2032(a)(1). Unless otherwise indicated, all section references are to the Internal Revenue Code as amended and in effect as of the date of decedent's death.

FINDINGS OF FACT

Some of the facts have been stipulated, and the facts set forth in the stipulation are incorporated in our findings by this reference. F.G. Holl (decedent) died on December 21, 1985. Bank IV Wichita, N.A. (petitioner), timely filed an estate tax return (Form 706) with the Internal Revenue Service in Austin, Texas. Petitioner's principal office was located in Wichita, Kansas, at the time the petition was filed.

Decedent was an independent oil and gas operator. On December 21, 1985, decedent possessed 342 leasehold interests and mineral interests in producing oil and gas properties. Over 80 percent of the leasehold interests were located in Kansas and accounted for approximately 96 percent of the total appraised value of the interests. The remainder of the interests in oil and gas producing properties were located in Wyoming and Ohio.

Nature of the Oil and Gas Industry

An owner of oil and gas property typically leases property to a lessee who explores for oil and gas on the property. The lessee is entitled to remove any oil or gas discovered during the lease period. If oil or gas is discovered, the lease usually provides for renewal as long as the property continues to produce oil or gas. Interests in oil and gas leases are generally assignable by the lessee in undivided fractional interests.

Leasehold interests are either working interests or overriding royalty interests. Owners of working interests pay the costs and expenses incurred in the drilling, development, and production of oil and gas property. The landowner is entitled to a fractional share of the oil and gas removed from his land and is not responsible for any of the costs of exploration or removal.

Overriding royalty interests, which represent a right to a fraction or percentage of the lessee's share of the minerals,

are sometimes carved out of the lessee's share of the oil and gas removed. Owners of overriding royalty interests generally do not pay any of the costs and expenses. Mineral interests are also referred to as royalty interests. Owners of mineral interests, like owners of royalty interests, generally do not pay any of the costs and expenses associated with the oil and gas property. In the oil and gas business, it is common for parties to hold only a percentage of the entire working interest.

Crude oil and natural gas are located underground. The minerals coexist with water and sand granules in the pore spaces of the reservoir rock. In a high-permeability reservoir that has been in production for a period of time, each quantity, or barrel, of oil in the entire reservoir has the effect of pushing the next barrel of oil to the surface. Practically speaking, it is not possible to identify the particular barrel of oil in-place that will be the next barrel produced and brought to the surface. It is possible that the oil that is a distance from the well bore may be pushed to the surface before the quantity that is nearer the well, although oil closer to the well bore is more likely to be produced next.

There is often a delay between the time oil is produced and the time it is sold. The frequency of oil sales is related to the capacity of the well to produce, storage facilities on the leased property, and other factors. If oil is sold by means of a pipeline connection, sales may occur every other day. If oil is transported by truck, the sale occurs when the oil is drawn from the storage tank; the frequency of sales varies between 1 and 3 times a month.

Valuation of Oil and Gas Property

Petitioner elected to value the gross estate as of the alternate valuation date under section 2032(a). Petitioner reported that the fair market values of the producing oil and gas interests as of the date of decedent's death and on the alternate valuation date were $8,958,676 and $3,091,977, respectively. The marked decline in the value of the interests was primarily attributable to a sharp decrease in the price of crude oil during that period. During the 6-month period following decedent's death, the price paid

for crude oil in Kansas, by a large Kansas purchaser, dropped from $28 per barrel to $13 per barrel. The price of gas during this period was also generally decreasing.

Petitioner determined the in-place value of the producing oil and gas interests as of the alternate valuation date by employing one of the accepted methods in the industry for valuing oil and gas properties. That methodology represents an estimate of the price at which the property would exchange hands between a willing buyer and a willing seller. There are three basic steps in this method of valuation, referred to as the discounted future net cash-flow method. First, the projected net cash-flow from the property is determined. The amount of reserves, the oil and gas to be produced over the economic life of the property, is estimated. This amount is applied to the projected price of oil and gas over the economic life of the lease to produce a future cash-flow. Future operating expenses and projected ad valorem and severance taxes are deducted to generate the future net cash-flow.

Second, the projected future net cash-flow is discounted to its present worth on the date of valuation. The discount rate is generally 1 percent above the prime rate where the leased property is located. The average prime rate in Wichita, Kansas, between decedent's date of death and the alternate valuation date was 9 percent.

