Article: "THESE ARE THE GOOD OLD DAYS! "
Favorable environment for taxpayers with strong appraisals
Cases:
· Smith (T.C. Memo 1999-368)
· Gross-Linneman (T.C. Memo 1999-254)
· Simplot (112 T.C. No.13)
· Davis (110 T.C. No. 35)
· Eisenberg (No.97-4331 (CA2,8/18/98))
· Jameson (T.C. Memo 1999-43)
· Mellinger (112 T.C. No.4)
· Nowell (T.C. Memo 1999-15)
· Adams (83 A.F.T.R. 2d 99-1887)
· Kaufman (243 F.3d 1445, 87 A.F.T.R.2d 2001-1250)
THESE ARE THE GOOD OLD DAYS!
Favorable environment for taxpayers with strong appraisals
The valuation environment, as reflected in the cases in this issue, has never been better for taxpayers and worse for the IRS. The courts have been demanding better work from appraisers and, at least in some cases, taxpayers’ appraisers have provided highly supportable conclusions. While we believe ending up in court is a failure (we have never had to go to court when we were retained at the outset of a valuation issue), the only reason to try a valuation case is to win.
MPI did go to trial to assist the Estate of Helen J. Smith, and came away with Judge Gale’s acceptance of our combined 76% minority and marketability discount on a real estate investment company. Capital gains discounts have been accepted in Davis and in the Eisenberg appeals case, confirming what we have been doing for many years. In Mellinger and Nowell, the courts have refused to aggregate ownership blocks of stock in separate trusts, allowing discounted minority values. The IRS has been refuted and state law respected in Adams and Nowell, decisions which valued limited partner interests as assignee interests and further support deductions of discounts. In Nowell, discounts of up to 65% were presented in valuing assignee interests. In all of the cases discussed, substantial marketability discounts, when well supported, have been accepted by the courts. In our practice, we have obtained many very good results in discussions with revenue agents and appellate conferees.
RECENT VALUATION DECISIONS
Estate of Helen J. Smith v. Commissioner, T.C. Memo
1999-368.Filed November 5, 1999.
The Spirit of 76%!
Helen Smith died January 25, 1993 with minority interests in two closely held corporations: Jones Farm, Inc. and First National Bank of Waverly.
Mrs. Smith’s one-third interest in Jones Farm, Inc., an S corporation owning a 1,300-acre farm in southern Ohio, was valued for estate tax purposes by MPI at $439 per share. The IRS was at $1,029 per share. Our price, based on a weighted valuation approach of net asset value (70%) and earnings (30%), was accepted. We used a 50% minority interest discount, applied a 26% capitalization rate to earnings and deducted a 35% discount for lack of marketability (even the IRS expert used a 36% marketability discount). The effective overall discount from net asset value was 76%. Judge Gale said the report of the MPI expert witness was "very persuasive and well supported by his underlying reasoning."
Mrs. Smith owned 12% of the stock of First National Bank of Waverly, a community bank. MPI valued the stock at $73 per share. The IRS said $159.73 would be the lowest price a willing seller would accept, having deducted a 10% marketability discount and arguing that 12% was a "swing block." Judge Gale rejected the IRS swing block argument because it did not consider a hypothetical buyer. MPI’s 35% discount for lack of marketability was accepted and our expert’s pre-discount valuation was described as "cogent and persuasive."
COMMENT: In valuing companies with high net asset value and low earnings returns, like Jones Farm, Inc. (or ranches, orange groves and other farming operations), large discounts are fully justifiable. The court’s agreement with our conclusion of a 76% discount is gratifying. The IRS attempt to use only an asset approach, without regard to earnings approaches, was solidly refuted. We should note, though, that the IRS expert’s conclusion was an overall discount of 43%.
Gross-Linneman v. Commissioner, T.C. Memo 1999-254. Filed July 29, 1999.
This case concerns the gift tax value of small minority blocks of the stock of an S corporation, G&J, a Pepsi Cola bottler and distributor. The case’s major issue (and lesson) pertains to the valuation of S corporations.
The opposing appraisers both used discounted cash flow valuation approaches. The taxpayer appraisal deducted C corporation taxes from the reported, untaxed S corporation earnings. The IRS appraiser did not deduct taxes. The tax adjustment accounted for most of the difference between the lower taxpayer appraisal and the higher IRS appraisal. The court rejected the taxpayer’s arguments, based in part on published IRS valuation guidelines, in support of the C corporation tax adjustment.
