March 01, 2014

Estate of Helen P. Richmond v. Commissioner of Internal Revenue, United States Tax Court, T.C. Memo. 2014-26, February 11, 2014

The Tax Court issued its memorandum opinion written by Judge Gustafson in determining the value of a minority interest in a closely held C corporation that held appreciated marketable securities. The decedent, Helen P. Richmond, died on December 10, 2005, holding a 23.44% interest in the stock of Pearson Holding Company (“PHC” or the “Company”). The parties disagreed over the appropriate valuation method to use, and the magnitude of adjustments related to built-in gains (“BIG”) tax liabilities, discount for lack of control (“DLOC”), and discount for lack of marketability (“DLOM”).

PHC was incorporated in Delaware in 1928 as a family-owned investment holding company. As of the valuation date, the Company’s assets consisted of a portfolio of marketable securities with a value of approximately $52.1 million. PHC’s investment philosophy, as described by its chairman and president, is “to preserve capital, to grow capital where possible, and to maximize dividend income for the family shareholders.” Other salient facts include the following:

  • PHC had paid dividends regularly from 1970 through 2005 at a rate growing slightly greater than 5%.
  • The turnover of PHC’s securities was 1.4% over the last 10 years, implying that a complete turnover could take 70 years.
  • There were nine transactions involving the sale or redemption of PHC stock by a shareholder between 1971 and 1993 at values apparently determined based on a dividend model. When another shareholder died in 1999, the estate used a dividend model to value his interest in PHC.
  • PHC’s unrealized appreciation on its assets was $45.6 million. Assuming the assets were sold on the date of death, based on a 39.74% combined Federal and State tax rate, a BIG tax liability of $18.1 million would result.

Estate Tax Return

For the purpose of filing the estate tax return, the estate retained the Company’s accountant, who had appraisal experience consisting of 10 to 20 valuation engagements and prior testimony experience, but did not have any appraiser certifications. The accountant issued an unsigned draft valuation report indicating a value of the decedent’s interest of $3.1 million based on a capitalization-of-dividends method. Despite the fact that the accountant was not consulted upon issuing the draft report and never asked to finalize his report, the estate reported this value on the estate tax return.

Commissioner’s Position before Trial

The IRS issued a statutory notice of deficiency to the estate determining a value of the decedent’s interest in PHC of $9.2 million. No explanation was provided with respect to the valuation method used, consideration of BIG tax liabilities, or the application of valuation discounts. The notice of deficiency also determined a 40% gross valuation misstatement penalty of $1.1 million pursuant to Section 6662(h).

The Commissioner’s Expert at Trial

The Commissioner’s expert valued the decedent’s interest using a net asset value (“NAV”) method. He applied a DLOC of 6% based on an analysis of closed-end fund studies, and a discount of 36%, comprised of a BIG tax discount of 15%, and a DLOM of 21% based on an analysis of restricted stock studies. To derive the BIG tax discount, he analyzed the correlation between unrealized appreciation and NAV discounts of closed-end funds and concluded that buyers are indifferent to the BIG tax liability on appreciation up to 50% of NAV. He determined “a dollar-for-dollar discount over 50% of the tax exposure” was appropriate, which resulted in an adjustment of $7.8 million, or 15% of NAV. Based thereon, the Commissioner’s expert determined the value of the decedent’s interest was $7.3 million.

The Estate’s Expert at Trial

The estate’s expert valued the decedent’s interest by relying primarily on the capitalization-of-dividends method. He divided the decedent’s share of dividends by a capitalization rate of 5.25% (based on a discount rate of 10.25% and a long-term growth rate of 5%) to determine a value of $5.0 million.

To corroborate his conclusions, the estate’s expert also employed a NAV method using the same starting point as the Commissioner’s expert ($52.1 million). Citing opinions by the Court of Appeals for the Fifth Circuit (i.e., the Dunn case) and Eleventh Circuit (i.e., the Jelke case), he applied a dollar-for-dollar reduction for the potential BIG tax liabilities. He applied a DLOC of 8% based on an analysis of closed-end fund studies and a DLOM of 35.6% based on restricted stock studies, resulting in a value of $4.7 million for the decedent’s interest based on the NAV method.

Tax Court’s Opinion

The Tax Court performed its own analysis utilizing a NAV method, starting with $52.1 million. Citing Jensen and Litchfield, the Tax Court determined the most reasonable discount for BIG tax liabilities to be derived from a present value approach. Based on testimony from the Commissioner’s expert, the Tax Court assumed the portfolio would turn over within a period of 20 to 30 years. In performing its calculations, The Tax Court held the potential BIG tax liability (i.e., $18.1 million as of the valuation date) constant and amortized it ratably over this time frame. The appropriate discount rate was determined to be 9.4%, but the Tax Court applied discount rates ranging from 7% to 10.27% to account for the ranges used by the experts. Based thereon, the Tax Court calculated the present value of BIG tax liabilities to range from $5.6 million to $9.6 million, selecting an adjustment of $7.8 million. Despite being critical of the Commissioner’s expert’s analysis, since his conclusion fell close to the mid-point of the Tax Court’s estimated range, the judge viewed this result as a concession on the Commissioner’s part. The Tax Court applied a DLOC of 7.75% and a DLOM of 32.1%, resulting in a value of the decedent’s interest of $6.5 million.

The Tax Court was critical of the application of the capitalization-of-dividends method, particularly for holding companies whose assets consist of marketable securities due to the sensitivity inherent in this method, noting that “the estate’s valuation method therefore ignores the most concrete and reliable data of value that are available—the actual market prices of the publicly traded securities that constituted PHC’s portfolio.”

Lastly, the Tax Court held that a 20% accuracy-related penalty under Section 6662 was applicable given the “substantial” valuation understatement. The Tax Court determined the estate did not act with reasonable cause and good faith in using an unsigned draft report prepared by the Company’s accountant, who was not a certified appraiser, and did not explain the valuation analysis used to report on the estate tax return.

Stout Comment

The Tax Court misses the point yet again. By introducing the concept in its decision, the myth that a present value approach is useful in determining the impact of BIG tax liabilities is perpetuated. The primary error is quite simple—the Tax Court failed to account for the fact that the assets would continue to appreciate and the BIG would grow commensurately. To illustrate one of the mathematical flaws in the Tax Court’s analysis based on the assumptions utilized in this case, an assumed 25 year turnover rate implies annual amortization of the BIG tax liability of 4%. PHC’s total rate of return of 9.4% is comprised of a dividend return of 5% and a capital appreciation return of 4.4%. To the extent the annual amortization of the BIG tax liability is held constant (i.e., 4%) and the portfolio is appreciating at a greater rate (i.e., 4.4%), then the company will continue to grow and pay annual BIG taxes forever. We maintain that a present value approach is not necessary. The future value of an asset discounted at the appropriate rate of return is equal to the value of the asset today. Estimating when a company will liquidate its assets is typically speculative. When the proper assumptions are utilized, the present value of the projected BIG tax liability will be the same as of the valuation date. Because we know the value of the asset and the value of the liability with relative certainty as of the valuation date, any deviation in value resulting from estimating the future value of an asset and a future tax liability via a present value approach as compared to a dollar-for-dollar approach is most likely due to imprecise assumptions utilized in the present value approach. We stand by the position that a dollar-for-dollar reduction is appropriate from an economic standpoint.