Ever since Gross v. Commissioners (TC Memo 1999-254), the Tax Court docket has struggled with the valuation of pass-through entities, resembling S firms (S corps). The query is: ought to the earnings of an S corp be tax affected by imposing an assumed company tax fee (based mostly on the taxes of comparable C corps, for instance) to pretax earnings after which capitalizing these earnings not directly?
Lately, in Jones v. Comm’r (TC Memo 2019-101), after a 20-year historical past of denying tax-affecting, one courtroom agreed that tax affecting was allowable. Nonetheless, simply two years later, in Jackson v. Comm’r (TC Memo 2021-48), one other courtroom didn’t discover tax affecting applicable.
Now, right here comes Cecil v. Comm’r (T.C. Memo 2023-24 (Feb. 28 2023)), the place the courtroom is once more permitting tax affecting in a valuation case. Cecil additionally offers one other take a look at how the courtroom weighs proof on valuation reductions. Lastly, the case can also be instructive in its remedy of the asset strategy when valuing an working enterprise.
Presents of Shares in Biltmore Firm
The case revolves round presents made by William A.V. Cecil, Sr., and Mary Ryan Cecil, of sophistication A (voting) and sophistication B (usually non-voting) shares within the Biltmore Firm (TBC) in November 2010. William’s mom was Cornelia Cecil nee Vanderbilt, the one youngster of George W. Vanderbilt, who constructed the Biltmore Home within the Blue Ridge Mountains in Asheville, N.C., between 1889 and 1895.
Right now, TBC owns the Biltmore Home, a nationwide vacationer attraction, and its surrounding acreage, and operates a big (1,300 staff) journey, tourism and historic hospitality enterprise. Guests to the historic property can keep at its inn, store at 5 stores, eat at eight eating places and have interaction in quite a lot of actions together with excursions, river rafting, fly fishing and equestrian coaching. The enterprise generates important income (about $70 million in 2010) and has been worthwhile yearly since 1995, apart from the recession yr of 2008.
In complete, the Cecils transferred to their youngsters and sure trusts one share of sophistication A typical inventory and 9,337 shares of sophistication B widespread inventory in complete. The shares weren’t publicly traded and, past the traditional illiquidity of privately held shares, had been additionally restricted by the by-laws of TBC and its shareholders’ settlement. The Cecil household owned the entire shares of TBC and had adopted formal written insurance policies aimed toward perpetuating household possession and administration of the corporate and its historic property.
After the reward, the Cecils filed Varieties 709 for 2010, valuing the gifted shares at a complete appraised worth of $20.9 million, based mostly on a going-concern valuation. The Inside Income Service, however, in its discover of deficiency, disregarded the existence of TBC totally and attributed no weight to its going-concern worth, valuing the presents as a substitute based mostly on the liquidation worth of the corporate’s property. The courtroom’s opinion doesn’t specify the precise discover of deficiency (NOD) worth, however based mostly on the web asset worth (NAV) technique offered by the IRS skilled at trial, it could have been greater than $140 million. Nonetheless, as we will see, the IRS made a significant climb-down earlier than trial.
Valuation Battle
The taxpayers produced two value determinations from skilled witnesses in courtroom, each of whom seem to have valued the TBC shares at considerably decrease values than taken on the tax return. The valuation strategies utilized by the taxpayer’s specialists included the discounted money movement (DCF) technique beneath the earnings strategy and the rule of thumb public firms (GPC) technique and the same transactions technique beneath the market strategy (each rejected the asset strategy).
Because the overwhelming majority of the shares of TBC had been gifted, for comparability, the overall worth of TBC (discounted) claimed on the reward tax return was roughly $22 million, whereas the overall worth implied by the taxpayer’s specialists at trial was roughly $11 million.
The IRS took a radically completely different view –it’s important skilled first, utilizing the NAV technique beneath the asset strategy, relied on value determinations of some property alongside along with his personal estimate of sure different property (resembling TBC’s many logos) to reach at a complete NAV of $146.6 million. He then utilized reductions based mostly on low cost information to this quantity to reach at a complete worth of $92 million.
Nonetheless, he additionally utilized what he known as the discounted future advantages technique, which seems to be a regular DCF, beneath the earnings strategy. Utilizing the DCF, he arrived at a worth of roughly $15.2 million, however added non-operating property to succeed in a complete worth of $36 million. Lastly, he put virtually all the load on his DCF conclusion and took additional reductions, to reach at a worth of $4,000 per class A share and from $3,066 (smaller blocks) to $3,276 (bigger blocks) per class B share. Operating these numbers, this means a complete worth for TBC of roughly $31 million.
Thus, from a $22 million versus $140 million valuation hole on the NOD stage, to a $11 million to $31 million valuation hole at trial. The courtroom nonetheless had fairly a valuation task!
