• Important valuation case addresses valuation methods, tax-affecting, among other issues—In Estate of Aaron U. Jones v. Commissioner (T.C. Memo. 2019-101), the Tax Court addressed many difficult valuation issues relating to minority interests in two related companies in the timber industry.
Aaron Jones made gifts to his daughters and trusts for their benefit of voting and nonvoting interests in two family-owned business entities—an S corporation (S corp) and a limited partnership. The gifts were reported on gift tax returns in 2009 with a value of approximately $21 million, but the Internal Revenue Service asserted that the value was in excess of $120 million with a gift tax deficiency of $45 million.
Two entities were involved: (1) Seneca Sawmill Company (SSC), which is a lumber manufacturer structured as an Oregon S corp, and (2) Seneca Jones Timber Co. (SJTC), which is an Oregon limited partnership that purchases, manages and holds the land and sells its lumber inventory to SSC. SSC was a 10% general partner of SJTC, and they shared a management team. The transfer of interests in both companies was restricted through buy-sell agreements and the operating/partnership agreements.
Aaron died after filing a petition in Tax Court in 2013. His estate hired appraisers to value the company again, and their valuation was somewhat higher than the values reported on the gift tax returns but still far below the IRS asserted values.
There were many valuation issues presented in the case but two of the most important were whether to use the income or asset-based approach for SJTC and whether tax-affecting the value of the interests in SJTC was proper.
On the overall valuation approach, the estate argued that SJTC was a going concern, which sold a product, so that the income approach was most relevant. The IRS argued that SJTC was a natural resource holding company that holds timber as an investment for its partners and that the value of its assets should determine its value. In the end, the court determined that it was most appropriate to use the income-based approach to value SJTC as an operating company because it was so closely related to the operating company SSC and that the minority interests being valued weren’t in a position to direct liquidation. The use of the income approach valued the company at almost one-fourth of what the asset-based approach would have determined.
The estate’s expert “tax-affected” the earnings of the company by reducing their value to take into account a 38% income tax that the partners (rather than the entity) would have to pay. The estate argued that a hypothetical buyer would consider the tax burden she would assume as a partner of the entity. The IRS argued that there was no evidence that the companies would lose their pass-through status and relied on recent cases that held tax-affecting wasn’t appropriate. However, the court distinguished those cases from the circumstances of Jones and held that the adjustment for the tax burden made by the estate’s expert was more convincing than the IRS’ valuation, which made no adjustment at all. The court also noted that the IRS’ expert didn’t rebut the tax-affecting strategy of the estate’s expert and that this was an argument between lawyers, not experts.
This lengthy case addresses many different valuation issues and certainly will be closely analyzed by the experts.
• Post-gift events affect stock valuation—The IRS Chief Counsel has issued Technical Advice Memorandum 201939002 relating to the effect of a post-valuation date event on the valuation of publicly traded stock.
Here, the taxpayer owned shares of a publicly traded company he co-founded. The taxpayer was in the midst of exclusive negotiations to merge with another corporation when he transferred his shares to a grantor retained annuity trust (GRAT). After he funded the GRAT (the TAM doesn’t specify the length of time intervening), the company announced the merger, and the stock price of the company increased substantially, although it didn’t reach the value of the merger price.
Generally, the value of property for gift and estate tax purposes is the price at which the property would change hands between a hypothetical willing buyer and a seller, both having reasonable knowledge of the facts, and neither being under any compulsion to buy or to sell. Treasury Regulations Section 25.2512-2(b)(1) states that in general, for a publicly traded stock, the average of the high and low value on the date of the transfer is the value of that stock for estate and gift tax purposes. However, Treas. Regs Section 25.2512-2(e) provides, in relevant part, that in cases in which it’s established that “the value per share of any security determined on the basis of the selling or bid and asked prices as provided under § 25.2512-2(b) does not represent the fair market value thereof, then some reasonable modification of the value determined on that basis or other relevant facts and elements of value shall be considered in determining fair market value.”
The TAM stated:
Generally, a valuation of property for Federal transfer tax purposes is made as of the valuation date without regard to events happening after that date. Ithaca Trust Co. v. United States, 279 U.S. 151 (1929). Subsequent events may be considered, however, if they are relevant to the question of value. Estate of Noble v. Commissioner, T.C. Memo. 2005-2, n.3…. Thus, a post-valuation date event may be considered if the event was reasonably foreseeable as of the valuation date. Trust Services of America, Inc. v. U.S., 885 F.2d 561, 569 (9th Cir. 1989); Bank One Corp., 120 T.C. 174, 306. Furthermore, a post-valuation date event, even if unforeseeable as of the valuation date, also may be probative of the earlier valuation to the extent that it is relevant to establishing the amount that a hypothetical willing buyer would have paid a hypothetical willing seller for the subject property as of the valuation date. See Estate of Gilford v. Commissioner, 88 T.C. 38, 52-55 (1987).
The TAM continued:
The principle that the hypothetical willing buyer and seller are presumed to have ‘reasonable knowledge of relevant facts’ affecting the value of property at issue applies even if the relevant facts at issue were unknown to the actual owner of the property. Estate of Kollsman v. Commissioner, T.C. Memo. 2017-40, appeal docketed, No. 18-70565 (9th Cir. Feb. 27, 2018). Moreover, both parties are presumed to have made a reasonable investigation of the relevant facts. Id. Thus, in addition to facts that are publicly available, reasonable knowledge includes those facts that a reasonable buyer or seller would uncover during the course of negotiations over the purchase price of the property. Id.
The TAM determined that a hypothetical willing buyer and seller would have obtained knowledge of the pending merger during their negotiations and due diligence, and such knowledge should be taken into account as part of the valuation.
This holding is troubling because of the assumption that public news of the pending merger wasn’t already reflected in the stock price based on research by professional analysts and investment management firms, but hypothetical buyers and sellers would have uncovered the information and better priced the stock.