In resolution, Judge Halpern correctly observed that an after-tax capitalization rate should be applied to after-tax cash flow, and a pre-tax capitalization rate should be applied to pre-tax cash flow. With correctly applied capitalization rates, the valuation result would be the same regardless of whether pre- or post- tax capitalization rates are used (a capitalization rate converts earnings into value). The judge decided that the winning IRS appraiser correctly applied a pre-tax capitalization rate to pre-tax cash flow.
COMMENT: The rate applied by the IRS appraiser to pre-tax cash flow looks a lot like an after-tax cap rate, but who are we to judge?
Opinions vary widely on the applicability of discounts or premiums in S corporation valuations. No premiums were advocated in this case. This decision does not provide definitive guidance on S corporation issues, but you can expect the IRS to raise more challenges to S corporation appraisals, particularly when C corporation taxes have been deducted in the appraisal exercise. The taxpayer lost here because the IRS had a more convincing appraiser, a rare occurrence.
Estate of Richard R. Simplot v. Commissioner, 112 T.C. No. 13.Filed March 22, 1999.
Richard R. Simplot died in 1993 owning 23.55% of the voting stock and 2.79% of the nonvoting stock of J.R. Simplot Co., a major agribusiness company (supplies McDonald’s with french fries). With a ratio of voting stock to nonvoting stock of 1 to 1,848, the voting shares had diminimus equity. Both classes would be treated equally in the event of a sale of the company.
The estate’s position was that the voting and nonvoting shares were "functionally equivalent" because they did not represent voting control and should have the same value per share. The IRS presented testimony in support of a voting power premium of from 3% to 10% of the company’s entire market value.
Judge Jacobs was convinced that the skewed capitalization merited a premium for the class of voting stock equal to 3% of the company’s $830,000,000 freely traded value. This produced a freely traded value of $331,596 per voting share and $3,417 per nonvoting share, a ridiculous result. Even after a 35% marketability discount, the voting stock per share value exceeded any reasonable estimate of its potential sale/merger value per share, the most anyone would pay for the shares.
COMMENT: We see many extreme ratios of voting to nonvoting shares. Such capitalizations, as in Simplot, create valuation uncertainty and the risk of unreasonable results. It is expected that the estate will file a Notice of Appeal by the first of the year.
Both parties’ experts deducted the full amount of potential capital gains tax
liability on a non-operating asset (5.3 million shares of Micron Technology) in
calculating its contribution to the company’s minority interest value. The deduction
never became an issue in the case. We regard this as significant and another step in the
right direction after the groundbreaking Davis and Eisenberg cases.
Estate of Artemus D. Davis v. Commissioner, 110 T.C. No. 35. Filed June 30, 1998
The Tax Court has finally handed down a decision clearly allowing a taxpayer to consider built-in capital gains taxes in valuing C corporation stock.
Artemus Davis, a founder of Winn-Dixie Stores, made minority gifts (25.77% each) of stock in a family investment holding company to two sons in November 1992. The company's largest asset was Winn-Dixie stock worth over $70,000,000 on the valuation date but with a cost basis of only $338,283. The greater part of $26.7 million in potential capital gains taxes was attributable to Winn-Dixie stock.
The IRS relied on previous court cases that said taxes should be no factor at all in the valuation process where liquidation was speculative. It also argued that the company could have converted to an S corporation, retained its assets for ten years and then avoided capital gains taxes. The IRS valued the stock at a price almost double that of the estate by ignoring capital gains taxes.
All of the estate’s experts deducted a minority discount. The estate and one of its two experts deducted the full amount of capital gains taxes in calculating net asset value. The other expert deducted a portion of the tax as part of the marketability discount.
The IRS was, however, undermined by its own expert, who also increased the marketability discount to reflect capital gains taxes.
Judge Chiechi concluded that a willing seller and buyer would surely consider some reduction in value due to taxes in negotiating a price, regardless of whether a liquidation or sale of assets was contemplated. She also viewed conversion from a C to an S corporation as an "unlikely" event. She said a deduction of the full amount of taxes was not appropriate unless a liquidation or asset sale was in the works. This meant that a valuation approach making taxes part of the marketability discount was acceptable. Her rationale:
"... we find that on the valuation date there was less of a ready market for each of those two blocks because of ADDI&C's built-in capital gains tax than there would have been for each such block without such a tax."
