The U.S. Tax Court just released its decision on Cecil. Everything considered, it’s a win for the taxpayer.
The U.S. Tax Court has finally issued its decision on the long-awaited Cecil case. 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 case went to trial in 2016. At trial, the taxpayer submitted two appraisals and alleged that the original value was too high and requested a refund.
TBC, 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. Vanderbilt descendants are the sole owners of TBC, which offers tours of the house and gardens and also operates hotels, restaurants, retail stores, and various outdoor activities in and around the property, employing over 1,800 employees and thereby generating significant revenue.
The taxpayers’ two experts valued the stock in the company using an income approach (discounted cash flow method, as well as the capitalized cash flow method) and two market approaches (guideline public company method and transaction method). The Internal Revenue Service (IRS) expert, however, valued the company’s stock using the asset approach (net asset value method) and an income approach (discounted cash flow method).
Importantly, all experts tax-affected the company’s earnings to arrive at a C corporation-equivalent value and thereafter used the SEAM (S corporation Equity Adjustment Model) to adjust the value to an S corporation value. The issue of tax-affecting is discussed in more detail below.
The various experts applied the appropriate discounts, including lack of control, lack of marketability, and lack of voting rights.
The Court’s Decision
The Tax Court opined on the following:
- The use of the income approach vs. asset approach for an operating business with no intent to liquidate
- The use of the guideline public company method and the importance of finding comparable companies
- The use of the transaction method and the importance of the timing of such transactions
- The discounts for lack of control, lack of marketability, and lack of voting rights
Income Approach vs. Asset Approach
The IRS expert’s asset approach took the net book value of $20.2 million (net of liabilities) and adjusted it for the difference in the market value of (i) the underlying real estate (increase of $71.7 million), (ii) the portfolio of fine art, antiques, and other collectibles (increase of $41.4 million), (iii) notes receivable (increase of $2.1 million), (iv) the trademarks and tradenames (increase of $9.5 million), and (v) the workforce-in-place (increase of $1.6 million). The resulting net asset value was $146.6 million.
After the application of a discount for lack of control, the noncontrolling equity value under the asset approach was $92 million (compared to only $36 million under the income approach). Although the IRS expert only assigned a 10% weighting to his asset approach, it would prove to be his downfall.
The Tax Court memo stated, “In that [TBC] 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 Tax Court assigned zero weight to the IRS expert’s opinion in establishing the equity value of the company (ignoring both the asset and the income approach). The Cecil case thereby represents another decision in a string of cases where an entity with significant assets and some characteristics of an asset-holding company is valued solely on its cash flows. Revenue Ruling 59-60 seems to leave room to give weight to the asset value when appropriate; however, this has not been the interpretation of the courts.
Public Guideline Companies and the Transaction Method
The taxpayers’ experts also drew some of the Tax Court’s ire. The Tax Court took issue with one expert’s reliance on a single public guideline company and the inclusion of the years 2007-2009 (the years of the Great Recession) in determining a normalized cash flow for the capitalized cash flow method.
The second taxpayer expert was criticized for his reliance on public guideline companies, two of which were “vastly different” from TBC. Finally, the expert’s transaction method included two transactions that took place during the Great Recession and were deemed unreliable by the Tax Court.
Clearly, there are not a lot of companies in the public market or transactions in the private market comparable to an entity holding the largest private estate built by the Vanderbilt family. Given the uniqueness of the entity, a minimal number of comps would be expected. The appraiser faced with this challenge will need to go the extra mile to explain and modulate his or her reliance on the comps.
On the discount front, the Tax Court sided with the taxpayer in its selection of the appropriate discount for lack of control. The IRS’s expert had applied a 38% discount for lack of control to the net asset value under the asset approach, and the discount was somehow derived from real estate limited partnerships and private real estate investment trusts (REITs), as well as closed-end funds.
The taxpayers’ expert applied a 20% discount for lack of control to the value derived under the transaction method, presumably based on a control premium study (although the Tax Court Memo speaks of transactions in noncontrolling interests). It is rare to see the IRS come out of the block with a lack-of-control discount nearly twice as high as that taken by the taxpayers’ expert, a conclusion we are sure the taxpayer would have appreciated. Having said that, the analysis does not seem to have been sound on that point.
One of the taxpayers’ experts applied an additional discount for lack of voting rights to distinguish the value of the voting shares from the nonvoting shares. Neither the second taxpayer expert nor the IRS expert did so. The Tax Court objected to the discount due to the age of the data (1994 and 1999) and because the Court believed the lack of voting rights had already been captured.
Generally speaking, most of the data used for determining discounts for lack of control is derived (as it was here) from closed-end funds and control premiums observed in the public market (the inverse being the minority discount). Those shares have the right to vote, but they are in a minority position and therefore cannot effectuate change or control. In this particular case, the gifted shares consisted of minority voting and minority nonvoting shares. All else being equal, the hypothetical investor would take the shares with a vote over the shares with no vote. We suspect that the additional nonvoting feature was therefore not already captured as suggested by the Tax Court. Maybe the age of the data or the analysis thereof was not properly explained to the judge.
