The taxpayer prevailed in a significant estate tax valuation case in Estate of Louise Paxton Gallagher (June 28, 2011). Mrs. Gallagher died owning 3,970 units of Paxton Media Group, which her estate valued at $34,936,000 on her estate tax return. Upon audit, the IRS determined a value of $49,500,000. Paxton Media Group was a limited liability company under state law but it had elected to be treated as an S corporation for income tax purposes.
After the audit was commenced but before the trial in the Tax Court started, the estate obtained two more appraisals which valued the units at $26,606,940 and $28,200,000, respectively. A pre-trial appraisal done by the IRS derived a value of $40,863,000, so there were a number of values in play when the case came before the Tax Court.
The IRS valuation expert used two methods to value the company: i) a market approach; and ii) an income approach (more technically referred to as the “discounted cash flow” method). The market approach derives the value of a closely held company by comparing its earnings to the earnings of similar public companies, adjusted for differences in size, marketability and other factors. The discounted cash flow approach discounts to present value future cash flows that the business is expected to produce for the owners. The IRS expert accorded each approach equal weight and averaged the results obtained by these two methods in determining a value of $40,863,000.
The taxpayer’s expert used the discounted cash flow approach and relied on the market approach only to verify the reasonableness of the value he derived. The court first determined that it would not rely on the IRS’ expert use of the market approach because it did not believe that the public companies used to establish value were sufficiently similar to the closely held business being valued. The court determined that only the discounted cash flow approach should be used to value this business.
In applying the discounted cash flow approach, the court analyzed the application of that approach by both of the appraisers and used certain assumptions and methodologies from each, and on some factors picked its own assumptions. The court in effect took information from the valuations and computed its own number. Some of the factors that had to be evaluated included: i) adjusting the income statement information for non-recurring items; ii) the rate at which revenue was expected to grow; iii) the company’s future operating margin; iv) the income and expenses that would be generated outside of the core business; v) the need for capital expenditures; vi) working capital levels that will be required; and vii) the appropriate discount rate to use to determine the present value of future cash flows.
The court’s treatment of the appropriate discount rate was interesting in that both parties’ experts used the “weighted average cost of capital,” which employs a weighted average of the companies’ borrowing cost and the return that would be expected by an equity investor. The court noted that it had previously expressly disapproved of this method for valuing small companies that had little possibility of going public. Nonetheless, because both of the experts had used this method, the court applied it as well. Ultimately, the court determined a discount rate of 10%, which is the same number derived by the IRS’ expert witness.
The court also addressed the experts’ differing opinions on whether the earnings produced by the business should be reduced by a hypothetical corporate tax rate, because the S corporation itself did not pay any corporate income taxes. The reason to make such an adjustment is based on the assumption that a future buyer would likely operate the company as a C corporation, so its earnings would be subject to corporate income tax following such a sale. The taxpayer’s expert witness believed such a theoretical tax burden should be applied to reduce future projected earnings. Naturally, this would result in a lower valuation for the company, which is what the taxpayer sought. The court rejected this argument and determined that the corporation should be valued in its status at the time of the decedent’s death. S corporation shareholders enjoy a lower total tax burden compared to shareholders of C corporations, and that benefit should enhance the value of the S corporation.
After a tentative value had been determined by discounting the future expected cash flows, the taxpayer’s expert then added a premium to account for the value of being an S corporation. He likely did this only because he had previously attempted to reduce the value of the corporate earnings by a theoretical corporate income tax. That adjustment presumably lowered the value of the company more than the premium he proposed to add increased it. The court determined that the value of being an S corporation was fairly taken into account simply by not imposing a theoretical corporate tax on the projected future earnings so no premium needed to be added.
Finally, the court addressed the appropriate discounts to reflect the fact that block being valued represented a minority interest in the company and the fact that the block was not readily marketable. The court determined that a 23% discount should be applied to the minority interest and a 31% discount for lack of marketability. The final value determined by the court for the block being valued was $32,601,640.
An interesting aspect of this case is that in applying the discounted cash flow method of valuation, in most instances the court followed the assumptions used by the IRS’ expert rather than those used by the taxpayer’s expert. Yet, the value determined was significantly lower than that claimed by the IRS expert, and even lower than what the taxpayer had claimed on the estate tax return that was filed. The reason is that the court completely disregarded the value determined by the IRS expert using the market approach, where the company is compared to public companies in similar businesses. The value the IRS had determined under the market approach was considerably higher than the value that resulted from the discounted cash flow method.
If you have a matter where a business interest needs to be valued by a valuation expert, it would be a good idea to have your expert study this opinion carefully. It contains a lot of useful information about how the Tax Court approaches valuation issues.