The U.S. District Court – Eastern District of Wisconsin issued an important decision in Kress v. U.S. in which Chief Judge William C. Griesbach relied largely on the findings of the taxpayers’ experts to value gifts of minority interests in a Subchapter S corporation (S corp) operating company, Green Bay Packaging, Inc. (GBP). In those experts’ reports, a Subchapter S corp was first valued on a C corporation (C corp) equivalent basis, which included tax-affecting the entity’s earnings, followed by quantitative and qualitative adjustments to address whether any economic adjustment/benefit should be ascribed to the Subchapter S election (the C to S method).
The court’s acceptance of the C to S method not only led to a victory for the taxpayer in this case, but also is a meaningful victory for the business valuation industry, which has been advocating for the C to S method, or close variations of it, for many years in its efforts to overcome results the industry deemed incorrect in a series of cases starting with Gross in 1999. While the Kress decision may not have the same weight as a U.S. Tax Court decision, it may be persuasive to other courts considering the issue going forward. Though not precedential, other courts will likely review the opinion put forth in Kress.
IRS’ Values
While the court didn’t accept the government expert’s analysis, it’s noteworthy that said expert also applied the C to S method. The opinion stated that the government expert, within the income approach, “applied an effective tax rate to GBP as if it were a C corporation, and then applied an adjustment to reflect the value of GBP as an S-corporation.” Unfortunately, at present, the specific methods applied by the government expert to quantify this adjustment are unknown.
The values put forth initially by the Internal Revenue Service were higher than all the values contained in the three expert reports reviewed by the court (two plaintiff experts and one government expert). According to the court, the IRS “abandoned its initial valuation assessments” and requested that the court adopt the government expert’s conclusions.
After acknowledging the efficacy of tax-affecting, the court went even further stating, “The court finds GBP’s subchapter S status is a neutral consideration with respect to the valuation of its stock. Notwithstanding the tax advantages associated with subchapter S status, there are also noted disadvantages, including the limited ability to reinvest in the company and the limited access to credit markets. It is therefore unclear if a minority shareholder enjoys those benefits.”
Ammunition for Taxpayers
The results of this case should give taxpayers and valuation experts ammunition to diffuse attempts by the IRS to eliminate tax-affecting from the valuation of pass-through entities, an approach suggested within a job aid for IRS valuation analysts prepared in 2014. For years, valuation experts have pushed back against a non-tax-affecting approach as being counter to the economic realities of the situation, essentially treating a pass-through entity as if both the entity and its owners were tax-exempt. The reality is that the earnings of an entity structured as a pass-through for income tax purposes create a significant tax burden for the owners.
This isn’t to say that there is no analysis to be performed to determine the relative value of the C corp and pass-through structures. Rather, it validates the approach of first determining value on a C corp equivalent basis, which typically involves tax-affecting the earnings. The step of first determining a C corporation equivalent value is necessary because the large majority of public market data used to develop valuation multiples and discount rates are derived from publicly traded C corporations. A secondary analysis to assess whether adjustments to value for differences in the structures is then warranted.
Section 2703 Challenge
The taxpayer in this case also faced an Internal Revenue Code Section 2703 challenge by the government. The government argued that restrictions on the transfer of stock in the company ought to be disregarded under IRC Section 2703. To not run afoul of Section 2703, the restrictions must pass a three-prong test. The written decision contains the court’s thorough analysis of the Section 2703 challenge.
In the taxpayers’ favor, the court ruled that the restriction passed the first prong (bona fide business arrangement), stating, “To be sure, family transfer restrictions in a company’s stock may not be a way to maximize shareholder value. But they are consistent with the goals of maintaining a family business and ensuring that the business continues to provide an opportunity for family members to make a living while at the same time continuing to serve the interests of its employees and the community. These are also bona fide interests of business leaders even though not purely economic.” The court went on to place importance on the fact that the company is unmistakably an operating business.
The restriction also passed the second prong of the test (not a device to transfer assets for less than full and adequate consideration), but the rationale the court cited is especially noteworthy. The court stated, “Although Chapter 14 is intended to generally address transfer tax avoidance schemes, it is clear from the statute itself that the phrase ‘members of the decedent’s family’ unambiguously limits its application to transfers at death.” Because this case involved gifts from the taxpayers to family members as living persons, Section 2703(b)(2) is satisfied. The court went on to say that even if the Tax Code was interpreted differently, the use of restrictions to maintain family ownership and control were sufficient to pass the test.
Surprisingly, the taxpayers failed to convince the court on the third prong of the test (terms are similar to arrangements entered into by parties in an arms’ length negotiation). The taxpayers didn’t put forth evidence that the terms are similar to those seen in arm’s length transactions. The court, therefore, concluded that it was improper for the taxpayers’ expert to consider the restriction in the context of marketability. This is unfortunate, as we regularly see operating agreements entered into between unrelated parties that restrict the transfer of shares outright or permit the transfer of shares if requisite consent is provided or subject to a right of first refusal. We can think of many reasons why owners of a closely held company would want to choose their partners.
Despite the failure on the third prong of the test, the court stated that the taxpayers experts gave no meaningful consideration to the restriction and, thus, the opinion of value was still fair and was more persuasive than the opinion put forth by the government’s expert. Ultimately, the court allowed discounts for lack of marketability of 25 percent and 27 percent as of the multiple valuation dates.
The Kress case should immediately be considered as support for tax-affecting the earnings of an operating business structured as a pass-through entity for income tax purposes.