Tax Court to valuators: Explain yourself!
Estate of Gallagher, T.C. Memo. 2011-148 (June 28, 2011)
Gross v. Commissioner, T.C. Memo. 1999-254 (July 29, 1999)
The U.S. Tax Court’s opinion in Estate of Gallagher is instructive for both attorneys and valuation experts. It demonstrates the court’s inclination to scrutinize expert testimony and demand that experts thoroughly explain the reasoning behind their valuation assumptions and adjustments.
The only issue to be decided in this case was the fair market value for estate tax purposes of the decedent’s 15% ownership interest in Paxton Media Group, LLC (PMG). A privately held, family-owned newspaper publishing company, PMG was originally established in 1896, elected to become an S corporation 100 years later, and converted to a limited liability company (LLC) in 2001 (but maintained its “S” status for tax purposes). The decedent died on July 5, 2004 (the valuation date).
At trial, the estate’s expert valued the decedent’s interest at $28.2 million, while the IRS’s expert valued it at $40,863,000. In a 53-page opinion, the Tax Court parsed the experts’ valuation reports, often rejecting their methods or assumptions as unsupported or inadequately explained. The court made its own determination of value: $32,601,640.
Discounted cash flow method
The estate’s expert relied primarily on the discounted cash flow (DCF) method, while the IRS’s expert applied both the DCF and guideline public company methods. One issue involved adjustments to the company’s income statements in calculating the earnings stream used under the DCF method. Both experts excluded certain income items they claimed were nonrecurring.
Among other things, the estate’s expert excluded a $700,000 gain from a life insurance policy obtained through an acquisition along with a $1.1 million “positive claim experience” from the company’s self-insured health insurance. The Tax Court disregarded these adjustments because the expert “provide[d] no explanation as to why the gains were nonrecurring.”
In addition, the estate’s expert made adjustments to reflect an overfunded pension plan that, he said, “increased the company’s reported net income” in most years. He eliminated the pension amounts from the company’s historical financial statements, “adding back the ‘full amount of the overfunding,’ $11,664,000, to PMG’s enterprise value.”
The court rejected this adjustment as well, finding that the expert “failed adequately to explain both his $11,664,000 calculation and the reason for assuming the overfunded plan provided no annual benefit under the [DCF] method.” It went on to say, “Because we fail to understand his adjustments, we shall disregard them.”
The opinion contains a lengthy discussion of the DCF method, focusing on the experts’ revenue growth computations, adjustments and discounts. In general, the Tax Court found the IRS expert’s analysis more persuasive and adopted it with certain modifications.
The court found several flaws in the estate expert’s analysis. For example, he selected a growth rate that was significantly higher than the company’s historical growth rate. He also adjusted his projections to account for expected increases in newsprint costs, but failed to explain how he arrived at the projected costs.
Guideline company method
The Tax Court found that the IRS’s expert improperly relied on the guideline company method. Under that method, an expert values the subject company by comparing it to similar public companies. In this case, the IRS’s expert analyzed only four public companies, and the court found that they weren’t sufficiently comparable to PMG to warrant application of this valuation method.
Generally, the less similarity there is between the guideline companies and the subject company, the greater the number of comparables required. Among other differences, PMG was substantially smaller than the guideline companies, had a different product mix, experienced greater revenue growth and was more highly leveraged.
Tax affecting projected earnings
In applying the DCF method, the estate’s expert “tax affected” PMG’s projected earnings — that is, he reduced the company’s projected earnings to reflect an assumed corporate tax burden. (See below “To tax affect or not to tax affect.”)
The Tax Court, however, declined to tax affect PMG’s projected earnings because the estate’s expert failed to offer a reason for doing so. The expert had reduced projected earnings based on an assumed 39% tax rate, so the court’s decision had a significant impact on the value calculation.
Back it up
As the Gallagher case shows, courts today no longer accept valuation experts’ opinions without careful scrutiny. Unless your experts can back up their conclusions with convincing reasons, you run the risk that the Tax Court will conduct its own valuation analysis.
To tax affect or not to tax affect
The tax affecting in question in Estate of Gallagher (see main article) is somewhat controversial. Even though S corporations don’t pay corporate level income taxes, valuators would routinely tax affect projected S corporation earnings at a C corporation equivalent rate, which allows the value derived from the income approach to be consistent with the required rate of return derived from publicly traded companies (for example, both on an after-tax basis).
In addition, the corporation could:
• Lose its S status (for example, by being acquired by a C corporation), or
• Fail to distribute sufficient income to cover its shareholders’ tax liabilities.
In 1999, however, the Tax Court ruled in Gross v. Commissioner that tax affecting was inappropriate in valuing a minority interest in an S corporation. The court explained that the primary benefit of S corporation status is the absence of corporate-level taxes, a benefit that shouldn’t be ignored in determining its value.
That doesn’t mean that tax affecting is never justified — in Gross, the court was influenced by the lack of evidence that the corporation in that case was likely to lose its S status. In fact, many valuation experts believe that tax affecting continues to be appropriate if there’s a good reason for doing so.