COMMENTS: The court's discount for lack of marketability included an amount equal to roughly one-third of capital gains taxes.
Converting the court's final numbers, which are expressed in dollars, to percentages proves especially interesting. The total overall discount from net asset value is slightly over 50%. If capital gains taxes are not considered, the combined discount for minority interest and lack of marketability is about 39%, not bad for what was virtually a one-asset holding company mainly holding marketable securities.
Eisenberg v. Commissioner, No.97-4331 (CA2, 8/18/98).
Using the Davis case as support, the Second Circuit vacated a Tax Court decision (T.C. Memo 1997-483) not allowing Mrs. Eisenberg to reduce the value of gifted minority stock in her real estate C corporation by the full amount of potential capital gains tax liability. Judge Hamblen had ruled a reduction was not appropriate because the corporation had no plans to liquidate, or to sell or distribute its sole asset, a building, and therefore imposition of the tax was speculative.
Prior to 1986 corporations could liquidate without paying a tax on appreciated assets under the General Utilities doctrine. After the 1986 Tax Reform Act, however, the tax can no longer be avoided. Judge Hamblen had relied, in part, on pre-1986 TRA cases that went against the taxpayer.
Since "a hypothetical willing buyer today would likely pay less for the shares of a corporation because of the buyer's inability to eliminate the contingent tax liability," the Second Circuit remanded in order for the Tax Court to ascertain Mrs. Eisenberg's gift tax liability.
Footnote #15 to the opinion gives an example where a buyer deducts the entire built-in gains tax in determining the price he will want to pay for stock. The court said:
"One might conclude from this example that the full amount of the potential capital gains tax should be subtracted from what would otherwise be the fair market value of the real estate. This would not be a correct conclusion. In this case, we are only addressing how potential tax consequences -- the capital gains tax -- may affect the fair market value of the shares of stock appellant gifted to her relatives in contrast to the fair market value of the real estate."
COMMENTS: Eisenberg is a far more significant case than Davis on the capital gains valuation discount because an appeals court decision carries the weight of law. The tax court in Davis allowed a tax discount because of the opinions of the three appraisers. Capital gains taxes are a potential factor in every valuation and their impact should be considered.
Although remanded to the tax court, the taxpayer reached a settlement with the government and did obtain a capital gains discount, the size of which is unknown.
On January 29, 1999, the IRS issued an Action on Decision (AOD CC-1999-001) in which it acquiesced on Eisenberg, saying that "the amount of such a discount will be treated as a factual matter to be determined by competent expert testimony based on the circumstances of each case..."
Estate of Helen Bolton Jameson v. Commissioner. T.C. Memo 1999-43. Filed February 9, 1999.
This is the third consecutive decision to take built-in capital gains tax liability into account in valuing the stock of a C corporation holding company. Our enthusiasm is tempered, however, because liability for taxes was more certain in Jameson than it was in Davis and Eisenberg.
Jameson died in 1991 with a controlling interest (98%) in Johnco, a personal holding company. Johnco’s major asset was land in Louisiana from which timber was harvested and sold, generating over 80% of Johnco’s gross revenue.
Pursuant to code Section 631(a), Johnco had previously elected to treat the cutting of timber for sale as "a sale or exchange of property used in a trade or business" and was enjoying capital gains tax treatment.
Judge Gale ruled that Johnco’s net asset value should be reduced by an amount equal to the "net present value of the built-in capital gains tax liability." He calculated taxes that would be owed for nine years and discounted them to present value, assuming a 10% annual timber growth rate, a 4% inflation rate, a 34% capital gains tax rate and a 20% discount rate. His reduction from Johnco’s net asset value worked out to be 12.5% but was 14.5% of the timber property's fair market value. He also deducted a 3% marketability discount for a combined reduction and discount of 15.3%.
Judge Gale also found, in refuting the taxpayers, that the relevant market for Johnco is the timber tract market, not the market for stock.
COMMENT: In our experience, IRS agents like Jameson, as they
think Davis and Eisenberg went too far on the capital gains issue. Jameson
differs, though, as a control interest was involved and because timber sales get capital
gains tax treatment.
Estate of Mellinger v. Commissioner, 112 T.C. No. 4. Filed January 26, 1999.
