     On its books and balance sheet, the LCRA was required to

record the water right at fair market value by generally accepted

accounting principles.   The LCRA had informally agreed to the

purchase price before knowing what the fair market value of the
                              - 17 -

assets was.   It began examining the value of the remaining water

right in December 1997.   After the purchase, the LCRA recorded

$75 million as the fair market value of the assets it purchased

from petitioner and booked the entire amount to the water right.

The LCRA justified this conclusion based on the sales prices of

other water rights, inflation adjusted prices it had paid for

water rights in the past, and the cost of building a new

reservoir with capacity equivalent to petitioner’s remaining

water.

     After the proposed sale to the LCRA had become public, the

city of San Antonio approached petitioner and inquired whether

petitioner would entertain a competing offer from San Antonio for

its water right.   Petitioner declined and indicated that it did

not want to start a bidding war.   In 2002, the LCRA entered into

a long-term water supply agreement with San Antonio, agreeing to

supply San Antonio 150,000 acre feet of water for 80 years.    San

Antonio is outside the Colorado River Basin.

                              OPINION

I.   Petitioner’s Conversion From C Corporation to S Corporation

     The parties do not dispute that petitioner is subject to tax

on the built-in capital gain on its assets as of January 1, 1997.

We briefly discuss the law that subjects petitioner to such tax.

     Subchapter S status entitles small, eligible corporations to

be taxed like partnerships, avoiding the corporate-level taxation
                              - 18 -

to which C corporations are subject.   Such an eligible

corporation may elect, under the provisions of section 1362, to

be an S corporation with the consent of all its shareholders.

Section 1374 was enacted in 1986 to prevent corporations from

electing to be S corporations for the purpose of avoiding tax on

built-in gains.   Tax Reform Act of 1986, Pub. L. 99-514, sec.

633(d)(8), 100 Stat. 2280.   Section 1374 requires that if a

corporation holds appreciated capital assets before it makes an

election under section 1362, and any of the appreciated capital

assets are sold within 10 years of the election, it will be

subject to corporate-level tax on the amount the corporation

realizes over its basis in the sold assets (built-in gain).    The

corporation is taxed only on the built-in gain present on the

effective date of the election; any gain after the effective date

is passed through to the corporation’s shareholders.   Therefore,

if an asset with built-in gain has uncertain value, the proper

valuation date for the asset is the effective date of the

corporation’s election.

     Petitioner agrees that because it elected to be an S

corporation as of January 1, 1997, it will be taxed on the built-

in gain on its assets as of that date.   The parties dispute the

value of petitioner’s primary asset, the water right, on that

date.
                               - 19 -

II.   Valuation Methodology

      At trial, petitioner presented the testimony of Terry Lloyd,

C.P.A., C.F.A., as an expert valuation witness.    Mr. Lloyd

prepared an expert witness report in accordance with Rule 143.

The record also contains the expert report of John E. Camp,

C.P.A./A.B.V., C.F.A., of Ferguson, Camp & Henry, whose report

provided the valuation used in the preparation of petitioner’s

1999 Federal income tax return (1999 return).   In addition, in

evidence is a draft expert report by Jonathan E. Kemmerer,

C.P.A., dated June 5, 1996, and a report by James Kowis, P.E., of

James Kowis Consulting, dated November 10, 2003.    Mr. Kemmerer’s

expert report was submitted in draft form, and is of limited use

to reach a final valuation conclusion.

      Respondent presented the testimony of Gregory E. Scheig,

C.F.A., C.P.A., of CBIZ Valuation Group, Inc., as an expert

valuation witness.   Mr. Scheig prepared an expert witness report

in accordance with Rule 143.   Mr. Lloyd, Mr. Camp, and Mr. Scheig

in their respective expert reports valued petitioner’s water

right in separate components: (1) The estimated 100,000 acre-foot

portion of petitioner’s water used for irrigation, (2) the 35,000

acre-foot portion of petitioner’s water involved in the Corpus

Christi transaction, and (3) the estimated 33,000 acre-foot

portion of petitioner’s water that was neither used for

irrigation nor involved in the Corpus Christi transaction.     Mr.
                              - 20 -

Scheig and Mr. Camp also valued a portion of the irrigation

component that they believed might become available at a later

date for other, higher value uses as irrigation use declined.

