Key words: Valuation; discount for built-in capital gains
Executive Summary: In this federal estate tax case, in a memorandum decision, the Tax Court (Judge Gustafson) determined the discount for built-in capital gains for a 23.44% interest in a Pennsylvania C corporation, which owned, as its principal asset, a non-diversified portfolio of highly appreciated publicly-traded stock. The result was primarily a victory for the IRS and resulted in the imposition of an accuracy penalty. The case is appealable to the U.S. 3rd Circuit Court of Appeals.
Facts: At the time of her death, the decedent owned 23.44% of the stock of Pearson Holding Company (“PHC”), a closely-held Pennsylvania C corporation that owned a non-diversified portfolio of highly appreciated publicly-traded stock worth $50,690,504 out of a total asset value at the corporate level of $52,159,430. The decedent died on December 10, 2005. The estate’s appraiser had appraisal experience (i.e., having written 10-20 valuation reports and having testified in court), but he did not have any appraiser certifications.
That appraiser prepared a draft report that valued the decedent’s interest in PHC at $3,149,767, using a capitalization-of-dividends method. He provided the unsigned draft of the valuation report to the executors and to the return preparer, and he was never asked to finalize his report. Without further consultation with that appraiser, the estate reported the value of the decedent’s interest in PHC as $3,149,767 on the Federal estate tax return that the executors filed with the IRS.
Burden of Proof
The first issue that Judge Gustafson dealt with was whether the burden of proof shifted from the estate to the IRS under IRC Sec. 7491. Judge Gustafson noted that he decided the case based upon a preponderance of the evidence, rendering the IRC Sec. 7491 burden shift immaterial.
Valuation Positions
The valuation positions of the parties and how the Tax Court came out are as follows:
Value-estate tax return: $3,149,767
Value-estate-trial-income approach (capitalization of dividends): $5,046,500
Value-estate trial-cost approach (net asset value method): $4,721,962
Value-IRS notice of deficiency: $9,223,658
Value-IRS-trial: $7,330,000-cost approach (discounted net asset value method)
Value-Tax Court: $6,503,804-cost approach (net asset value method)
BIG tax discount-Estate:$18,113,083 (100%, i.e., dollar-for-dollar reduction of BIG tax)
BIG tax discount-IRS: $7,817,106 (essentially 15% of the net asset value of $52,114,041)
BIG tax discount-Tax Court: $7,817,106 (15% of $52,114,041)
Estimated amount of time to total diversification-Estate: n/a
Estimated amount of time to total diversification-IRS: 20-30 years
Estimated amount of time to total diversification-Tax Court: 20-30 years
Discount-lack of control-estate: 8%
Discount-lack of control-IRS: 6%
Discount-lack of control-Tax Court: 7.75%
Discount-lack of marketability-estate: 35.6% (using restricted stock studies analysis)
Discount-lack of marketability-IRS: 21% (using restricted stock studies analysis)
Discount-lack of marketability-Tax Court: 32.1% accepting restricted stock studies analysis)
Appraisal method-estate tax return: Capitalization of dividends (income approach)
Appraisal method-estate-trial: Capitalization of dividends (income approach)
Appraisal method-IRS-trial: Net asset value
Appraisal method-Tax Court: Net asset value
Annual stock diversification: 1.1% (2000-2005)/1.4% (2005-)*
IRS appraiser-trial: John Thomson
Estate appraiser-trial: Robert Schweihs

* Would take 70 years to fully diversify the appreciated stock at that rate

Built-in capital gains tax (“BIG tax”) discount

The principal issue in this case was determination of the proper BIG tax discount. The appraisers differed considerably in amount and method of computation.

At the outset, Judge Gustafson observed:

As the owner of less than a majority of PHC’s stock, [the decedent] could not unilaterally change the management or investment philosophy of the company; nor could she unilaterally gain access to the corporate books, increase distributions from the company, or cause the company to redeem its stock. She could not force PHC to make an S election or to diversify its holdings. She had no rights to “put” her stock to the company (i.e., to force it to buy her shares), and the company could not “call” her stock (i.e., could not demand to buy it).