Court docket Ruling
The courtroom had three main valuation judgments to make in arriving at its opinion:
- To what extent ought to the asset strategy be thought-about on this valuation train?
- Ought to TBC earnings be tax affected within the earnings and market approaches?
- What valuation reductions are applicable?
The asset strategy. “In that TBC is an working firm whose existence doesn’t look like in jeopardy, and never a holding firm, we imagine that TBC’s earnings relatively than its property are one of the best measure of the topic inventory’s honest market worth.” The courtroom additionally discovered the IRS’ skilled’s use of the asset strategy to be inconsistent with appraisal requirements because the holder of any of the gifted pursuits lack management and, thus, the flexibility to trigger liquidation.
The courtroom held that the liquidation of TBC is unlikely, as anyone holder of the topic pursuits must:
- “purchase extra shares as a way to trigger TBC’s liquidation”;
- “persuade different shareholders to vote for liquidation”; or
- “wait till the shareholders of their heirs resolve to liquidate”
The courtroom additionally gave weight to the voting belief and shareholders’ settlement and testimony from members of the family.
Tax affecting. The courtroom, after summarizing its 20-year lengthy string of anti-tax affecting selections from Gross to Giustina (TC Memo 2011-141) offered a deeper dive on the reasoning in Jackson and Jones. Noting that in Jones, “the events agreed {that a} hypothetical purchaser and vendor would have in mind the entity’s enterprise kind when figuring out the worth of a restricted companion curiosity” and that “the Commissioner disagreed along with his specialists,” the courtroom famous that in Jones, the specialists largely agreed that tax affecting was applicable, it was simply the attorneys who disagreed.
In Jackson, nevertheless, the courtroom didn’t discover tax affecting applicable. Whereas in Jones, the “specialists agreed to have in mind the type of the enterprise entity and agreed on the entity sort,” in Jackson, “we held that tax affecting wouldn’t be applicable as a result of the property’s specialists had not persuaded us that the patrons can be C firms.” Nonetheless, even in Jackson the courtroom didn’t discover that there’s “a complete bar in opposition to using tax affecting when the circumstances name for it.”
Thus, the Cecil courtroom noticed that “both sides’s specialists (…) completely agree that tax affecting ought to be taken into consideration (…) and specialists on each side agree on the particular technique that we must always make use of to take that precept into consideration, we conclude that the circumstances of those circumstances require our utility of tax affecting.” Nonetheless, the courtroom emphasised “that whereas we’re making use of tax affecting right here, given the distinctive setting at hand, we’re not essentially holding that tax affecting is at all times, and even most of the time a correct consideration for valuing an S company.”
Valuation Reductions
The courtroom applies a reduction for lack of management of 20%. It rejected the (greater) low cost of the IRS skilled as a result of it was based mostly on actual property restricted partnerships and closed finish funds information. These databases are in flip based mostly on buying and selling in holding firms, whereas TBC is an working firm. To not go away the apparent unspoken right here: Sure, it’s odd that the IRS had a better low cost, however it’s much more odd that the info would lead to greater reductions for a holding firm versus an working firm. That is extremely uncommon.
For the shortage of marketability low cost, the taxpayer’s specialists utilized reductions from 25% to 30%, whereas the IRS’ skilled utilized a reduction in a spread between 19% and 27%, relying on voting rights and dimension of the block.
The courtroom first rejected the evaluation of one of many taxpayer’s specialists, as a result of it was based mostly on: (1) research of restricted inventory that had been too previous (apparently, the info was largely from the Nineteen Seventies and Eighties), (2) research of pre-initial public providing transactions, which the skilled had admitted had been unreliable, and (3) a put possibility evaluation, which the courtroom famous produced a spread of reductions from 11.6% to 22.6% p and acknowledged “we can’t fathom how that evaluation helps his ultimate low cost fee of 30%.”
Lastly, as a result of the IRS’ skilled had differentiated between smaller and bigger blocks and between differing voting rights, the courtroom felt that these reductions had been applicable. Apparently, the courtroom rejected the applying of a voting rights low cost (once more, based mostly on previous research) as a result of every skilled already accounted for “valuing a nonvoting minority curiosity.”
Refund for Taxpayer
In the long run, the courtroom accepted one of many taxpayer’s skilled’s conclusions earlier than tax affecting and earlier than reductions. Reductions are utilized on the ranges opined at by the taxpayer’s skilled for lack of management and on the IRS’ skilled for lack of marketability. The courtroom didn’t land on a precise worth conclusion, however it seems that ultimate judgment will likely be entered at a worth considerably under the worth on the Kind 709, so this taxpayer will likely be getting a really good refund!