     While expert opinions may assist in evaluating a claim, we

are not bound by these opinions and may reach a decision based on

our own analysis of all the evidence in the record.   Helvering v.

Natl. Grocery Co., 304 U.S. 282, 295 (1938); Estate of Newhouse

v. Commissioner, 94 T.C. 193, 217 (1990).   Where experts offer

conflicting estimates of fair market value, we must weigh each

estimate by analyzing the factors they used to arrive at their

conclusions.   Casey v. Commissioner, 38 T.C. 357, 381 (1962).

This Court may accept or reject the opinion of an expert in its

entirety, or we may be selective in the use of any portion.

Estate of Davis v. Commissioner, 110 T.C. 530, 538 (1998); Parker

v. Commissioner, 86 T.C. 547, 562 (1986); Buffalo Tool & Die

Manufacturing Co. v. Commissioner, 74 T.C. 441, 452 (1980).     Mr.

Lloyd concluded that the value of the water right was $10.7

million on the valuation date.   Mr. Camp concluded that the value

of the water right was $29,397,000, and petitioner reported this

value on its 1999 return.   Mr. Scheig concluded that the value of

the water right was $45,809,384 on the valuation date.   Mr.

Scheig’s valuation represents a significant departure from

respondent’s position in the notice of deficiency, in which

respondent stated that petitioner’s assets were worth $76,609,000
                                - 21 -

on the valuation date.    Respondent’s departure from his position

in the notice of deficiency prompted petitioner to file a motion

to shift the burden of proof.    As stated above, our decision does

not rely on the burden of proof, and petitioner’s motion was

denied as moot.

III.    Cogent Proof That Petitioner’s Return Was Incorrect

       Positions taken by a taxpayer in a tax return are treated as

admissions and cannot be overcome without cogent proof that they

are erroneous.     Mendes v. Commissioner, 121 T.C. 308, 312 (2003);

Estate of Hall v. Commissioner, 92 T.C. 312, 337-338 (1989).    On

its 1999 return, petitioner reported a value of $29,397,000 for

its water right.    In its petition, petitioner contends that the

fair market value of its water right is $10.7 million.    In order

to prevail in showing that the value of the water right is less

than that reported on its return, petitioner must present cogent

evidence that its reported values were wrong.     Estate of Hall v.

Commissioner, supra at 338.

IV.    Valuation

       The central dispute between the parties in this case focuses

on the foreseeability of events that occurred after the valuation

date.    Events subsequent to the date of valuation are not

generally considered in determining an asset’s fair market value,

except to the extent that they were reasonably foreseeable as of

the date of valuation.     Estate of Jung v. Commissioner, 101 T.C.
                                - 22 -

412, 431 (1993); Estate of Gilford v. Commissioner, 88 T.C. 38,

52 (1987); Hess v. Commissioner, T.C. Memo. 2003-251.    These

events can be helpful in valuing assets if they shed light on the

expectations that a hypothetical willing buyer and seller might

have reasonably entertained at the valuation date.     Estate of

Bailey v. Commissioner, T.C. Memo. 2002-152.     Petitioner’s expert

at trial, Mr. Lloyd, contended that as of the valuation date, the

purchase of petitioner’s water right by the LCRA was

unforeseeable to the hypothetical willing seller and buyer.

Respondent contends that it was foreseeable that the LCRA would

eventually purchase the water right; the question was simply when

and at what price.   Respondent also asks us to accept as evidence

of his valuation the facts surrounding the closings of the Corpus

Christi transaction and the LCRA’s purchase of the water right in

January 1999.   See, e.g., Estate of Jung v. Commissioner, supra

at 431.   We shall examine the factors affecting each component of

the water right to determine to what extent the subsequent events

were foreseeable.    Set forth below is a time line of the events

relevant to our determination in this case.

