MPI - Business Valuation Reports

Article: "CHANGES TO S CORPORATION RULES "

Cases:
· Barudin (T.C. Memo 1996-395)
· McClatchy(106 T.C. No. 9)
· Scanlan (T.C. Memo 1996-331)
· Bonner (84 F. 3d 196 (CA5 1996))
· Wheeler (77 AFTR 2d 96 (1995 DC TX))
· Cloutier (T.C. Memo 1996-49)

MPI VALUATIONS: A CASE STUDY

CHANGES TO S CORPORATION RULES

S corporations have long provided a major benefit to business owners - one level of tax on profit - but estate planning options were restricted by the number (35) and type (only individuals and certain trusts) of shareholders. The Small Business Job Protection Act, signed in August 1996 (and effective for tax years after 1996), eliminated many of the old restrictions and provides certain new options.

Electing Small Business Trust (ESBT) - This new trust may have several beneficiaries, each counted as a shareholder. The turst is not required to distribute income, and it may acquire stock only by way of gift or bequest and not by a purchase. The trust will, however, be subject to incmoe tax at the highest individual marginal rate (39.6%).

ESOPs - ESOPs can own S stock, but without the tax advantages granted with respect to C corporation stock (deductibility of ESOP contributions, the ESOP dividends deduction and the Section 1042 tax-free rollover of gain).

Number of Shareholders - Previously limited to 35 shareholders, an S corporation may now have 75 shareholders (husbands and wives, and their estates, count as one shareholder).

Charitable Organizations - Starting in 1998, qualified charitable organizations may qualify as S corporation shareholders. This changes will facilitate charitable donations of S stock but ownership of the stock may, in certain circumstances, create tax problems for the charitable organization. Some of these changes, and others not mentioned, may be advantageous to S corporation owners. The new legislation did not go so far, however, as to put S corporations on a level playing field with other pass-through entities such as LLCs and limited partnerships. A current valuation of tangible and intangible assets can be very important for a business planning an S corporation election.

RECENT VALUATION DECISIONS

Estate of James Barudin v. Commissioner, T.C. Memo 1996-395. Filed August 26, 1996.

The estate tax value of one of the 95 ownership units of a general partnership owning commercial real estate in New York City was the issue here. In allowing a combined minority and marketability discount of 45% from "net liquidation value," Judge Swift said a general partner's right to dissolve under New York law "would have little impact" since one of the general partners owned a majority of the units and effectively controlled the partnership. The decision probably would have been less favorable for the taxpayer had there been no majority partner so this is not necessarily a good case despite the discount allowed.

The taxpayer's expert relied on a prior sale of a fractional interest to justify a combined discount of 67.5% while the government's 28% combined discount was derived from "various market studies." Interestingly, 45% is just below the mid-point between the taxpayer's and government's numbers. The court rejected the prior sale as an indication of value because not enough facts about its circumstances were presented. On the other hand, a 28% discount did not reflect the absence of a voice in managing the partnership's affairs.

COMMENT: Last year's McCormick decision (T.C. Memo 1995-371) also involved a minority partner in a general real estate partnership. As in New York, governing North Dakota law permitted a general partner to liquidate at will. We like McCormick better than Barudin, not only because of our expert testimony in the case, but there was no controlling partner and yet the court still allowed substantial discounts, saying a buyer would not purchase a minority interest in order to force a liquidation.

Estate of Charles K. McClatchy v. Commissioner, 106 TC No. 9. Filed April 3, 1996.

Charles K. McClatchy, Chairman, CEO and director of McClatchy Newspapers, Inc., owned unregistered shares of stock in his company which were subject to volume and manner of sale restrictions under Rule 144 of the Securities Act of 1933. The restrictions applied during his lifetime, as he was an "affiliate" under Rule 144, but lapsed when affiliate status was lost by reason of his death in April, 1989. The IRS conceded that securities law restrictions reduced the stock's value for gift tax purposes but argued against any discount for estate tax purposes. Unfortunately for the McClatchy family, this was an estate tax case and the court used a "moment of death" valuation approach in handing a clean victory to the IRS.