Third, the present worth of the projected net cash-flow is reduced by an appropriate risk reduction factor. The risk reduction factor is a confidence factor that measures the uncertainty inherent in projecting the future cash-flow from the property interests. This reduction factor reflects the profit or the rate of return that the investor expects to receive from the property. After being adjusted by the risk reduction factor, the fair market value of a producing oil and gas interest is usually between 65 percent and 80 percent of the present value of the future net cash-flow. The internal rate of return on a producing oil and gas interest is generally in the range of 20 percent to 30 percent but can be as high as 35 percent.

The risks that are associated with an oil and gas property are categorized as technical, economic, and political risks. Technical risks are risks involved in predicting future

production and recovery operations. Economic risks are risks involved in predicting future product prices, expenses of recovery operations, and interest rates. Political risks are risks involved in predicting future tax liabilities and the ability to operate in a foreign country or in environmentally sensitive areas. The risks are cumulative in that they are estimated over the life of the property. The risk factor, however, is not proportional to time. That is, the risks associated with projecting the income over the economic life of the property increase over time. Accordingly, the risk reduction factor is lower in the earlier part of the projection.

An alternative method of valuation, the cumulative net cash-flow method, is also standard in the industry. Under this approach, the appraiser prepares a net cash-flow based on the same factors used in the first step of the discounted future net cash-flow method. The undiscounted cash-flow is accumulated over a certain period of time. The time period is generally shorter than the life of the lease.

Petitioner received $980,698.47 in net income from sales of oil and gas between the date of decedent's death and the alternate valuation date. Petitioner reported on its estate tax return that the value of the oil and gas produced and sold between the date of decedent's death and the alternate valuation date was $686,488.93. Respondent determined that the value was $930,839.76.

OPINION

Petitioner bears the burden of proof. Rule 142(a), Tax Court Rules of Practice and Procedure. Property included in the gross estate is generally included at its fair market value on the date of a decedent's death. Sec. 2031(a); sec. 20.2031-1(b), Estate Tax Regs. Fair market value is defined as the price at which property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of all relevant facts. United States v. Cartwright, 411 U.S. 546, 551 (1973); sec. 20.2031-1(b), Estate Tax Regs. Fair market value is a question of fact and the trier of fact must weigh all relevant evidence and draw appropriate inferences. Hamm v. Commissioner, 325 F.2d 934, 938 (8th Cir. 1963), affg. a Memorandum Opinion of this Court;

Estate of Andrews v. Commissioner, 79 T.C. 938, 940 (1982).

An estate may elect to determine the fair market value of the gross estate as of an alternate valuation date. Section 2032(a) provides as follows:

SEC. 2032(a). GENERAL.-The value of the gross estate may be determined, if the executor so elects, by valuing all the property included in the gross estate as follows:

(1) In the case of property distributed, sold, exchanged, or otherwise disposed of, within 6 months after the decedent's death such property shall be valued as of the date of distribution, sale, exchange, or other disposition.

(2) In the case of property not distributed, sold, exchanged, or otherwise disposed of, within 6 months after the decedent's death such property shall be valued as of the date 6 months after the decedent's death.

The purpose of section 2032(a) is to permit a reduction in the amount of tax that would otherwise be payable if the gross estate has suffered a shrinkage in its aggregate value between the date of a decedent's death and the alternate valuation date. Maass v. Higgins, 312 U.S. 443, 446 (1941); sec. 20.2032-1(b)(1), Estate Tax Regs.

The assets to be valued on the alternate valuation date include all property interests that existed on the date of a decedent's death and are a part of the gross estate as determined under sections 2033 through 2044. Sec. 20.20321(d), Estate Tax Regs. Those assets are referred to as "included property." Sec. 20.2032-1(d), Estate Tax Regs., also provides that:

such property interests remain "included property" for the purpose of valuing the gross estate under the alternate valuation method even though they change in form during the alternate valuation period by being actually received, or disposed of, in whole or in part, by the estate.

The parties agree that the proceeds derived from oil and gas reserves produced and sold between the date of decedent's death and the alternate valuation date are "included property." They also agree that the value of the oil and gas produced during the interim period for Federal estate tax purposes is the in-place value of those reserves on the date of severance. The parties have applied different