          Event                             Date

LCRA discusses purchase of                1967, 1972
  water right with petitioner

San Antonio and petitioner                1991
  discuss a possible purchase
  of a portion of petitioner’s
  water right
                                - 23 -


          Event                            Date

LCRA discusses purchase of
  water right with Mr. Lehrer            1992

Corpus Christi option agreement          1992
  is executed

TNRCC approves Corpus Christi            Mar. 18, 1993
  change of use amendment

Corpus Christi option agreement          Feb. 1994
  is amended

Texas experiences drought                Summer 1996

TNRCC requests legislative               Aug. 30, 1996
  guidance regarding interbasin
  transfers

Corpus Christi exercises its             Nov. 26, 1996
  option

Petitioner elects S status               Jan. 1, 1997

1997 Texas legislature convenes          Jan. 14, 1997

Petitioner applies for Corpus            Jan. 30, 1997
  Christi interbasin amendment

Grandfather date for interbasin          Mar. 1, 1997
  transfers under Senate Bill 1

Petitioner files application             Aug. 27, 1997
  for interbasin transfer and
  change of use for its remaining
  water

Effective date of Senate Bill 1          Sept. 1, 1997

LCRA begins to analyze purchase          Late 1997
  of petitioner’s water

Mr. Rose of LCRA meets with              Dec. 12, 1997
   Mr. Lehrer
                                - 24 -




            Event                            Date

LCRA first has discussions                 1998
  with Austin regarding long-term
  water supply contract

San Antonio approaches petitioner          1998
  to discuss a competing offer

Petitioner and LCRA sign letter            Feb. 18, 1998
  agreement for purchase

Public announcement of LCRA                Feb. 19, 1998
  purchase

Petitioner and LCRA sign purchase          July 20, 1998
  agreement

Petitioner applies to TNRCC for            July 22, 1998
  amendment for change of use and
  expanded service area for transfer
  to LCRA

LCRA and Austin reach water supply         Sept. 17, 1998
  agreement

TNRCC approves petitioner’s Corpus         Oct. 7, 1998
  Christi and LCRA applications

Corpus Christi transaction                 Jan. 7, 1999
  closes

LCRA transaction closes                    Jan. 8, 1999

LCRA and San Antonio reach 80              2002
  year water supply agreement

     A.     Irrigation Component

     At the valuation date, petitioner’s only customers for its

water right were rice farmers.     The rice farming customers used

approximately 100,000 acre feet of water each year for irrigation

purposes.    The sale of this irrigation water produced revenue to

petitioner and was expected to continue to produce income in the
                               - 25 -

future.   The projected irrigation income was foreseeable as of

the valuation date and must be included in our valuation of

petitioner’s water right.

     Petitioner’s average net annual income from irrigation sales

over the 5 years before the valuation date was $354,837.     As of

the valuation date, a decline in rice farming in Texas was

expected over the next 50 years as a result of various hardships

imposed by economic and environmental climates.     As a result, the

demand for irrigation water in petitioner’s service area was

expected to decline over 50 years.      The experts differed on the

expected rate of decline.   Mr. Scheig stated that the most likely

rate of decline was .4 percent per year, but he also factored in

a 25-percent chance of a 3-percent rate of decline and a 25-

percent chance of a 100-percent rate of decline.     We do not give

any weight to Mr. Scheig’s third scenario (a 100-percent decline

in irrigation use) because, based on the reports and testimony of

the experts in this case, it is obvious that the likelihood of a

conversion of all of petitioner’s irrigation water to other uses

was minuscule.   Rice farmers were very protective of the water

they used.    The use of petitioner’s water for irrigation purposes

benefited the inbasin users because irrigation returned more

water to the Colorado River Basin than other uses (especially

uses requiring interbasin transfers, which returned no water to

the basin).   Rice farmers in Texas also had significant influence
                               - 26 -

on the legislators who, in turn, had influence over the TNRCC.

From a political and regulatory standpoint, the sale of 100

percent of petitioner’s irrigation water was too remote to be

considered in this analysis.