Lastly, the Tax Court did agree with the IRS expert on the determination of the discount for lack of marketability. Worryingly, the Tax Court discounted the use of restricted-stock and pre-IPO studies, as well as the use of a put option analysis. The restricted-stock studies were deemed too old, the pre-IPO studies were deemed too unreliable, and, while not directly criticizing the put option analysis, it was deemed irrelevant.
On the other hand, the IRS expert applied different discounts for the Class A and Class B shares and to different block sizes (with the larger block receiving a larger discount). It is unclear from the Tax Court Memo what data the expert relied on, but the Tax Court accepted his discounts for lack of marketability of 19%, 22%, and 27% compared to the taxpayers’ expert’s discount of 30%.
Background on Tax-Affecting
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 (DCF) method. One notable exception was the Jones2 case.
As mentioned above, all valuation experts in the Cecil matter, including the IRS expert, tax-affected the earnings of TBC when using the DCF method to derive a value. In addition, valuation experts for both the taxpayer and IRS have used the SEAM to address the valuation-related tax differences between C corporations, S corporations, and their respective shareholders.
From the perspective of the valuation profession, the core issues in this case were twofold: (1) whether it is appropriate to tax-affect the earnings of a pass-through entity when applying the DCF method and (2) whether valuation adjustments are necessary to properly estimate the equity value of a pass-through entity when tax-affecting has been used in the analysis.
The DCF Method
The DCF method is a generally accepted valuation method for valuing operating companies. When using this method, analysts project a measurement of earnings for the subject S corporation and discount these earnings to their present value using a discount rate. Typically, the discount rate used in the DCF method is derived from empirical studies of publicly traded shares of C corporations (dual-level taxation entities). Consequently, the discount rate reflects corporate income taxes and shareholder-level dividend and capital gains taxes.
S corporations are not subject to federal corporate income taxes (single-level taxation entities). However, S corporation shareholders are subject to shareholder-level ordinary income taxes on their pro-rata share of the earnings of the S corporation. In addition, S corporation shareholders avoid dividend and capital gains taxes to the extent of accumulated earnings and profits. Consequently, the application of a C corporation discount rate to the earnings of an S corporation represents a mismatch of cash flow and discount rate data without appropriate adjustments to reflect the tax differences between these two types of corporate entities.
Although the DCF method is accepted and typically used in tax-related valuations, there is a substantial disagreement between the IRS and the valuation profession regarding the issue of tax-affecting the earnings of pass-through entities such as S corporations. The origin of this dispute dates back to the 1999 U.S. Tax Court decision in Gross v. Commissioner (“Gross”).3
The Gross Case
In Gross, the IRS was successful in convincing the Tax Court that tax-affecting the earnings of the subject S corporation when using the DCF method was not appropriate. Ever since then, the IRS has maintained this mantra. This argument has been persuasive in seven other Tax Court cases (Heck,4 Wall,5 Adams,6 Dallas,7 Guistina,8 Gallagher,9 and, most recently, Jackson 10) as well. With the exception of Jones, the IRS has not yet lost this argument in Tax Court to date. In Jones, the IRS’s own expert argued for tax-affecting, and only the Commissioner did not.
In Gross and other related Tax Court cases, taxpayer experts have used a DCF method and applied an entity-level corporate tax rate to the projected earnings (i.e., the earnings are “tax-affected”) of the subject S corporation. However, these experts then failed to make corresponding adjustments for the S corporation shareholders’ avoidance of dividend and capital gains taxes.
Consequently, these valuations have failed to adequately address the tax attributes of the C corporation discount rate and the full spectrum of tax-related differences between C corporations, S corporations, and their respective shareholders. The Tax Court has found these valuations to be less than convincing and has sided with the IRS on the issue of tax-affecting. As one might expect, the elimination of the tax effect in the DCF method substantially increases the value of equity of the subject S corporation, and the taxpayer generally faces a significant adjustment in taxes due.
The basic concepts that proponents of the Gross decision adhere to are twofold: (1) Only corporate entity-level taxes should be reflected in the valuation analysis, and (2) S corporations are not subject to corporate entity-level taxes. Consequently, in the minds of Gross proponents, tax-affecting is not appropriate. This naïve position lacks logic, empirical support, and mathematical reasoning in that it ignores the relevant statutory tax differences between C corporations, S corporations, and their respective shareholders.
In addition, the notion that shareholder-level taxation is irrelevant to a valuation analysis is inconsistent with market realities. If shareholder-level taxation is irrelevant, why are there REITs and master limited partnerships? Why are hedge funds and private equity funds structured as limited partnerships? Why were S corporations created in the first place? Why have pass-through entities been the most dominant and fastest growing type of corporate structure in the U.S. during the past 30 years? Of course, the answer is “All taxes matter.”
