A major issue in the Dallas opinion involved tax affecting S Corporation earnings.
Given the importance of this topic, we will review prior opinions, discuss the major
aspects of the controversy and provide our perspectives on this topic. Prior to Dallas,
four noteworthy cases addressed the issue of tax affecting S Corporation earnings, as
follows:
The tax affecting issue is also complicated by other factors, including, but not
limited to, whether or not one is valuing a controlling or minority interest, the level of
distributions to shareholders and assumptions about the hypothetical willing buyer and
seller. These factors lead some in the financial valuation community to submit that S
Corporations do have advantageous characteristics compared to C corporations that should
be considered, something the Tax Court noted in the Wall opinion.
We believe that sound economic principles require tax affecting S Corporation earnings.
Our view is based on the comparability principle which asserts that pretax earnings must
be matched with pretax multiples and after tax earnings must be used with after tax
multiples, where pretax and after tax earnings are economically different. However, in any
valuation, the appraiser must thoroughly analyze the relevant factors for their impact on
value, and our view includes a careful analysis that considers the advantageous
characteristics inherent in an S Corporation.
The fair market value of non-voting common stock in an operating S-corporation was
addressed by Judge Colvin in this case. Mr. Dallas made transfers by sale to trusts for
the benefit of his sons in 1999 and 2000 and received cash and promissory notes with
self-canceling provisions in exchange for Class B non-voting shares of Dallas Group of
America, Inc. (“DGA”) stock. The Judge concluded that the prices paid for the
DGA shares did not represent arm’s-length transaction prices, subjecting the
transactions to review for gift tax purposes.
The central issues in the valuation of the stock included whether the earnings should
be tax affected; was it appropriate to make salary adjustments in the context of a
minority interest valuation; minority interest and lack of marketability adjustments; and
whether to adjust for the difference in value of voting versus non-voting stock. Judge
Colvin found little support in the taxpayer’s expert reports and said the IRS
expert’s report and comments were “cogent and thorough”.
The Judge (a) denied the salary adjustments, since a minority buyer could not impose
such a change; (b) applied a 15% minority interest discount to DGA’s non-operating
assets and a 20% minority discount on the operating assets; (c) allowed for no distinction
between voting versus non-voting shares; and (d) allowed a 20% lack of marketability
adjustment. The final values derived were just below the mid-point of the average of the
taxpayer’s and IRS experts.
COMMENT: MPI was one of the experts representing the taxpayer. While the
debate continues on tax affecting S-corporations, we believe that the right approach in a
company like DGA is tax affecting the earnings and, if necessary, the multiples applied to
those earnings. In our experience, the 20% discount for lack of marketability for a
minority interest value in an operating company is low.
The Tax Court’s majority decision rejecting a “defined value” formula
clause used in the valuation of gifts of interests in a family limited partnership has
been reversed. The Fifth Circuit approved gifts of a dollar amount equal to the appraised
fair market value of limited partnership interests reduced by (1) gift taxes assumed by
the donees and (2) the “mortality driven” discount attributable to the
donees’ conditional liability for estate taxes in case a donor failed to live three
years (Code Section 2035).
The IRS did not make “form over substance” or “violation of public
policy” arguments against formula clauses.
The Tax Court erred in relying on the donees’ percentage allocation agreement two
months after the date of the gifts and in denying the Section 2035 reduction.
COMMENT: The formula clause was designed to provide a gift tax charitable
deduction for any increase in the value of the limited partnership interests. Acceptance
of the clause meant that a combined valuation discount of 49% in valuing the interests as
“assignee” interests was allowed to stand. The partnership’s assets were
marketable securities, interests in real estate limited partnerships and oil and gas
interests.
Mr. Kohler died March 4, 1998, owning 12.85% of the stock of Kohler Co., a well-known
manufacturer of plumbing and other products. His executors elected to value the stock as
of the alternate valuation date, September 4, 1998, which was four months after a
corporate tax-free reorganization under which shares with restrictions (transfer and
purchase option) were received in exchange for the old shares. The IRS argued the
reorganization should be disregarded (use the pre-reorganization value) or, alternatively,
the new restrictions should be ignored, for valuation purposes. The Court disagreed,
saying the reorganization was neither a “change in form” or
“disposition” under Code Section 2032, the real intent of which was “to
address changes in value caused by market forces.”
