Last year was relatively quiet in the valuation arena. However, for those looking for inchoate signs of change, the prospects for a significant shift appeared in tax-affecting valuations for shareholders of S corporation (“S corp”) stock. Among the most difficult signals to read is the start of a material change in case law. Two cases in 2019 suggest the Internal Revenue Service’s long-standing approach to valuation of S corp stock may require revision. At this time, it remains uncertain if the cases represent a false positive for taxpayers, but after 20 years of consistent acceptance of the current IRS position, the 2019 cases offer a potential look at a coming change.
Whenever a presidential election year approaches, legislative activity, particularly tax legislation, grinds to a halt. Without the specter of near term tax legislation, the focus for taxpayers and advisors turns to how courts view valuation issues. Economists look for green shoots as a sign of a turn in the economy. The valuation profession has been waiting years for a turn in case law regarding tax-affecting valuations of S corps. Maybe recent cases represent the tips of those green shoots.
It’s been approximately 20 years since the IRS convinced the Tax Court in Gross v. Commissioner (“Gross”) that it’s not appropriate to tax affect the earnings of an S corp for valuation purposes. Since Gross, this argument has been persuasive in a string of Tax Court cases.
In Estate of Louise Paxton Gallagher v. Comm’r (“Gallagher”), the tax-affecting issue was decided as it was in Gross. Although it found that tax-affecting corporate earnings wasn’t justified, the court implied it was open to persuasion on the issue. The court wrote:
Absent an argument for tax affecting [the Company’s] projected earnings and discount rate, we decline to do so. As we stated in Gross …, the principal benefit enjoyed by S corporation shareholders is the reduction in their total tax burden, a benefit that should be considered when valuing an S corporation.
Eight years after Gallagher, the first case addressing the “argument for tax-affecting” provided a slight shift in the issue although it didn’t occur in Tax Court. The first fissure in the tax-affecting wall appeared in a taxpayer’s refund action in a U.S. District Court in Wisconsin. In Kress v. United States (“Kress”), the court accepted an analysis using tax-affecting an S corp.
In Kress, both the appraiser hired by the IRS and the taxpayer’s appraiser tax-affected the earnings of the S corp as if it were a C corporation (“C corp”). The IRS’ appraiser then separately quantified and added an S corp premium. Ultimately, the court determined – consistent with the position taken by the taxpayer’s expert – that there was no premium benefit to the S corp status. Specifically, the court found that:
[The Company’s] subchapter S status is a neutral consideration with respect to the valuation of its stock. Notwithstanding the tax advantages associated with subchapter S status, there are noted disadvantages, including the limited ability to reinvest in the company and the limited access to credit markets. It is therefore unclear if a minority shareholder enjoys those benefits.
Importantly, the court indirectly sanctioned the tax-affecting approach used by the experts who applied an effective tax rate to the company as if it were a C corp by only refusing application of a premium.
A couple of months later, the Tax Court released an opinion accepting tax-affecting of the earnings of an S corp and limited partnership in Estate of Aaron U. Jones v. Comm’r (“Jones”). The court navigated through the no tax-affecting positions in “the three Gs” – Gross, Gallagher, and Estate of Natale B. Giustina v. Comm’r (“Giustina”) – by viewing tax-affecting as a fact-based issue stating, “As we did in Gross … and subsequent cases, we decide this question of fact on the basis of the record before us.”
The court’s factual analysis turned on its opinion that the estate’s expert more accurately took into account the tax consequences/benefits of flow-through status and found that approach more convincing and complete than the zero tax rate proffered by IRS. The court’s rejection of the IRS position for a zeroed-out tax rate as accepted in the three Gs may be the lasting principle established by Jones.
The long-term significance of Jones is uncertain. Does Jones portend a Tax Court change from Gross, or is it a stand-alone fact-based aberration? The Jones decision may also stand isolated because the judge was presented with a single expert testifying for tax-affecting. Subsequent tax court cases may view the Jones result as a failure of proof by the IRS and merely acceptance of the sole expert testimony received rather than a successful “argument for tax affecting.” Planners and appraisers shouldn’t expect the IRS position to change because the tax-affecting case scoreboard still reads seven to one.
The importance of the looming decision in Estate of William A V. Cecil v. Comm’r is now greater than ever to bring clarity to Tax Court views on tax-affecting. In Cecil, a Tax Court case that was argued and briefed more than three years ago, both the taxpayers and IRS experts employed a valuation model that tax affects S corp earnings. If Cecil is decided as a full Tax Court opinion that recognizes tax-affecting as appropriate, the cracks appearing in the 2019 cases will have been the first signs in breaching the tax-affecting wall.
A quiet development during 2019 was a steady and significant decline in Internal Revenue Code Section 7520 interest rates. The rate in December 2018 was 3.6%. Since then, the rate has fallen to 2% in December 2019. The December rate is the lowest since March 2016. Applicable federal rates (AFR) followed a similar trend. The overall decline in interest rates during 2019 has contributed to a rising stock market and higher equity values.
In this low rate environment, favored transfer planning techniques are those that provide the greatest desired benefit when the potential remainder asset growth rate exceeds the IRC Section 7520 rate. A low Section 7520 rate increases the chances for a favorable outcome of passing asset appreciation tax-free to the remainder beneficiaries. For assets with greater expected appreciation than the Section 7520 rate, certain planning techniques, such as grantor retained annuity trusts and charitable lead annuity trusts, offer powerful potential. Similarly, sales to grantor trusts benefit from a lower AFR.
Equity values and interest rates generally move in opposite directions. With the current interest rates at low levels, future asset appreciation is unlikely to receive a boost from a further fall in interest rates.
In the recently released IRS priority guidance plan, there are four items listed under “Gifts and Estates and Trusts,” and two are valuation related. Of interest in the current plan is a focus on regulations: (1) under IRC Section 2032(a) regarding imposition of restrictions on estate assets during the six month alternate valuation period, and (2) under Section 7520 regarding the use of actuarial tables in valuing annuities, interests for life or terms of years and remainder or reversionary interests.
No financial planning is immune from economic shocks, but estate and gift tax issues and planning should expect little disruption until the election outcome comes into clearer focus. Depending on the outcome of the election, taxpayers may face a wealth tax, higher gift and estate tax rates and lower exclusion amounts, which will be the catalyst for frantic planning activity late this year.
The IRS has published the inflation-adjusted estate and gift tax exclusions for 2020. The basic exclusion amount for the unified credit against estate tax will increase from $11.4 million per person in 2019 to $11.58 million in 2020 (or $23.16 million per married couple). The annual exclusion for gifts will remain at $15,000 per person. The sunsetting of the estate exclusion amount back to $5 million adjusted for inflation remains scheduled to begin in 2026.
A version of this article originally appeared in the January 2020 issue of Trusts & Estates magazine.