We use empirical data derived from publicly traded C corporations to determine the discount rate used in the DCF method. Consequently, tax-affecting the earnings of an S corporation when using the DCF method is not only permissible, but also appropriate.
However, tax-affecting is not the only adjustment required. Since the tax-affected DCF Method provides a C corporation-equivalent value of S corporation equity, this indication of value must be adjusted to reflect the relevant tax differences between C corporations, S corporations, and their respective shareholders. In addition to the Tax Court, other courts have weighed in on this important concept.
In 2006, the Delaware Chancery Court accepted tax-affecting for an S corporation in Delaware Open MRI.11 In its published decision, the Delaware Chancery Court constructed an adjustment to the corporate tax rate used in the DCF method in order to reflect the tax differences between C corporations, S corporations, and their respective shareholders. In 2007, the Massachusetts Supreme Court upheld a lower Massachusetts court decision allowing both the use of tax-affecting and the Delaware Chancery Court calculations in the valuation in Bernier v. Bernier.12
The Delaware Chancery Court calculations are not really a valuation model and are subject to significant limitations in order to use them properly in a DCF method analysis. The June 2015 edition of the Business Valuation Review presented an article titled “Delaware Open MRI and the Van Vleet Model.”13 This article addresses the mathematical equivalency of the Delaware calculations and the Van Vleet Model as well as the application limitations of the Delaware calculations. Despite the application differences in these two approaches, the bottom line is that both the Delaware Chancery Court and the Van Vleet Model are on the right conceptual track.
Published in the March 2003 edition of Trusts and Estates magazine and developed by Daniel R. Van Vleet, the Van Vleet Model provides an algebraic equation referred to as the SEAM. This model addresses the much-debated issue of how to value pass-through entities such as S corporations and limited liability companies when C corporation data is used to estimate such value. In other words, the SEAM may be used to adjust the equity value provided by a tax-affected DCF method in order to arrive at a conceptually supportable value of S corporation equity.
The SEAM corrects for the differences in entity-level and shareholder-level taxation between C corporations, S corporations, and their respective shareholders. Depending on the tax rate inputs used in the equation, the SEAM may provide an indication of S corporation equity value that is greater than, less than, or equal to the value of C corporation equity. It all depends on the mathematical relationship among the tax rate inputs to the SEAM equation. All experts in the Cecil case have tax-affected the DCF method, and experts for both the taxpayer and IRS have applied the SEAM in their analysis.
A Win for Tax-Affecting
The first S corporation Tax Court case challenging the use of tax-affecting within the DCF model was the 1999 Gross decision. The Cecil case has been in deliberations since 2016. It took the Tax Court over six years to make a decision.
U.S. taxpayers and the valuation profession at large had hoped that the issue of tax-affecting and the proper valuation of pass-through entities such as S corporations would finally be put to rest. While the Tax Court concluded that “the circumstances … require our application of tax affecting,” the Tax Court also noted “that while we are applying tax affecting here, given the unique setting at hand, we are not necessarily holding that tax affecting is always, or even more often than not, a proper consideration for valuing an S corporation.”
In summary, while a win for tax-affecting in this case, the long-awaited resolution of the issue remains elusive.
- Estate of William A.V. Cecil, Sr., Donor, Deceased v. Commissioner, U.S. Tax Court, Docket Nos. 14639-14, 14640-14, TC Memo 2023-24.
- Estate of Jones v. Commissioner, U.S. Tax Court, TC Memo 2019-101.
- Gross v. Commissioner, U.S. Tax Court, TC Memo 1999-254, aff’d, 272 F.3d 333 (6th Cir. 2001).
- Estate of Richie C. Heck v. Commissioner, U.S. T.C. Memo 2002-34
- Wall v. Commissioner, U.S. Tax Court, TC Memo 2001-75.
- Estate of William G. Adams, Jr. v. Commissioner, U.S. Tax Court, T.C. Memo 2002-80
- Dallas v. Commissioner, U.S. Tax Court, TC Memo 2006-212.
- Estate of Giustina v. Commissioner, U.S. Tax Court, TC Memo 2011-141, 586 F. App’x 417 (9th Cir. 2014).
- Estate of Gallagher v. Commissioner, U.S. Tax Court, TC Memo 2011-148 and TC Memo 2011-244.
- Estate of Jackson v. Commissioner, U.S. Tax Court, TC Memo 2021-48.
- Delaware Open MRI Radiology Associates, P.A., Petitioner, v. Howard B. Kessler, et al., Respondents, C.A. No. 275-N, Court of Chancery of the State of Delaware, April 26, 2006.
- Judith E. Bernier v. Stephen A. Bernier, Supreme Judicial Court of Massachusetts, Dukes County, September 14, 2007.
- Daniel R. Van Vleet, “Delaware Open MRI and the Van Vleet Model,” Business Valuation Review, 2015.