If the McClatchy family appeals, they will have to file in the Ninth Circuit where the Ahmanson case was decided. In Ahmanson, a corporate shell with no assets during the decedent's lifetime received valuable stock "at the precise moment of death" pursuant to certain declarations of trust and was valued accordingly. The following language from the Land case, a Fifth Circuit decision, is cited in both Ahmanson and McClatchy:

"Brief as is the instant of death, the court must pinpoint valuation at this instant -- the moment of truth . . . It is a fallacy, therefore, to argue value before -- or after death on the notion that valuation must be determined by the value of the interest that ceases or of the interest that begins. Instead, the valuation is determined by the interest that passes. . . "

Unless there is a successful appeal, the denial of an approximate 21% discount will cost nearly $5,800,000 in estate taxes, plus penalties and interest. In the meantime, the Tax Court's view is that McClatchy Newspapers stock unencumbered by securities law restrictions was the "interest that passed."

COMMENT: Owners of unregistered and restricted public stock might be advised to treat the McClatchy decision as a warning signal and consider a gift program, particularly where their estates may not qualify as "affiliates." MPI has prepared a large number of restricted stock studies over the years. We are also proud of the expert testimony we provided in the landmark Gilford Tax Court case [Estate of Saul R. Gilford v. Commissioner, 88 T.C. No. 4 (1987)].

Estate of Arthur G. Scanlan v. Commissioner, T.C. Memo 1996-331. Filed July 24, 1996.

Can a 1994 redemption price based on a 1993 control value be used in determining a stock's minority interest value as of two dates in 1991? Judge Laro thought so, just as long as the redemption price was "harmonized" to account for passage of time, new financial data and lack of control and marketability.

Gift (April, 1991) and estate (July, 1991) tax values of Eatel, a telecommunications company, were disputed in this case. In September, 1992 Eatel's board of directors solicited offers for the company and in March, 1993 an offer was received to buy all of Eatel's stock for $75.1555 per share. The Scanlan family, owners of 37.1% of the outstanding stock, decided to exercise their right of first refusal which led to the company's redemption of stock owned by all other shareholders in January, 1994 at the same price as the March, 1993 offer.

The government reduced the redemption price by 4% in concluding a value of $72.15 per share for both the gift and estate. The estate's expert, an investment banker, relied on a two page update of his 1989 minority interest study. His gift tax value was $34.84 and estate tax value $35.20. Judge Laro's opinion give several specific reasons why the investment banker's values were rejected. There is no point in listing the reasons here but it will suffice if we say that they resulted from lack of preparation and inadequate support for assertions made in the update and during testimony.

Judge Laro thought the government was wrong, too, but like the government, used the redemption price as his starting point, stating that arm's length sales "at or around the time of valuation" are the "best indicator" of value. He then reduced the redemption price by 30% to account for "time . . . , the change in the setting . . . (and) marketability and minority discounts" and held that the date of death value, as well as the date of gift value, was $50.50885 per share.

COMMENT: It seems incredible to us at MPI that, given the risks associated with pursuing a matter into Tax Court, the taxpayer's valuation expert would submit no more than a two page update of a two year old report. Values in the update might well have been upheld had they been more adequately supported.

Estate of Bonner v. Commissioner, 84 F.3d 196 (CA5 1996). Filed June 4, 1996.

The Fifth Circuit reversed a district court decision which had denied a fractional interest discount on undivided interests in real and personal property owned outright.

The decedent died in 1989, owning 50% undivided interests in New Mexico real estate and a pleasure boat and a 62.5% undivided interest in a Texas ranch. His taxable estate also included the remaining interests in those assets held by a QTIP trust under the Will of his wife who had died in 1986.

The government's argument that interests in the QTIP trust and the outright interests merged at death was rejected. The court's reasoning was since the decedent had no control over disposition of the assets in the QTIP trust, they should be valued separately.