The estate’s appraiser took the tact of the Fifth (Dunn Est. v. Comr.) and Eleventh Circuits (Jelke Est. v. Comr.) and concluded that the BIG tax discount should be 100% of the BIG tax, i.e., dollar-for-dollar reduction of the BIG tax. On the other hand, the IRS appraiser attacked the BIG tax discount in a rather bizarre and convoluted way. He analyzed the correlation between unrealized appreciation (i.e., built-in gain) and NAV discounts for closed-end funds as of December 31, 2004.

He compiled data from closed-end funds with unrealized appreciation accounting for 11% to 46% of the total net asset value, and he was unable to find any statistical correlation between the BIG discount that could be observed on sales and the unrealized appreciation of the seven closed-end funds. He concluded that in the case of companies with unrealized appreciation that consist of as much as 46% of the company’s value (which he rounded up to 50%), buyers are indifferent to the BIG tax liabilities on that appreciation when purchasing an interest in a closed-end fund. Therefore, the IRS appraiser reasoned that a potential buyer would be indifferent to PHC’s BIG tax to the extent that it was attributable to the portion of its unrealized appreciation that is equal to 50% of its $52,114,041 NAV (i.e., tax attributable to $26,057,021).

PHC’s unrealized appreciation accounted for $45,576,677 of its value (i.e., approximately 87.5% of the total NAV of $52,114,041), so the remaining appreciation (i.e., the amount of unrealized appreciation above 50% of NAV, or $45,576,677 less $26,057,021) is $19,519,656 (i.e., approximately 37.5% of NAV). The IRS appraiser concluded that “a dollar-for-dollar discount over 50% of the tax exposure” was appropriate. Thus, the IRS appraiser allowed a dollar-for-dollar discount for the tax attributable to the appreciation over 50% of PHC’s NAV (i.e., a dollar-for-dollar discount for the tax attributable to $19,519,656 in appreciation, i.e., a discount of $7,757,111 when using a 39.74% combined Federal and State capital gains tax rate).

Applying an effective tax rate of 39.74% to this gain equal to 37.5% of PHC’s NAV (i.e., the portion of PHC’s unrealized appreciation for which the tax liability would be afforded a dollar-for dollar discount), the IRS appraiser figured that the allowable discount for BICG should be 14.9% (i.e., 39.74% times 37.5%), rounded up to 15%.

Judge Gustafson concluded the following about the viability of the estate appraiser’s 100% reduction of BIG tax approach:

[W]e consider it plainly wrong in a case like the present one. The relevant inquiry is, of course, what price a willing buyer and seller would agree to; and it is clear that they would not agree to a 100% discount. To demonstrate this fact, PHC (with assets worth $52 million but burdened by an $18.1 million BICG tax) can be compared to a hypothetical holding company (“HHC”) that is identical to PHC except that HHC is burdened not by any BICG tax but by an $18.1 million note payable that is due tomorrow. No investor would be indifferent to this distinction and treat PHC and HHC as if they were equivalent. The investor knows that, if he buys HHC, then tomorrow he must pay off the $18.1 million note and have a portfolio not of $52 million worth of stock but only $34 million; and in the future–beginning tomorrow–he will receive the capital gains and the dividends generated by that smaller $34 million portfolio. On the other hand, the investor also knows that if instead he buys PHC, then he may defer the payment of the $18.1 million BICG tax as long as he retains the appreciated stock; in the future–until he sells off the appreciated stock over time and incurs the tax piecemeal over that period–he will receive the capital gains and dividends generated by the entire $52 million portfolio. PHC is simply worth more than HHC, because a prospective BICG tax liability is not the same as a debt that really does immediately reduce the value of a company dollar for dollar. A 100% discount, on the other hand, illogically treats a potential liability that is susceptible of indefinite postponement as if it were the same as an accrued liability due immediately. We do not adopt this approach. [Emphasis added]

However, Judge Gustafson was not impressed or persuaded by the IRS appraiser’s reasoning, concluding:

