In the April 7, 2025, decision in Kaleb J. Pierce (“Petitioner”) vs. Commissioner of Internal Revenue (T.C. Memo. 2025-29), the Court tackled such hot button issues as tax affecting a pass-through entity and the appropriate treatment of events known and knowable in preparing projections. Judge Greaves was the presiding Judge in this case dealing with a gift tax deficiency resulting from 2014 gifts to irrevocable trusts.

Background

The company in question, Mothers Lounge LLC, an S corporation for federal tax purposes (“Company”), was in the business of providing various “trendy” maternity products to first-time mothers by mail order.

The Company’s history reads very much like a made-for-TV documentary of questionable husband and wife entrepreneurs taking advantage of first-time mothers with cheap, knock-off maternity products but highly inflated shipping costs and no return option. By creating a subsidiary for each product, the Petitioner and his wife were able to run the inflated shipping scam for each product without the consumer catching on or bundling purchases. The Company was run by the Petitioner, and all new product discovery and marketing was driven by his wife (“Ms. Bosco”). The two co-owned the Company.

On the heels of various patent infringement lawsuits and blackmail associated with an affair the Petitioner was having with an employee, the Petitioner and his wife decided to engage in estate planning. The minority gifts and sales made in 2014 were audited by the IRS in 2016. The IRS determined gift tax deficiencies for both the Petitioner and Ms. Bosco of $4,824,000 and accuracy-related penalties of $1,929,000.

At that point, the Petitioner and Ms. Bosco abandoned their previously submitted valuations and let the Service know that a valuation report from a newly retained valuation firm was pending. The Petitioner’s new expert, Jeffrey Pickett, of Lone Peak Valuation Group (Lone Peak), prepared new projections in 2017 (“2017 Projection”) for IRS negotiation purposes and prepared the eventual report used at trial (“2024 Report”).

Mr. Pickett stated that he was rushed by time constraints for the 2017 Projection, leading to a flawed due diligence process with post-valuation-date considerations, but was able to run a thorough process for the 2024 Report, with a projection based on data available as of the valuation date.

Valuations and Experts

For the Petitioner, Mr. Pickett opined that the fair market value of Mothers Lounge as of the valuation date was $18,678,000 before discounts. Mr. Pickett applied a 25% marketability discount and a 5% control discount. After considering these discounts, he valued the 29.4% gift interest at $3,913,000 and the 20.6% sale interest at $2,741,000.

The Respondent offered the expert testimony of Mark Mitchell of Mitchell Fox Valuation Advisors. Mr. Mitchell testified that he reviewed and relied on the 2017 Projections without any independent verification. Mr. Mitchell valued Mothers Lounge at $28,107,000 before discounts. Mr. Mitchell applied a 30% marketability discount and no lack-of-control discount. After accounting for these discounts, he calculated the value of the 29.4% gift interest at $5,784,421 and the value of the 20.6% sale interest at $4,053,029.

The experts and the Court agreed that the income approach, specifically the discounted cashflow method, was the best method to determine the value of the interests.

Court Findings

The Court “easily” rejected Mr. Mitchell findings, as he failed to show that he made any independent corroboration of the Lone Peak 2017 Projection that he relied upon. His report does not indicate that he reviewed the underlying data or grappled with the assumptions underlying the projection. Instead, he indicated that he “considered the projections from the 2017 Lone Peak report to represent a reasonable basis on which to base assumptions for the income approach analysis” without further analysis.

The Court noted several concerns readily apparent as to the soundness of the assumptions made in the 2017 Projection that Mr. Mitchell did not address. For example, the 2017 Projection does not discuss — much less analyze — the impact of the Petitioner’s infidelity and the corresponding FBI investigation that was known as of the valuation date.

The 2017 Projection also relied extensively on post-valuation-date data. In fact, Mr. Pickett testified that he “couldn’t reach that same conclusion, empirically, without the additional post-valuation data.” This reliance blurs the line between information that was known or knowable as of the valuation date and the information that was not reasonably foreseeable as of the valuation date.

Therefore, the Court accorded Mr. Mitchell’s discounted cash flow model no weight.

Mr. Pickett’s 2024 Report provided an in-depth analysis of the economy, the specific industry, growth prospects, and a measured assessment of the risk and opportunities. The Court concluded that Mr. Pickett’s revised forecasts in the 2024 Report are credible and adopted them in totality.

Tax Affecting

Both sides tax affected the earnings of the Company; however, the Court had to determine whether the record is sufficient to apply tax affecting because of their limited approach to the application of tax affecting. The Court listed several cases where tax affecting was not accepted by the Courts but also stated, “However, we have applied it where the record clearly sets out the necessity for tax affecting.”

Since both experts agreed that a hypothetical buyer and seller would consider the fact that the Company is an S corporation, and both parties agreed on the use of the Delaware Chancery method to account for this variable, the Court found “under these circumstances, it is proper to apply tax affecting to the Company’s earnings.”

The Delaware Chancery method of tax affecting applies a reduced fictitious tax rate at the entity level to account for the lower overall tax burden of a pass-through entity. This fictitious tax rate is based on the ratio of overall pass-through entity taxes (individual tax rates) compared to the overall C corporation tax rate (corporation tax rates and shareholder-level tax rates). This method accounts for the burdens of current tax that the owner might owe on the entity’s earnings and the benefits of future dividend tax avoided. This ratio is applied to the C corporation tax rate to estimate the fictitious entity-level tax rate.

The Court accepted Mr. Pickett’s fictitious entity-level tax rate of 26.2% rather than the IRS expert rate of 25.8% due to better supporting documentation.

Discount Rate and Company-Specific Risk Premium

The experts’ true source of conflict comes from the company-specific risk factor to be added to the discount rate. The build-up method allows for the consideration of company-specific risks that are not present in the larger market. A company-specific risk premium must not include factors already accounted for in determining the cost of equity. Mr. Pickett added a 5% company-specific risk adjustment to his cost of equity.

He based this on the following five risks associated with the Company that he did not believe were adequately accounted for: (1) termination of certain contracts, (2) possible loss of lawsuits, (3) limited long-term success of the inflated shipping model, (4) impact of marital strife, and (5) impact of the Company’s failure to adopt social media.

The Court noted that Mr. Pickett does not explain in his report how he derived the 5% company-specific risk adjustment. When pressed at trial, he failed to set forth sufficient detail to allow the Court to understand the calculation. He estimated that a 5% company-specific risk adjustment would decrease the Company’s value by 19%, which he thought was reasonable.

The Court found his explanation wholly deficient to gauge the reliability of his 5% adjustment and backed out the entire 5%, resulting in a discount rate of 18% equal to the cost of equity pre-company-specific risk premium.

Discounts for Lack of Control and Lack of Marketability

The Court quickly dismissed the IRS expert non-application of any discount for lack of control on the operations by stating, “Mr. Mitchell improperly restricted the application of the discount to only nonoperating assets.”

The Court adopted the 5% lack-of-control discount selected by Mr. Pickett in totality.

The Court also accepted Mr. Pickett’s conclusion of a 25% discount for lack of marketability based on a detailed review of the pre-IPO studies and the Stout restricted stock study.

Conclusion

A well-reasoned case that can generally be scored as a resounding victory for the taxpayer. One interesting observation is the retention by the IRS of experts that tax affect, as this was not always the case. A bright line is forming that, when done correctly under the right circumstances, tax affecting is winning with the experts and the Courts in their quest to determine fair market value.