     Mr. Lloyd did not consider any decline in his analysis.     Mr.

Camp predicted that demand for irrigation water would decrease by

20 percent and calculated this decline over 25 years.   On the

basis of the parties’ reports and testimony, we find it was

reasonably foreseeable on January 1, 1997, that the demand for

irrigation water would decline 20 percent over the first 10

years.   We also find that it was foreseeable on the valuation

date that the need for irrigation would decline an additional 20

percent over the following 10 years, freeing up 1,600 acre feet

of water.

     For the most appropriate estimation of value, we use the

average annual income from irrigation water over the 5 years

before the valuation date ($354,837) as a base price.   Here, and

in most of our calculations, we shall factor in a 3-percent

inflation rate.3   We then take into account the 2-percent

expected annual decline in irrigation income that we estimated

above, for a net inflation rate of 1 percent.   In addition, all


     3
      We do not factor in a 3-percent inflation rate for our
valuation of the Corpus Christi transaction because the option
agreement did not provide for an inflation increase to the base
price of $450 per acre foot.
                                - 27 -

of the experts agreed that the base price should be discounted

for the cost of capital.   Most agreed that 8 percent was an

appropriate rate.4   We shall adopt the 8-percent discount rate.

When the stream of projected irrigation income, increased by the

net inflation rate of 1 percent, is discounted at an 8-percent

rate, this results in a value of $3,742,062 for the irrigation

component of petitioner’s water right.

     B.   Corpus Christi Component

     Corpus Christi informed petitioner that it intended to

exercise its option to purchase 35,000 acre feet of petitioner’s

water right in November 1996.    The amended option contract set

the price for the water at $450 per acre foot, in addition to the

$25,000 monthly payments until closing.    However, some

uncertainty existed as to whether and when petitioner would

obtain regulatory approval from the TNRCC for an interbasin

transfer of 35,000 acre feet of water.    As a result of this

uncertainty, it was unknown as of the valuation date when and if

the transaction would be completed.

     Respondent argues that regulatory approval by the TNRCC was

foreseeable because in the end no farmers protested the


     4
      For example, the 8-percent discount rate was derived by Mr.
Scheig as follows: In 1996-97, the yield on U.S. Treasury bonds,
a risk-free investment, was 6.73 percent. Increasing this figure
an appropriate amount to account for the greater risk inherent in
owning water rights instead of Treasury bonds, results in a cost
of capital discount of 8 percent.
                              - 28 -

application, and the entities that did protest were not concerned

about the harm to the basin, but rather were afraid the approval

would lead to many future transfers.   We do not find respondent’s

argument persuasive because as of the valuation date, petitioner

had not yet filed its application for approval of the Corpus

Christi transaction.   The record shows that at that time, the

LCRA and others intended to oppose the transfer to Corpus

Christi, and petitioner could not predict whether its application

would be approved.

     Mr. Scheig assumed regulatory approval would be obtained 2

years after the valuation date and that petitioner would receive

the monthly payments over this 2-year period, with the balance at

closing.   He discounted that amount using an 8-percent cost of

capital discount and a 15-percent lack of marketability discount,

to reflect the restrictions in the regulatory approval process

involved in transfers of petitioner’s water.

     Mr. Lloyd assumed regulatory approval would be obtained 3

years after the valuation date.   He discounted the total monthly

payments made to that date by a 12-percent cost of capital.    He

then discounted the balance due at closing ($13,810,000) by 30

percent, to reflect the rate of return a private equity buyer

would require given the risks involved.

     We recognize the regulatory risks and time delays that

threatened the Corpus Christi transaction.   Mr. Scheig testified
                               - 29 -

that a sale within the basin would likely take about 6 months to

complete, while a contested interbasin transfer could take 5

years.   We believe that an estimate of 3 years is reasonable in

predicting the closing date for the Corpus Christi transaction,

especially given the intent of the 1997 legislature to deal with

water rights.