Judge Kroupa gave no weight to the valuation of Kohler stock by the IRS expert, which
was $100 million higher than the estate’s value. His lack of credentials
(non-membership in the American Society of Appraisers or the Appraisal Foundation),
failure to abide by Uniform Standards of Professional Appraisal Practice (USPAP), lack of
customary USPAP certification and $11,000,000 overvaluation error were emphasized in the
opinion.
This case is about relying on prior shareholder stock transaction prices to value gifts
of stock.
Ernst & Young provided annual valuations of Huber Corp., a diversified operating
company, for the following purposes:
· Valuing gifts to nonprofit organizations
· Valuing CEO’s stock options
· Fixing compensation of board members
· Evaluating the company’s performance
· Valuing shareholder redemptions
The Court said all four requirements from the Ninth Circuit Morrissey* case
had been met in ruling that the shareholder transactions using E&Y’s price were
at arm’s length and “the best reference” for valuing Huber shares for gift
tax purposes. In reviewing the facts surrounding 90 transactions over the previous five
years, Judge Goeke found that (1) the parties were often unrelated or not closely related,
(2) the sellers were not pressured to sell, (3) donative intent was not seen in the
transactions, and (4) the parties reasonably relied on the E&Y appraisal.
The IRS was too focused on transactions where parties were closely related:
“We therefore conclude that the existence of close family relationships between
parties of some of the 90 sales transactions in the record is neutralized by the
fact that many of the transactions took place between parties that were hardly related or
unrelated and who had fiduciary obligations to obtain the best price. We view the variety
of relationships among the shareholders in Huber as a positive indicator of the existence
of arm’s length sales.”
*243 F.3d 1145, revg.
T.C. Memo. 1999-119.
Mrs. Amlie owned a significant minority block of stock in a bank. Her
court-appointed conservator, mindful of fiduciary responsibility, potential capital gains
taxes, litigation costs and liquidity needs, spent several years pursuing agreements
fixing a price and buyer for the stock. An agreement was finally reached in 1995 whereby
the stock would be sold for $118 per share to a son’s trust. The conservator had
consulted with a valuation professional as to the fairness of a $118 price. Two years
later the son’s trust and the bank agreed the stock would be redeemed for at least
$217.50 per share. Mrs. Amlie died in 1998. The stock was reported for estate tax purposes
at the $118 per share price received by the estate. The IRS assessed a deficiency based on
the trust’s redemption proceeds, stating that the 1995 agreement did not meet the
requirements of Code Section 2703 and should be disregarded.
Section 2703 states that any agreement to acquire property at less than fair market
value will be disregarded unless it is binding on the parties before and after death, its
restrictions have a bona fide business purpose and are not substitutes for a testamentary
disposition, and the agreement is comparable to those of similar arm’s length
arrangements.
Although Judge Gale carefully reviewed the facts for each requirement separately, there
were recurring themes throughout his discussion. For example, the conservator’s
reliance on professional valuation advice and the risks of potential litigation with the
bank were prominently mentioned in the “testamentary disposition” and
“comparable arm’s length arrangements” sections. A fiduciary obligation to
exercise prudent management when holding a minority interest in a closely held business
was a “bona fide business purpose” for securing the 1995 agreement. As for the
inadequacy of a $118 price compared to $217.50, the Judge said:
Needless to say, all 2703 issues were decided in the estate’s favor.
Arthur Temple transferred assets worth over $34 million to his children and
grandchildren in 1997 and 1998 by way of gifts of non-controlling interests in an LLC and
three limited partnerships. The assets were real estate in Texas and California and
Temple-Inland and Time Warner stock. The gifts were valued using a combined discount of
58.75% (25% minority interest and 45% lack of marketability).
California real estate LLC
60.0%
Texas real estate partnership
38.0%
Marketable securities partnerships
21.3% (6/97)
15.4% (1/98)