The estate had claimed a 45% discount in valuing the interests held outright while the QTIP's remaining interests were apparently not discounted. The Fifth Circuit's language could be read to allow discounts on the latter as well. The case was remanded to the district court where the estate will presumably claim discounts on all interests.

Estate of Wheeler v. United States, 77 AFTR 2d 96 (1995 DC TX).Filed December 4, 1995.

A minority interest discount of 10% was allowed in determining the estate tax value of 50% of the voting stock in a family owned company.

Elmore K. Melton, Jr. was sole shareholder, president and chairman of The Melton Company prior to 1983 when he began a program of making gifts of voting and non-voting stock to his two sons. When he died in 1991, he still had 50% of the voting stock while each of his sons owned 25% of the voting stock and 50% of the non-voting stock. Minority and marketability discounts of 10% and 25%, respectively, reduced the value of Mr. Melton's stock on the original estate tax return. The government contended that 50% was not a minority. It also argued that the estate, having been granted a 25% marketability discount, was not entitled to an additional 10% minority discount. The court said:

". . . the minority discount is . . . based upon lack of control. A shareholder with 50% of the stock can block action by other shareholders but does not have a sufficient interest to control corporate affairs. Where indications of value are predicated upon control or complete ownership, a discount must be applied to provide indications of value for a minority or less-than-controlling interest. "

". . . a minority discount and a discount for lack of marketability are conceptually different, and an award of the latter does not preclude application of the former."

COMMENT: The size of the minority discount in the Wheeler case is of no importance. What is important is judicial recognition of the concept that a 50% block lacks control, the essence of a minority interest discount. MPI valuation studies have always treated 50% interests as minority positions with a veto power and valued them accordingly.

Estate of Joseph R. Cloutier v. Commissioner, T.C. MEMO 1996-49. Filed February 13, 1996.

The Cloutier estate and the IRS stipulated a pre-discount estate tax value for a 100% interest in a holding company, the principal asset of which was an NBC television affiliate in Ft. Wayne, Indiana. The only issue was whether a discount for lack of marketability could be deducted from the agreed amount. While acknowledging that marketability discounts are often appropriate in valuing 100% stock interests in closely held corporations, the court said the discount could not be used where there was no indication of a relationship between the agreed value and the prices of publicly traded stock of companies in the same or a similar business. A review of appraisals submitted by both parties showed a reliance on prices from industry acquisition transactions. Accordingly, since "unlisted stock" had not been valued "by reference to the price of listed stock," a marketability discount was not warranted.

COMMENT: The opinion by Judge Laro has an implicit cautionary note for those who use appraisers and provides further insight into the applicability of marketability discounts to valuations of controlling interests. The estate's expert, an accountant, had favored a 25% discount in his three-page report which the court said consisted mainly of "bald assertions." The court was highly critical of the expert's lack of detail and "meaningful discussion."

Management Planning, Inc. was retained by the Executor of an estate in early 1992 to determine the fair market value of a 49.8% block of common stock in a real estate holding and development company. The company’s assets consisted of office buildings leased to third parties and raw land held for future development. Appraisals obtained at the time valued the company’s adjusted net asset value at $26 million. For income tax purposes, the company was a C corporation, and the estate was in a fully taxable position.

MPI determined that the block should be valued at a 72% discount from underlying net asset value for estate tax purposes. Our minority interest discount was based on our REIT approach and our lack of marketability discount was based on our restricted securities analysis.

The estate was examined in 1995 and the field agent for the Internal Revenue Service sent our appraisal to the National Appraisal Office for review. The agent offered a settlement at a combined discount of 70% from net asset value. The case was settled.

Though most minority and lack of marketability discounts are not this substantial, MPI valuations have supported hundreds of discounted values in many different industries and circumstances. Our thorough, fully documented reports have always been accepted by the Internal Revenue Service without the need for Tax Court.

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