March 2014 | Issue 72
U.S Tax Court Judge David Gustafson was faced with the task of determining the fair market value of an interest in an investment company named Pearson Holding Co. (“PHC”). The case is Estate of Richmond v. Commissioner T.C. Memo 2014-26 (February 11, 2014).
At the time of her death, December 10, 2005, Helen Richmond owned a 23.44% interest in PHC, a family-owned investment holding company. PHC was incorporated in Delaware in 1928. It is a subchapter C corporation. Its portfolio consists for the most part of dividend-paying common stocks. PHC’s shares are held by 25 members whose interests range from 0.17% to 23.61%.
Throughout its history, PHC had followed a policy of investing for dividends. Portfolio turnover was very low, about 1.4% per annum in recent years. The company’s $52 million portfolio was represented 97% by common stock. Larger holdings included Exxon Mobil, Merck and GE.
Because of the infrequency of sale of holdings, PHC has over the years developed a high level of unrealized and untaxed capital gains in its portfolio. These taxes become payable when capital gains are realized from the sale of portfolio holdings. As of December 31, 2005, 87.5% of the value of PHC’s portfolio consisted of appreciation on which capital gains tax had not yet been paid, but which would eventually become due upon the sale of appreciated securities. PHC followed a strategy of not realizing capital gains taxes so as to maximize the amount of money that could be put to work holding dividend-paying stocks.
The Estate’s Filing and the IRS’s Response
The decedent’s estate tax return reported a value of the estate’s interest in PHC as $3,149,767. This amount was determined by a CPA employed by PHC. It was calculated by means of a capitalization-of-dividends method.
On June 12, 2009, the IRS issued a statutory notice of deficiency to the estate, determining an upward valuation of the decedent’s interest in PHC to $9,223,658.
The Trial – IRS Presentation
At trial, the IRS offered John A. Thomson as its business valuation expert. Thomson used a discounted net asset method to value the interest. Beginning with a net asset value of PHC of $52,114,041, Thomson calculated the decedent’s 23.44% share to be $12,214,925. He then applied a 6% discount to adjust for the fact that the decedent held only a non-controlling minority interest, and then applied a further discount of 36% to adjust for both the lack of marketability of PHC’s non-publicly traded shares and for the tax obligation created by the built-in capital gains tax (“BICG”). This discount he allocated 21% to the lack of marketability and 15% to reflect the BICG tax. Applied together, these discounts produced an overall discount of 40% and a value for the PHC interest of $7,330,000.
The Trial -Estate’s Presentation
The estate’s valuation expert was Robert Schweihs. He valued the decedent’s interest in PHC primarily by means of a capitalization-of-dividends method, an income approach. Schweihs’ calculation was done by means of a formula known as the Gorden Growth Model or dividend growth model. This formula, shown below, calculates today’s value of a stream of steadily growing annual cash flows lasting ‘til eternity.
PV = E(1+g)/(k-g)
PV = the present value (today’s value)
E = the most recent annual dividend ($252,436)
k = the required rate of return per annum (discount rate)
g = the expected long-term annual growth rate of dividends
Using a discount rate (k) of 10.25%, a long-term growth rate (g) of 5% and the decedent’s share of the 2005 annual dividends of $252,436, the formula produced a value of $5,046,500.
Mr. Schweihs also did a valuation based on net asset value. He employed an 8% discount for lack of control (compared to Thomson’s 6%), a 35.6% discount for lack of marketability (versus Thomson’s 21%) and a discount for BICG tax equal to 100% of the existing unrealized tax. This amounted to $4,245,707, or about 35% of the net asset value of the holding. This compares to a 15% discount for BICG tax proposed by Thomson. The asset approach employed by Mr. Schweihs produced a value of $4,721,962.
The estate chose to advance at trial the higher of Mr. Schweihs’ numbers, $5,046,500. This was the value produced by the capitalization-of-dividend approach.
The Court’s Finding
The principal disagreements between the parties were (i) which valuation method should be used, capitalization-of-dividends or net asset value, and (ii) if the net asset value is used, what discounts should be applied.
The court concluded that the net asset value approach better determined PHC’s value. It felt that the capitalization-of-dividends method “ignores the most concrete and reliable data of value that are available – – i.e., the actual market prices of the publicly traded securities that constituted PHC’s portfolio.” The court went on to point out that the market values of the portfolio securities inherently reflect the market’s judgment of the projected future income streams of each stock. Therefore a net asset valuation takes into account the expected dividend stream of the portfolio.
In dealing with the adjustment needed to property reflect the BICG tax, the court noted that there have been cases where courts have agreed to a discount equal to 100% of the BICG tax. He considers that wrong in this case however. He points out that a buyer of this portfolio may retain the use of the appreciated stocks for a period of time and enjoy income from them. This is different from a situation where the tax would have to be paid immediately after purchase. Said the court, “A 100% discount … illogically treats a potential liability that is susceptible to indefinite postponement as if it were the same as an accrued liability due immediately. We do not adopt this approach.”
The court instead made a calculation of the present value of the BICG taxes if they were to be paid in equal annual payments over a period ending some 20 to 30 years in the future. This produced a range of values of from $5.5 million to $9.6 million. The IRS had proposed a discount of about $7.8 million, which, in the light of his calculations, the court found reasonable.
There was less disagreement between the parties as to the other valuation discounts. The court adopted a discount for lack of control of 7.75%, and for lack of marketability of 32.1%. This latter figure was the average discount from a range of restricted stock studies considered by both parties. These adjustments produced a final value for the estate’s interest in PHC of $6,503,805.
The estate initially reported the value of the PHC holding as $3,149,767. The final value determination by the Tax Court was $6,503,805. The reported value was 48% of the final value. This is below the 65% threshold for possible imposition of a penalty for substantial underpayment. Such a penalty will not be imposed, however, if the taxpayer can show that he acted reasonably and in good faith with respect to the underpayment.
The court considered the matter, and concluded that the estate did not act with reasonable cause and in good faith in using an unsigned draft report prepared by its accountant as a basis for reporting the value of the PHC interest. Although the accountant had some appraisal experience, he was not a certified appraiser. Said the court, “In order to be able to invoke ‘reasonable cause’ in a case of this difficulty and magnitude, the estate needed to have the decedent’s interest in PHC appraised by a certified appraiser. It did not.”
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.