The United States District Court (the “court”) rendered an opinion regarding the fair market value, for gift tax purposes, of a closely held S corporation, Green Bay Packaging, Inc. (“GBP”). The case James F. Kress and Julie Ann Kress, Plaintiffs, v. United States of America, Defendants (“Kress”) related to gift tax liability associated with gifts of GBP shares in 2007, 2008, and 2009. GBP is a family-owned business that manufactures corrugated packaging, folding cartons, coated labels, and related products. The case covered many topics regularly debated by appraisers, including the application of the Guideline Public Company Method, valuation differences between S corporations and C corporations, discounts for lack of marketability, transfer restrictions, and the impact of broader economic conditions (in this case, the 2008-2009 recession) on the valuation of privately held companies.
The valuation of operating businesses organized as S corporations has attracted significant intellectual debate within the appraisal community. Appraisers have generally argued that any valuation benefit associated with an S corporation should be based on the effective difference in after-tax income to shareholders. The Internal Revenue Service (IRS), in contrast to the position taken by many appraisers, has taken the position that tax-affecting is not appropriate for S corporations. This position has prevailed in several Tax Court cases.
In contrast, in Kress, the appraiser hired by the IRS tax-affected the earnings of GBP as if it were a C corporation, and then separately quantified an S corporation premium, to our knowledge a first. Ultimately, the court determined – consistent with the position taken by the taxpayers’ (the Kress family) first expert – that there was no benefit to the S corporation status. Specifically, the court found that “GBP’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.”
All of the experts opined to a discount for lack of marketability to apply to the shares of GBP, which was expected to be family-owned for the foreseeable future and incorporated family transfer restrictions in its bylaws. The IRS’ expert opined to discounts for lack of marketability approximating 11% in each of the three years, based largely on the costs of going public. The taxpayers’ first expert opined to discounts for lack of marketability ranging from 28% to 30% in the three valuation dates based on a review of restricted stock studies and pre-IPO studies. Finally, the taxpayers’ second expert applied a 20% discount for lack of marketability each year.
The court concluded that the marketability discounts opined to by the IRS’ expert were too low, noting that the appraiser’s “reliance on the cost of an IPO resulted in the application of an incorrect discount for lack of marketability,” and that the appropriate discount for GBP, as an operating company, should be well in excess of that generally applied for a holding company. The court found that the marketability discounts opined to by the taxpayers’ first expert were most supportable, though the court also evaluated whether the family transfer restrictions (which restricted transfers to parties other than family members) should be considered in the valuation based on criteria set forth in Section 2703(b). After reviewing the relevant criteria, the court found that because no evidence was provided that similar restrictions are “common in the commercial world,” the family transfer restrictions should be disregarded for valuation purposes. However, the court ultimately determined that the downward adjustment to the discount for lack of marketability determined by the taxpayers’ first expert should be relatively minor and concluded on discounts for lack of marketability ranging from 25% to 27% for the three valuation dates.
All three experts applied the Guideline Public Company Method. The IRS’ expert and the taxpayers’ second expert also applied an Income Capitalization Method, but ultimately the court found the use of the Guideline Public Company Method to be most applicable, noting that “all of the experts agreed that the Market Approach captures real world investors’ decisions on the valuation dates.” The IRS’ expert identified up to 20 companies in the same business as GBP. But the expert ultimately focused on only two companies and simply calculated changes in multiples without considering broader industry and economic conditions on a holistic basis with the attributes of GBP. Notably, no adjustment was applied on account of the economic recession because, according to the appraiser, GBP was in good financial condition.
As a result, the court opined that the appraiser’s 2009 value was “inflated because he did not adequately account for the 2008 recession and relied on an outlier as a comparable company.” The court cited comments on negative industry trends by GBP’s Chief Financial Officer, and emphasized that, consistent with IRS Revenue Ruling 59-60, the overall economic outlook, and outlook for the specific industry, are highly relevant in valuing privately held shares. In contrast, the taxpayers’ first expert evaluated a somewhat larger number of guideline public companies (up to six) and a holistic approach to the comparative analysis.
Kress includes a number of key takeaways for appraisers, certainly the most noteworthy being that the Court determined there was no benefit to an S corporation status in this case, notwithstanding the position the IRS has taken that tax-affecting is not appropriate for S corporations. While many companies benefit from an S corporation election and the additional after-tax income associated therewith, such a determination is fact-specific and should be combined with other considerations (such as the level of distributions paid, the level of corporate and ordinary income tax rates as of the valuation date, and the marketability restrictions associated with being an S corporation).
Second, the appraisers’ separate application of the Guideline Public Company Method illustrates the importance of considering a larger set of guideline companies and taking account of fluctuations in any one comparable from year to year. Any comparison, irrespective of the condition of a given company, should also account for industry and economic conditions.
Finally, the appraiser given most credibility by the court was an appraiser who had developed familiarity with the business over an extended period of time. While the court addressed many of these issues individually, ultimately the court largely sided with the valuation opinion of an appraiser retained by the taxpayers “who spent ample time with the company and management and truly understands GBP’s business,” rather than an expert retained by the IRS whose approach “was to simply follow the numbers where they led him.”
This further reiterates how two importance factors lend credibility to an appraisal: