Gallagher: Tax Court Reviews Business Valuation Principles
The opinions of the U.S. Tax Court in estate valuation cases can be instructive guidance on legal and valuation principles that are equally relevant to divorce cases. A recent decision of the Tax Court in an estate taxation case contains an excellent summary of those principles, as well as the latest thinking on a variety of hot valuation topics, including normalization of financial statement, tax-affecting of Subchapter “S” corporations, and valuation discounts.
In Estate of Gallagher v. Commissioner, T.C.Memo 2011-148, the IRS disputed the business valuation used by a decdent’s estate in an IRS Form 706 estate tax return. Rather than the $35 million dollar value claimed by the taxpayer, the IRS asserted a value of $49.5 million for the decedent’s 15% interest in a newspaper publishing conglomerate. The taxpayer and IRS each obtained new appraisals for trial, which narrowed the gap somewhat, with the Tax Court eventually finding the value to be $32 million.
Initially, the Tax Court noted that the taxpayer’s “admission” of the company’s value ($35 million reported on the tax return) was merely rebuttable evidence of the value, which could be overcome by a preponderance of evidence at trial. This ruling allowed the taxpayer to offer its appraisal of $28 million during the trial, rather than being bound by the taxpayer’s assertion on its tax return.
The Court also found that recent arm’s-length transactions in the company’s stock may be the most reliable method of valuing the company. Yet, in the absence of such transactions, expert opinions are probative evidence of value, and the Court may mix-and-match the findings of competing experts in arriving at its conclusion.
One of the hot topics addressed by the Court in Gallagher is the consideration of data or events that are subsequent to the date of valuation. The Tax Court held that it was proper to consider quarterly financial statements that were issued shortly after the death of the taxpayer because they were more accurate than those issued just before the valuation date. Hindsight was admissible in this case because the data in the subsequent financial statements was knowable on the valuation date; it just hadn’t been fully compiled or analyzed at the time of death. It did not matter to the Court that the subsequent financial statements would not have been available to a buyer on the valuation date (and in a transaction of this magnitude, a buyer probably would not rely on internal financial statements without performing due diligence anyway).
Another hot topic was the IRS expert’s use of market-based methods in his valuation report. Perhaps it demonstrates the proficiency of the Tax Court that the Court was willing in Gallagher to reject the IRS expert’s reliance on the guideline public company method rather than deferring to the expert’s professional judgment. The Court found that the IRS expert did not sufficiently prove the similiarity of the subject company to comparable public companies. If a company the size of this company is not sufficiently similar to public companies, it is hard to imagine how a more modestly-sized company could be valued under this method.
The Gallagher opinion also analyzed the experts’ use of the discounted cash flow (DCF) method. The DCF method is hardly ever used in divorce cases, partly because it is difficult to get reliable earnings projections from owners who are embroiled in matrimonial litigation. For this reason, the Court’s DCF analysis will not be reviewed in this article. A good summary of the Gallagher decision (in chart form) is available here.
The Gallagher court declined to tax-affect the earnings of the subject company, which was organized as a Subchapter “S” corporation until it was converted to an LLC prior to the valuation date. Simply put, the Court found no compelling reason to apply a hypothetical shareholder-level tax liability against earnings in order to place the company’s valuation on equal footing with a Subchapter “C” corporation. The Court cited Gross v. Commissioner as legal authority for its position, without further explanation. Later in the opinion, the Court also rejected a bottom-line adjustment made by the taxpayer’s expert to account for the benefits realized by “S” corporation shareholders.
The next section of the Gallagher opinion is a concise, learned discussion of capitalization rates and valuation discounts. The Court held that minority discounts may be applied only if the expert’s method yields the value of a controlling interest, and should not be applied if the expert has calculated value on a minority basis. Since the Court adopted the opinion of the expert who calculated enterprise value, the minority discount was applied. However, the Court adjusted the minority discount, finding that the expert underestimated the control premium. The experts’ calculations of marketability discounts were nearly identical.