This week, in Estate of Aaron Jones, TCM 2019-101, the Tax Court held entirely in favor of the taxpayer in a set of complex valuations of sawmill and timber operations.[1] By far the most surprising and intriguing of the decisions made by the Court in its opinion was a decision to approve the tax-affecting of the financial results of a pass-through entity when calculating the valuations.
Tax-affecting
Tax-affecting has been a hugely controversial issue in the valuation profession, starting with the Tax Court’s decision in Estate of Gross in 1999. Most appraisers believe that adopting what the Court here describes as a “zero tax rate” for pass-through entities like partnerships and S corporations makes little sense. This is because the taxes eventually have to be paid, just by the owners of the entity, rather than by the entity itself. The distinction that the Court appears to draw in the Aaron Jones decision is one of justification: the appraisers that do tax-affect need to provide justification for doing so, which didn’t happen most recently in Estate of Gallagher. In the Aaron Jones decision, the Court stated:
… we again rejected tax-affecting because the taxpayer’s expert did not justify it but again acknowledged that the benefit of a reduction in the total tax burden borne by S corporation owners should be considered when valuing an S corporation.
The same issue apparently was the deciding factor in Estate of Giustina. In regard to the Giustina decision, the Court in Aaron Jones stated:
… we rejected tax-affecting in the valuation of a partnership because we found the taxpayer’s expert’s method to be faulty: He used a pretax discount rate to present value posttax cash flow.
Major Loss for the IRS
As noted, the win for the taxpayer was comprehensive, but that almost understates the loss for the Internal Revenue Service here: The total value determined by the taxpayer’s expert was $21 million for one of the companies at stake, SJTC.[2] The government’s position on the same company: $141 million. This was no split-the-baby decision in a small fight over a few points on the discount. The decision points were:
- Operating versus holding company: The Court held that SJTC should be valued as an operating company, with an income-based approach. The IRS contended that SJTC could sell timberlands (thus realizing its net asset value, or a portion thereof) rather than just continuing to plant trees, and harvest and sell logs. The Court points out that the interests being valued, as minority interests, weren’t in a position to direct a liquidation of company assets.
- Applying revised projections: The Court held that the taxpayer’s expert correctly relied on updated 2009 projections for the business and that considering these projections together with earlier projections made for the most recent annual report for the business (as done by the taxpayer’s expert) was inappropriate. In the Court’s opinion, it’s clear it viewed the later projections to be more accurate than the earlier ones and that the two don’t represent a “high and low” scenario for a discounted cash flow analysis.
- Tax-affecting the valuation of SJTC: The taxpayer’s expert had applied a 38% tax rate to SJTC pretax earnings in computing net cash flow and, also, the cost of debt capital used to calculate the discount rate. He also applied a similar tax rate in calculating earnings measures for his guideline public companies method. He then added a “pass through entity” premium to reflect the benefit to shareholder for owning an interest in the entity due to the avoidance of double taxation (as is the case for C corporation shareholders).
- The market approach: Both experts used the guideline public companies method, comparing SJTC with companies in the timber and lumber industries. The government, on brief, accepted the taxpayer’s position here (as does the Court).
- Intercompany debt. The government wanted the substantial loans from SSC to SJTC added as a nonoperating asset. The Court, recognizing the two companies were managed as a single group, agrees with eliminating these left-pocket-to-right-pocket transactions.
- Other issues: The valuation of SSC was generally accepted by the government, except for the same disagreements over tax-affecting, which the Court rejected. There was also a (small) disagreement over the discount for lack of marketability, where the Court also rejected the government’s expert’s conclusions and adopted the taxpayer’s.
The Tax Court, summing up earlier decisions on tax-affecting, said: “… the question in those cases, as here, was not whether to take into account the tax benefits inuring to a flowthrough entity but how.” Valuation experts will be studying this decision, and the specific analysis performed by the taxpayer’s expert in Aaron Jones with interest on how to solve just this question.