U.S. Tax Court Releases Decision on Cecil v. Commissioner

U.S. Tax Court Releases Decision on Cecil v. Commissioner

Court rules on tax-affecting company income

March 15, 2023

Long awaited, the U.S. Tax Court just released its decision on Cecil.1 Is this the case that finally brings clarity to tax affecting?

In November 2010, Mr. William Cecil Sr. and Ms. Mary Cecil (both since deceased) transferred voting and nonvoting stock in The Biltmore Company (“TBC”) to their children and grandchildren. The IRS determined a $13-million combined gift tax deficiency in March 2014.

The Biltmore Company, a Delaware S corporation, owns the Biltmore House, built by George W. Vanderbilt, and the surrounding acreage in Asheville, North Carolina. The house was inherited by his only daughter (William’s mother) and remains the largest privately owned house in the United States. TBC offers tours of the house and gardens and also operates hotels, restaurants, retail stores, and various outdoor activities.

The two biggest valuation issues to be decided dealt with whether TBC should be valued using an income approach or an asset approach (yielding drastically different value conclusions) and whether the earnings under the income approach should be tax affected.

Shockingly, all experts tax-affected the company’s earnings to arrive at a C corporation-equivalent value. Historically, the IRS position has been that it is improper to “tax affect” the operating earnings of pass-through entities when using the discounted cash flow method. The benefits of the S corporation status (if any) were appropriately captured in what is known as the SEAM (S corporation Equity Adjustment Model).

And just like that – we have agreement by all parties. The Judge left room for other fact patterns to require a different approach in the future, but this certainly marks a monumental step forward.

Discounts, including lack of control, lack of marketability, and lack of voting rights, were applied thereafter.

Next, the Tax Court opined on the use of the income approach vs. asset approach for an operating business with no intention of liquidating.

Although the IRS expert only assigned a 10% weighting to his asset approach, it would prove to be his downfall. The Tax Court assigned zero weight to the IRS expert’s opinion in establishing the equity value of the company, and the Tax Court memo stated, “In that [the Biltmore Company] is an operating company whose existence does not appear to be in jeopardy, and not a holding company, we believe that [the company’s] earnings rather than its assets are the best measure of the subject stock’s fair market value.”

The first S corporation Tax Court case challenging the use of tax-affecting within the discounted cash flow model was the 1999 Gross decision. While a big win for tax-affecting in this case, the Court left room for a different conclusion under a different setting.

1Estate of William A.V. Cecil, Sr., Donor, Deceased v. Commissioner, United States Tax Court, T.C. Memo 2023-24 (Feb. 28, 2023)