Decedent’s taxable estate included Frederick’s of Hollywood stock in a Q-tip trust established by her husband and her own revocable trust. The two trusts together owned 55.7% of the outstanding shares, 27.8% in each trust. The estate valued each block separately, deducting a 30% blockage discount from the public market price. The IRS said the decedent was effectively the owner of the entire 55.7% block in support of its aggregation theory and argued for the application of a control premium.
Judge Cohen decided the Q-tip trust’s shares were not owned by the decedent, relying on her interpretation of Code Section 2044 under which Q-tip trust property is includible in a surviving spouse’s taxable estate. She also looked back to the Bonner case [84F.3d196(1996)] where the Fifth Circuit dealt with fractional interests in property in a Q-tip trust and ruled similarly.
Estate of Nowell v. Commissioner, T.C. Memo 1999-15.Filed January 26, 1999.
Citing Mellinger, Judge Cohen rejected the aggregation for valuation purposes of interests in two limited partnerships held in Q-tip and revocable trusts in a surviving spouse’s taxable estate.
Perhaps more important was the judge’s decision on a second issue. Partnership agreements provided that a transferee of a limited partnership interest could not become a substitute limited partner without the general partners’ consent. Under Arizona partnership law a partner in a limited partnership could not "confer to an assignee" the rights of a partner unless the partnership agreement provided otherwise. These provisions persuaded Judge Cohen to agree with the estate that a limited partnership interest should be valued as though it were an assignee interest and not a full partnership interest. The judge did not concern herself with the transferees’ identity (grandchildren, one of whom was a general partner) and correctly used a hypothetical buyer approach.
COMMENT: The estate had deducted valuation discounts in a range of 50% (securities partnership) to 65% (real estate partnership). Presumably, a valuation as assignee interests was a tacit approval of the 50% and 65% discounts. Hopefully valuation opportunities arising from Mellinger, Nowell and Bonner are rarely missed.
Patricia M. Adams, et al. v. United States, 83 A.F.T.R. 2d 99-1887 (N.D. Tex.). Filed March 17, 1999.
The U.S. District Court for the Northern District of Texas seems to have erred in its approach to determining the estate tax value of the decedent’s 25% interest in Taylor Properties, a general partnership owning various family properties, including ranch land, marketable securities and oil and gas interests.
Because death would trigger dissolution of Taylor Properties under Texas law, the decedent’s heirs were entitled to receive a 25% interest in the partnership’s liquidation value. The court focused on the latter, ignoring the fair market value concept of what a willing seller and willing buyer might negotiate for a 25% interest in the partnership, and refused to allow discounts for minority interest, lack of marketability, unattractive asset mix, etc. It did, however, allow a 5.4% discount for liquidation costs.
COMMENT: The court’s liquidations approach may be flawed because it might have failed to consider the problems in selling partial or fractional interests in ranch land and oil and gas properties, and in actually finding a willing buyer.
Estate of Alice Friedlander Kaufman v. Commissioner, T.C. Memo 1999-119. Filed April 6, 1999.
Decedent was the largest shareholder (19.86%) of Seminole, a manufacturer/wholesaler of industrial uniforms. The valuation date was April 14, 1994.
Two uninformed owners of smaller blocks (4.67% and 3.25%) sold their shares in May and June, 1994 for $29.77 per share. The buyer had asked Merrill Lynch to appraise the stock as of December, 1993 so he could offer to cash out disinterested shareholders. Although both sellers knew the offer was based on a Merrill Lynch appraisal, they never saw the report which, by the way, concluded a $29.77 price per share and was finally delivered in July, 1994.
The estate tax return reported the decedent’s stock at $29.77 per share while the IRS countered at $56.50 per share.
Through testimony and analysis of factors considered by the sellers at $29.77 per share, the IRS effectively proved that the sellers were not well informed. Judge Laro agreed. He also found fault with, and disregarded, the estate’s valuation expert and agreed with the conclusion of the IRS expert, an IRS staff appraiser.
THE SCORECARD
Ten cases: Five taxpayer victories! Five IRS victories?
Capital Gains Discount A Matter of Law!
Minority Discounts of Up To 50%!
Marketability Discounts Of 25% to 40%!(with IRS at up to 36.1%)
Combined Minority and Marketability Discounts of 50% to 76%!
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