     The experts agreed that the expected payments petitioner

would receive from the Corpus Christi transaction (both the

monthly payments and the balance at closing) should be

discounted.   The monthly payments were contractually guaranteed

to generate income for petitioner until the sale closed or the

option agreement ended.    We conclude above that it was

foreseeable that the sale would be completed 3 years after the

valuation date, which would require Corpus Christi to pay $25,000

per month for 36 months.    The value of the monthly payments is

$25,000 multiplied by 36 months, or $900,000.    When this income

stream is discounted using our 8-percent cost of capital

discount, the value of the monthly payments is $773,129.

     The payment of the balance at closing should be discounted

by a higher rate than the cost of capital.    We disagree with Mr.

Lloyd’s assertion that a buyer of water rights would require the

same rate of return as a private equity or venture capital

investor.   The risk that regulatory hurdles would impede a sale

of petitioner’s water right is mitigated by the fact that
                                - 30 -

petitioner would still be able to sell water to others in the

event that a transfer did not occur.     Although the changes the

1997 legislature would impose on the regulation of water in the

Colorado River Basin were unforeseeable as of the valuation date,

the regulatory and legislative risks affecting the Corpus Christi

transaction were not so great as to require a 30-percent discount

rate.     Given that petitioner had a buyer and a purchase price set

before the valuation date, a 15-percent discount, as Mr. Scheig

used, sufficiently factors in the regulatory and legislative

risks.

     After 3 years of monthly payments, plus the payments that

were made before the valuation date, the balance due at closing

of $450 per acre foot would be $13,810,000.     Discounted at 15

percent, the value of this closing payment is $9,080,299.

Therefore, the total value of the Corpus Christi component,

including the monthly payments, is $9,853,428.

     C.      The Unused Water

        After providing 100,000 acre feet of water to its irrigation

customers and 35,000 acre feet to Corpus Christi, petitioner had

the right to use 33,000 additional acre feet of water (the unused

water) from the Colorado River.     In the several years leading up

to the valuation date, the unused water flowed past petitioner’s

diversion point.     There was no evidence that petitioner’s

irrigation customers, the rice farmers, anticipated a need for
                                - 31 -

the unused water in the future; on the contrary, as we explained

above, irrigation use was expected to decrease.      The unused water

was available to be sold or leased by petitioner at any time and

had value as of the valuation date that must be included in our

analysis.   Respondent argues that it was foreseeable that the

LCRA would be the most likely purchaser of petitioner’s water

right and that the LCRA would be willing to pay up to $600

million for the water because its alternative was to spend $600

million for a new reservoir.    Respondent also argues that there

was merely a remote chance that approval would not be obtained

for a sale of the unused water because it was obvious that no

harm would be caused by a transfer.      Petitioner contends that

because there were no active purchasers pursuing its water at the

valuation date, there was no market at all for the unused water,

and it was not foreseeable that it would be sold.      We believe

that at the valuation date, a reasonable prediction fell

somewhere between the parties’ respective positions.

     Any sale or transfer of the unused water outside the

Colorado River Basin or for nonirrigation use would face the same

regulatory hurdles that were present in the Corpus Christi

transaction.   Any future sale of the unused water would also face

legislative risk and would presumably be subject to any changes

made by the 1997 legislature.    In addition, because there were no

active buyers for the unused water as of the valuation date, a
                              - 32 -

sale was more uncertain and would likely take place later than

the Corpus Christi transaction.   As we did in the Corpus Christi

valuation, we must now determine the appropriate and foreseeable

base price, time delay, and discount rate for a sale of the

unused water.

     In Mr. Lloyd’s valuation of the unused water, he assumed a

base price of $250 per acre foot of water based on the report of

an engineering and valuation consultant estimating the price the

LCRA could derive from a sale of petitioner’s water right.     He

assumed that it would take 6 years to find a buyer for the unused

water and obtain regulatory approval for a sale.   He factored in

3-percent inflation and discounted the price by 40 percent to

reflect private equity returns at the valuation date.

     Mr. Scheig began with a base price of $600 per acre foot for

the water right, based on two transactions from other basins near

the Colorado River Basin.   He applied a 15-percent discount for

lack of marketability to the base price.