This reasoning is not supported by the evidence. We are unconvinced that a buyer would be wholly indifferent to the tax implications of built-in gain that constitutes up to half of a company’s assets. Furthermore, [the IRS appraiser] points to no data to show that, once a fund’s unrealized appreciation exceeds 50% of its NAV, there would then begin to be a correlation between NAV discount and the unrealized appreciation above 50%; nor is there evidence that the discount would simply be dollar for dollar for the portion in excess of 50% and not something more–e.g., an increase in elasticity (price sensitivity) for BICG liability once it reaches a certain point. He presented no data at all concerning funds with built-in gain constituting more than 50% of NAV. As a result, we cannot endorse [the IRS appraiser]’s approach to calculating the BICG discount, but we view the resulting discount amount–$7,817,106–to be a concession on the Commissioner’s part. [Emphasis added]

Turning to his own analysis of the appropriate BIG tax discount, Judge Gustafson observed:

Our conclusion: present value of the BICG tax liability If (as we hold) the BICG tax liability cannot be disregarded in valuing PHC, but if (as we also hold) PHC’s value cannot be reasonably discounted by that liability dollar for dollar, then the most reasonable discount is the present value of the cost of paying off that liability in the future. … The Commissioner’s expert did not use this present value approach, because he observed that at PHC’s historic rate for turning over its securities, it would take 70 years before all the stock had been sold and all the built-in gain had been taxed. If the $18.1 million of BICG tax were discounted over that period, on the assumption that PHC’s stocks would be gradually sold and its BICG tax would be gradually incurred over 70 years (on an average of $258,758 per year), then the present value of the $18.1 million liability would be only $3,664,119 (assuming a 7% discount rate).

However, this 70-year assumption would mistakenly allow PHC’s unique, subjective investment goals to dictate the value of the company, whereas what we seek is a fair market value—the price at which PHC would change hands between a willing buyer and a willing seller, not the price that a particular seller might demand or that a particular buyer might be willing to pay, and therefore not a price that assumes subsequent management of the company by a specific owner. As the estate rightly acknowledged, “The willing buyer and the willing seller are hypothetical, not actual persons, and each is a rational economic actor; that is, each seeks to maximize his advantage in the context of the market that exists at the valuation date.”

The advice that PHC received to diversify its portfolio (i.e., to sell stock more quickly than its 70-year trend would call for) indicates that a rational actor would expect a turnover period shorter than 70 years. PHC’s decision not to follow that advice was not irrational, but it was particular to PHC’s subjective goals. Even assuming that the PHC management would indefinitely follow its traditional philosophy and would sell stock only at the 70-year pace, and assuming that PHC shareholders would refuse to sell at prices that presumed a shorter turnover, that refusal would not affect the fair market value of PHC; it would instead indicate that PHC’s particular managers and owners were willing to forfeit or forgo some of PHC’s fair market value in order to pursue other aims.

The estate put on no evidence as to the length of the period that a typical investor would consider likely or optimal for turning over PHC’s stock (apart from the general fact that PHC’s advisors repeatedly suggested that PHC sell stock in order to diversify) but asserted only PHC’s particular historic rate (yielding a 70-year turnover period and, to the estate’s detriment, a relatively small $3.6 million BICG tax liability discount). [IRS appraiser]’s testimony on this score–i.e., that, notwithstanding PHC’s historic turnover rate, a potential investor would expect that a portfolio like PHC’s would turn over within a period of 20 to 30 years–is not rebutted, and we find it reasonable. …

We found the dollar-for-dollar method to be problematic, but we find his $7.8 million bottom line–which we take as a concession by the Commissioner–to be reasonable, for reasons different from those he advances.
…
A present-value approach that uses either a 20-year or a 30-year holding period and uses the different discount rates employed in various contexts in this case yields the following range of present values for the $18.1 million BICG:

Discount rate 20 years 30 years
10.27%
(as calculated by P using
Ibbotson’s data) $7,570,358 $5,565,937

10.25%
(as used by P in the capitalization of
dividend model) 7,580,584 5,575,086

9.414%
(as calculated by the Court using
PHC’s historic data) 8,029,070 5,982,097

7%
(generally accepted rate
of return) 9,594,513 7,492,200

Since the Commissioner’s $7.8 million concession falls comfortably within this range of $5.5 to 9.6 million, we use that figure. As a result, on the basis of these findings and the record before us, we find a $7,817,106 BICG discount to be reasonable in this case.

