September 2014 | Issue 76
PERSONAL GOODWILL, IS IT PART OF COMPANY VALUE?
Background
Franklin Adell died on August 13, 2006. Included in his estate was a 100% interest in a company called STN.Com, Inc. (“STN”). The estate initially valued STN at $9.3 million. The IRS issued a notice of deficiency which valued STN at $92.2 million. The parties ultimately found themselves in U.S. Tax Court. The case is Adell v. Commissioner, T. C. Memo. 2014-155 (August 4, 2014).
STN, founded in 1994, was a Michigan-based company that provided satellite up linking services to TV broadcasters. At the time of Mr. Adell’s death, STN’s sole business purpose was to broadcast an urban religious program named “The Word Network” (The Word).
According to its articles of incorporation, The Word was organized exclusively for charitable, educational and scientific purposes. No part of its assets or net earnings could inure to the benefit of its directors, officers, or other private persons. Mr. Adell was president and a director of The Word. His son Kevin was treasurer, secretary and a director of The Word.
On November 24, 1999, The Word and STN had signed a services agreement under which STN agreed to provide such management, technical and other services and facilities to The Word as required to run its operations. In consideration, The Word agreed to pay STN a monthly fee equal to the lesser of STN’s actual costs or 95% of net programming revenue received by The Word in a one-month period.
Pursuant to the services agreement and continuing through Mr. Adell’s date of death, The Word paid to STN 95% of its revenue each month. The Word was STN’s only customer. During the three fiscal years ended May 31, 2006, the annual fees paid to STN by The Word averaged approximately $13 million, an amount equal to 95% of The Word’s revenue.
The Appraisals – the Estate
The estate had initially reported a value for STN of $9.3 million. This was based on a discounted cash flow analysis. The estate’s appraiser subsequently learned that the terms of the service agreement with The Word required a payment to STN of the lesser of 95% of The Word’s revenues or the actual amount of STN’s costs. This latter amount was an amount far lower than the 95% of The Word’s revenues that the company had been receiving. The estate’s appraiser performed a further analysis based on this new information. He concluded that if STN were in a new owner’s hands, that the new owner could not count on STN earning any profits, since the revenues from their only client, The Word, could not exceed STN’s expenses. Accordingly, the estate’s appraiser concluded that STM, since it would have no profits, needed to be valued on a net asset basis. He carried out such an analysis, and came up with a value of $4.3 million. This is the value that the estate advanced in court.
The Appraisal – the IRS
The IRS’ appraiser valued STM using a discounted cash flow method. He determined a date-of-death value of $26.3 million. He used sales projections based on the assumption that The Word would continue to pay STN 95% of its revenues. The IRS appraiser used a discount rate of 25.5%, a rate higher than the 20% used by the estate’s appraiser. However, the IRS applied this discount rate to a stream of cash flow that was substantially higher, producing the value of $26.3 million.
The Court Chooses the Income Approach
The court was charged with the task of coming up with a value conclusion in the face of two competing valuations, the higher one being more than 6 times higher than the lower one. As a first step, the court rejected the theory that STN would be unprofitable in the hands of a new owner. The court believed that the company could be profitable because:
- The company had five straight years of profits,
- The Word never enforced the limitation on STN’s programming fee,
- There was no indication that The Word planned to enforce the limitation,
- Even if The Word did enforce the limit, STN could expand and serve other customers.
The court found, therefore, that a hypothetical buyer and seller could not ignore the company’s historical profitability, and that therefore an income approach was the most appropriate way to value the company.
Personal Goodwill Enters the Picture
There were two income-based appraisals on the table; the estate’s initial report ($9.3 million) and the IRS’ report ($26.3 million). The most significant difference between them was in their treatment of the intangible value that Kevin provided to STN. Both recognized the importance of Kevin’s relationship with The Word and its customers, but they accounted for that value differently. The estate’s appraiser applied an economic charge for Kevin’s personal goodwill that ranged from $8 million to $12 million per year over the projection period, thereby increasing STN’s projected operating expenses and decreasing its cash flow.
The IRS’ appraiser assumed that a hypothetical buyer could retain Kevin for a salary of $1.3 million. This resulted in a higher estimate of STN’s cash flow, and thus a higher valuation of STN.
Conclusion
The court became convinced that Kevin had substantial personal goodwill that was valuable to the operation of STN’s business. The court also believed, in the absence of an employment or non-compete agreement between Kevin and STN, that this goodwill belonged to Kevin and not to the company. The IRS’ appraisal in effect captured some or all of this value and attributed it to the company. The estate’s cash flow appraisal, on the other hand, made an appropriate adjustment to the projected cash flow to reflect payment to Kevin for use of the goodwill.
The court concluded that the estate got it right in their first appraisal, and adopted their value of $9.3 million.
IRS Circular 230 disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding any penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction(s) or tax-related matter(s) addressed herein.