     Mr. Camp used a base price of $783.39 per acre foot, derived

from various adjustments made to a price of $105 charged by the

LCRA to its customers.   His base price took into account 3-

percent inflation and a cost of capital of 8 percent.   Mr. Camp

then reduced the base price by 10 percent for the lack of a ready

market in Texas for water contracts and 30 percent for regulatory

risks.
                              - 33 -

     We are not persuaded by the experts’ analyses.   Mr. Lloyd

and Mr. Camp based their high discount rates on the premise that

there were no potential buyers for the unused water as of the

valuation date.   The LCRA was a potential buyer.   The LCRA’s

interest in petitioner’s water right over the 30 years before the

valuation date should be considered in valuing the unused water.

Mr. Kowis, an employee of the TNRCC and its predecessor agencies

for 27 years, testified that as of 1996, the LCRA was the most

logical potential buyer for petitioner’s water, and he was not

surprised by the ultimate sale to the LCRA for $75 million.      Mr.

Rose, the general manager of the LCRA who negotiated with Mr.

Lehrer, testified that discussions had halted because Mr. Lehrer

was interested in selling only a portion of petitioner’s water

right, and the LCRA was interested in acquiring the entire water

right.   It is apparent that the actual sale that occurred was in

part the result of Mr. Lehrer’s change in position on this issue

and in part the result of changes in the political landscape.

The valuation of the unused water must take into account the

potential for a purchase by the LCRA.

     Mr. Scheig’s use of transactions in the Rio Grande and other

basins near the Colorado River Basin as comparables is flawed.

At trial, Mr. Scheig admitted that the market conditions in the

Rio Grande were very different from those in the Colorado River

Basin.   Unlike the uncertainty surrounding the conversion of
                              - 34 -

irrigation water to municipal water in the Colorado River Basin,

the Rio Grande operated with a stable and predictable marketplace

and regulatory umbrella.   In addition, the market and regulatory

conditions in petitioner’s specific service area are key to the

valuation of petitioner’s water right.     Mr. Scheig admitted that

he did not examine the regulatory situation, transporting of

water, or infrastructure of water districts involved in the

transactions that occurred in the other basins near the Colorado

River Basin.

     The most reasonable approach to establishing a base price

for the unused water is to examine comparable transactions.     The

only comparable transaction that occurred in petitioner’s service

area within the relevant time period was the Corpus Christi

transaction.   The sale to Corpus Christi was an arm’s-length

transaction, and the price was established through negotiations.

When the price was agreed upon and when the option was exercised,

the parties were aware of the regulatory requirements that would

need to be fulfilled, as well as the legislative risks.

Therefore, it is reasonable to use the price established by the

parties to the Corpus Christi transaction, $450 per acre foot, as

a base price for the unused water.     We must now decide the

appropriate discount rate to apply.

     Several negative factors affected the market for the unused

water.   A buyer had not been identified, so a sale was less
                              - 35 -

certain than the Corpus Christi transaction.    It was unknown what

the 1997 legislature might do, and any resulting legislation

could impede regulatory approval.    Although the LCRA was a

potential buyer for the unused water, it was possible that a sale

would not occur.   The interruptible nature of petitioner’s water

made it less saleable.   This would be a major factor for any

buyer and a municipality would need a backup supply of firm water

for drought periods before it would buy an interruptible supply.

     These negative factors, however, must be balanced against

the possibility that petitioner would be able to sell or lease

the unused water to an inbasin user or a politically powerful

municipal user, which would eliminate much of the regulatory

cost, legislative risk, and delay.     Taking all these factors into

account, we conclude that the base price of $450 per acre foot

for the unused water should be discounted by 17 percent.