Discount for lack of control (“DLOC”)

The battle over DLOC boiled down to a battle over statistical measuring methods. The IRS appraiser looked at the mean of 59 data points in closed-end funds and calculated it as 6.7%. He then concluded that, even though the decedent did not control PHC, the decedent’s 23.44% interest was a large and influential block of PHC’s stock, so that her lack of control was somewhat mitigated, so the IRS appraiser reduced DLOC by .7% to 6.0% because of the “low dispersion of the remaining ownership interest [in PHC] and ease of management”. The estate’s expert used the same data but simply selected the median of the data set, 8.0%, as the appropriate DLOC.

Judge Gustafson did not accept the IRS appraiser’s subtle invitation to consider the “swing vote” issue and had the following to say about his DLOC analysis:

[IRS Appraiser] did not explain how he chose -0.7% as the amount of the appropriate reduction, and it appears to be simply a visceral reduction, for which we do not see the justification.

After tossing out three data points that were outliers on the high and low ends, Judge Gustafson selected the median and concluded that a DLOC of 7.75% was reasonable in this case.

Discount for lack of marketability (“DLOM”)

In computing DLOM, the IRS appraiser relied upon seven restricted stock studies. He chose the low end of the range, 26.4%, and then reduced it to 21% because PHC paid consistent dividends, had a very small amount of debt and was managed by professional investors.

For reasons not stated in the opinion, the estate’s appraiser did not perform an independent analysis of DLOM. Rather, he selected the highest end of the range of the same seven restricted stock studies that the IRS appraiser used: 35.6%. He argued that the seven restricted stock studies that the IRS appraiser used to derive DLOM are based on entities whose stock (unlike PHC’s) would relatively soon be freely marketable. The estate’s appraiser contended that restricted stock in publicly-traded corporations, on which public trading is restricted for only a brief defined period (during which only private trades may be made) may be less discounted in value than stock (like PHC’s) whose non-public status is of indefinite duration.

Judge Gustafson was not happy with the DLOM work of either appraiser. Judge Gustafson concluded that a 32.1% DLOM was appropriate, reasoning:

The parties seem to agree that the general range of marketability discounts relevant for consideration in this case is 26.4 to 35.6%, with an average discount of 32.1%, and we are unconvinced by either party’s rationale for deviating from this generality. We therefore find that a marketability discount of 32.1%–i.e., the average of the data sets–is reasonable in this case.

Conclusion

Judge Gustafson concluded that the value of the decedent’s 23.44% stock holding in PHC was worth $6,503,804 on the date of death, which was closer to the IRS’s valuation position of $7,330,000 than the estate’s valuation position of $5,046,500.

Accuracy-related penalty

IRC Sec. 6662(g)(1) provides for a 20% accuracy-related penalty where the taxpayer’s value on the return is less than 65% of the proper value. Mathematically, the return position, $3,149,767, was 48.43% of the value that Judge Gustafson determined, $6,503,804, thereby falling within the ambit of the penalty. There is an exception to imposition of the penalty. IRC 6664(c)(1) provides that the penalty is not to be imposed “if it is shown that there was a reasonable cause for such portion and that the taxpayer acted in good faith with respect to such portion.”

In sustaining the penalty, Judge Gustafson reasoned that the reasonable cause exception was inapplicable, noting:

While we do not disagree with the estate’s assertion that the decedent’s interest in PHC may be difficult to value, we believe that this further supports the importance of hiring a qualified appraiser. On the record before us, we cannot say that the estate acted with reasonable cause and in good faith in using an unsigned draft report prepared by its accountant as its basis for reporting the value of the decedent’s interest in PHC on the estate tax return. [Estate’s return appraiser] is not a certified appraiser. The estate never demonstrated or discussed how [Estate’s return appraiser] arrived at the value reported on the estate return except to say that two prior estate transactions involving PHC stock used the capitalization-of-dividends method for valuation. Furthermore, the estate did not explain–much less excuse–whatever defects in [estate return appraiser]’s valuation resulted in that initial $3.1 million value’s being abandoned in favor of the higher $5 million value for which the estate contended at trial.