     Finally, we must decide how long it might take for

petitioner to sell the unused water.    Petitioner would need to

find a buyer, negotiate an agreement, and complete the regulatory

process.   The experts and other credible witnesses at trial

estimated that the regulatory process alone could take from 1 to

5 years for an interbasin transfer, before factoring in any court

proceedings.   On the basis of the regulatory climate, it was

reasonably foreseeable at the valuation date that any attempted

transfer out of the basin would be opposed by the LCRA and other
                                - 36 -

inbasin users.    We consider a delay of 6 years to be reasonable

for petitioner to complete a sale of the unused water.

     We find that it is reasonably foreseeable that petitioner

would sell 33,000 acre feet for $450 per acre foot (increased for

inflation) 6 years after the valuation date, for a purchase price

of $17,215,220.   Discounting the purchase price by 17 percent,

the value of the unused water at the valuation date was

$6,711,157.

     D.   Potential Unused Water

     As we discussed above, rice farming and the demand for

irrigation water in Texas was expected to decline following the

valuation date.    It was foreseeable that this decline would cause

water formerly used for irrigation to become available for sale

by petitioner for other uses.    The water that would become

available as a result of the decrease in demand (the potential

water) gives additional value to petitioner’s water right.     We

shall decide how much water was expected to become available,

when it was foreseeable that the water would become available,

and a reasonable discount rate.

     Each expert used the same base price he had used for the

unused water analysis.    Mr. Camp accounted for the potential

water by assuming that as 5,000 acre feet of water became

available, petitioner would apply for regulatory approval to

change its use and attempt to sell it.    As we discussed above, he
                                - 37 -

predicted that 20 percent (20,000 acre feet) of petitioner’s

irrigation water would become available over the next 25 years.

In addition to the cost of capital, he discounted the base price

by 10 percent for uncertainty of the availability of petitioner’s

run-of-the-river water, 10 percent for lack of marketability, and

30 percent for regulatory risks.

     Mr. Lloyd’s report did not attribute any value to the

potential water right.   Mr. Scheig’s report weighed the following

three scenarios: (1) A .4-percent annual decline in irrigation

use; (2) a 3-percent annual decline in irrigation use; and (3) a

100-percent decline in irrigation use and sale of all the

irrigation water right within 10 years.   Mr. Scheig discounted

the base price by 15 percent.

     We concluded above that 20 percent of the irrigation water

would become available over 10 years, potentially for other uses.

In valuing the potential water, however, it is unreasonable to

assume that a sale of 2 percent per year was likely.   It is

unrealistic to predict that small increments would be sold as

they became available.   A municipal, industrial, or water supply

purchaser would be unable to obtain funding (through a bond firm)

to develop a conveyance system for a purchase of small quantities

of water on an incremental basis.    Our analysis therefore assumes

that 20 percent of the irrigation water (20,000 acre feet) would

be sold 10 years after the valuation date, and 20 percent of the
                                 - 38 -

remaining irrigation water (16,000 acre feet) would be sold after

another 10 years.

     We use a base price of $450 per acre foot for the potential

water, as we did for the unused water, taking into account

inflation.    The base price for the potential water should be

discounted by a higher rate than that used for the unused water.

It is only by speculation that we assume any of this water will

become available.    The regulatory, economic, and legislative

uncertainty surrounding a future sale of the unused water is

matched, and possibly exceeded, by the speculative nature of the

potential water supply.      Therefore, we conclude that a 20-percent

discount is appropriate in valuing this water.          This scenario

would result in a payment 10 years after the valuation date of

$11,742,959, and a payment 20 years after the valuation date of

$12,625,244.    Applying a discount rate of 20 percent, the value

of the potential water on the valuation date was $2,225,871.

V.   Conclusion

     We conclude that on January 1, 1997, the fair market values

of the components of petitioner’s water right were as follows:

 Irrigation       Corpus        Unused      Potential          Total
                  Christi
 $3,742,062     $9,853,428                 $2,225,871        $22,532,519
                              $6,711,157

While this value is significantly less than the amount paid by

the LCRA after the political climate settled favorably to

petitioner’s position as seller, such result simply was not
                             - 39 -

sufficiently predictable on January 1, 1997, to form the basis

for a valuation.


                                      Decision will be entered

                                 under Rule 155.