Consequently, the value reported on the estate tax return is essentially unexplained.
…
In order to be able to invoke “reasonable cause” in a case of this difficulty and magnitude, the estate needed to have the decedent’s interest in PHC appraised by a certified appraiser. It did not. Instead, the estate relied on the valuation by [estate return appraiser] but did not show that he was really qualified to value the decedent’s interest in the company. [Emphasis added]

Therefore, Judge Gustafson sustained the accuracy-related penalty.

Comments: Reliance upon an unsigned business appraisal report to use on a federal estate tax return? Are you kidding me? In this day and age, it is unfathomable to me to rely upon the valuation work of an accountant who does not hold a special designation as a business appraiser for use on a federal estate tax return! The accuracy-related penalty was harsh but probably warranted under the facts.

I return to Hood’s Rules of Business Valuation: (1) actual value is irrelevant; (2) actual value is unknown; and (3) perceived, defensible value is everything. Perception is reality. Non-accredited practitioners can be easily painted as unexperienced and incompetent, even if they know what they’re doing. The risk of employing a non-accredited appraiser in a tax matter simply is too great to bear in my opinion.

In my opinion, there are five major business valuation credentialing organizations: American Society of Appraisers (“ASA”), AICPA (but only CPAs who hold the ABV designation), Canadian Institute of Certified Business Valuators (“CICBV”), Institute of Business Appraisers (“IBA”) and National Association of Certified Valuation Analysts (“NACVA”). Run from anyone who doesn’t hold a designation from one or more of these organizations. However, just because the business appraiser holds a designation doesn’t mean that the appraisal will be competent work. Caveat emptor.

In computing the BIG tax discount, Judge Gustafson disregarded the dollar-for-dollar reduction method and instead utilized a present value analysis and a holding period assumption, which the Tax Court also employed in Borgatello v. Comr. and more recently in Jensen Est. v. Comr. I agree with Judge Gustafson’s analysis of the BIG discount as the present value of the BIG tax liability.

As I have said and written before, the dollar-for-dollar reduction of the BIG tax, while certainly simple, strikes me as arbitrary and contrary to what a willing seller would agree to in an arm’s-length transaction. I predict that you’ll continue to see more of this type of analysis, except in the Fifth and Eleventh Circuits.

This case is appealable to the U.S. Third Circuit Court of Appeals. It is unknown at this point whether the estate will appeal. However, what seems clear is that if the estate does appeal, it will invite the Third Circuit to follow the lead of the Fifth and Eleventh Circuits.

On the other hand, the IRS appraiser’s modified dollar-for-dollar closed-end fund methodology, which Judge Vasquez expressly rejected in Jensen Est. v. Comr., was rejected again in this case by Judge Gustafson.

On DLOM, Judge Gustafson didn’t really respond to the principal criticism of the restricted stock studies that the estate’s appraiser raised: restricted stock isn’t restricted from public sale for very long, whereas closely-held stock has an indefinite holding period absent a put right. In my opinion, this is a very valid criticism of the restricted stock studies.

If they mean anything at all in the context of valuing interests in closely-held entities, results from a restricted stock studies analysis should serve as a floor on DLOM, i.e., that’s as low as it can be for a closely-held entity without a put right. I’m not a big fan of using a benchmark analysis of any kind, and that includes the pre-IPO studies and the restricted stock studies. I prefer a mix of measures to be employed, including an income approach like QMDM and an options approach, as opposed to putting all of one’s eggs into one method’s basket.

Cites: Richmond Est. v. Comr., T.C. Memo 2014-24; Jensen Est. v. Comr., T.C. Memo 2010-182; Litchfield Est. v. Comr., T.C. Memo 2009-21; Jelke Est. v. Comr., T.C. Memo 2005-131, vacated and remanded on other aspects of the valuation issue, 507 F. 3d 1317 (11th Cir. 2007), cert denied, U.S. Sup. Ct. Docket No. 07-1582 (2008); Dunn Est. v. Comr., 301 F. 3d 339 (5th Cir. 2002), rev’g T.C. Memo 2000-12; Borgatello Est. v. Comr., T.C. Memo 2000-264.