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Tax Affecting in Valuations –Court Cases & Trends

Series 2 – October 30, 2019

To Receive CPE Credit• Individuals

• Participate in entire webinar• Answer polls when they are provided

• Groups• Group leader is the person who registered & logged on to the webinar• Answer polls when they are provided• Complete group attendance form • Group leader sign bottom of form• Submit group attendance form to training@bkd.com within 24 hours of webinar

• If all eligibility requirements are met, each participant will be emailed their CPE certificate within 15 business days of webinar

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Shaun Duffin, CPA/ABV, ASA PartnerForensics & Valuation Services

Alex Brandon, ASA, ABVSenior Managing ConsultantForensics & Valuation Services

Agenda• Introduction• Historical considerations around tax affecting in valuations• TCJA’s effect on taxes in valuations

*Much of the discussion today will focus on what we view as the most contested area involving taxes – how to handle taxes when valuing pass-through entities (PTEs)

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Gross v. Commissioner• Gross v. Commissioner, T.C. Memo. 1999-254, aff’d. 272 F. 3d

333 (6th Cir. 2001), cert. denied, 537 U.S. 827 (2002)• G&J Bottling, an S corporation, was a large independent

Pepsi-Cola bottler • In 1992, five separate gifts of less than 1% interests were made• Taxpayer estimated a value of $5,680 per share• Tax court estimated a value of $10,910 per share

Gross v. Commissioner• Two areas of dispute

1. Tax affecting of the discounted cash flows of the company used to estimate value by the income approach

2. Size of marketability discount• Three-judge panel at the Sixth Circuit Court of Appeals decided

that tax affecting was not appropriate in this instance by a two to one vote

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Gross v. Commissioner• Gross implications

Taxpayer IRS

Pre-Tax Cash Flow 10,000$ 10,000$ Income Taxes @ 40% (4,000) -

After-Tax Cash Flow 6,000 10,000

Divided by Capitalization Rate 10% 10%

Indicated Value 60,000$ 100,000$

Premium from IRS Approach 66.67%

Subsequent Tax Court Cases• Estate of John E. Wall v. Commissioner, T.C. Memo. 2001-75• Estate of William G. Adams, Jr. v. Commissioner, T.C. Memo.

2002-80• Estate of Richie C. Heck v. Commissioner, T.C. Memo. 2002-34• Delaware Open MRI Radiology Associates, P.A. v. Howard B.

Kessler, 898 A.2d 290, (Del. Ch. 2006)(Note: these older court cases typically had very specific facts & circumstances that varied from most companies)

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IRS Position on S Corp Taxation• Per IRS Job Aid [Emphasis Added] “With respect to the attribute of pass-through taxation, absent a

compelling showing that unrelated parties dealing at arm’s-length would reduce the projected cash flows by a hypothetical entity level tax, no entity level tax should be applied in determining the cash flows of an electing S Corporation. In the same vein, the personal income taxes paid by the holder of an interest in an electing S Corporation are not relevant in determining the fair market value of that interest”

Pre-TCJA Taxation of S Corporations• Appraisers generally tax affected S corps & applied a pass-through

benefit factor• Approaches Daniel Van Vleet’s S corp Equity Adjustment Multiple (SEAM) Fannon’s Simplified model (later withdrawn in favor of adjusting COC) Grabowski model Treharne model Pre-tax discount rate

• Tax affecting pass-through entities is one of the most contested areas within valuation from the IRS

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Recent Developments – Taxes & Value• Tax Cuts & Jobs Act of 2017• Kress v. U.S., Case No. 16-C-795, U.S. District Court, E.D.

Wisconsin, March 25, 2019• Estate of Jones v. Commissioner, T.C. Memo. 2019-101

Tax Cuts & Jobs Act• Key changes affecting valuations Reduced corporate tax rates (largest single impact) Limitations on deductibility of interest expense Limitations on NOLs Accelerated capital expensing

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Kress v. United States• Green Bay Packaging Inc. (GBP), a family-owned S corporation• Paper & packaging manufacturer• 3,400 employees• 32 manufacturing locations operating in 15 states• Serves the corrugated container, folding carton &coated label

markets

Kress v. United States• Plaintiffs James F. Kress & Julie Ann Kress gifted minority

shares of GBP to their children & grandchildren at year-end 2006, 2007 & 2008

• The IRS challenged the gifting valuations in late 2010• In August 2014, the IRS sent Notices of Deficiency with per

share values nearly double those of the original appraisals• Plaintiffs filed suit in Federal District Court (Eastern District of

Wisconsin)

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Kress v. United States• Plaintiff’s appraisers: John Emory (Emory & Co. LLC) & Nancy

Czaplinski (Duff & Phelps)• IRS appraiser: Francis Burns (Global Economics Group)• Burns’ value, while higher than the Plaintiff’s appraisers, came

in lower than the IRS conclusion• Court accepted Mr. Emory’s appraisals

Kress v. United States

*Summary compiled by Mercer Capital

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Kress v. United States• Both Burns & Emory tax-affected GBP’s earnings as if it were a

C corporation• Burns tax-affecting S corporation earnings is inconsistent with

the IRS’ position• The court did not accept Burns’ S corporation premium

Estate of Jones v. Commissioner• In May 2009, Aaron Jones made gifts to his children/trusts• Taxpayer gifted voting & nonvoting interests in entities that

collectively operated as a lumber & timber company• Seneca Sawmill Co. (SSC), an S corporation • Seneca Jones Timber Co. (SJTC), a limited partnership

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Estate of Jones v. Commissioner• Taxpayer reported a total value of the gifts of $21 million• IRS asserted a value of $120 million & notified taxpayer of a gift

tax deficiency of $45 million• Mr. Jones filed a petition in the Tax Court in November 2013

Estate of Jones v. Commissioner• Mr. Jones’ estate engaged Robert Reilly of Willamette

Management Associates Mr. Reilly’s concluded value was slightly higher than the value originally

submitted by the estate• The IRS experts were Philip Schwab & John Ashbrook Mr. Schwab valued the companies slightly higher than the IRS

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Estate of Jones v. Commissioner

*Summary compiled by Bessemer Trust

Estate of Jones v. Commissioner• Mr. Reilly tax-affected the earnings of SSC & SJTC at individual

tax rates• IRS objected to the tax-affecting, citing common arguments

&prior cases (such as Gross v. Commissioner)• Court explained that prior cases did not prohibit tax-affecting

earnings forever (depends on the subject facts & circumstances)

• Court accepted Mr. Reilly’s valuation, a win for the taxpayer

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BKD Observations• Tax affecting PTEs is one of the most highly contested areas

within valuations relating to the IRS• In our experience, many valuation firms do tax-affect PTEs• Pre-TCJA, many valuation firms also applied a PTE premium,

e.g., SEAM• While Kress & Jones help provide a great turn in the taxpayers’

advantage, there is still a long way to go (appeals, jurisdictions, etc.)

BKD Observations• Post-TCJA, many valuation firms tax-affecting at C corporation rates,

but not applying PTE premiums• Has created a situation where PTE shareholders are sometimes

paying actual tax (at the personal level) in excess of the taxes reflected in the valuation

• Many S corporation clients have contemplated the conversion to a C corporation

• IRS is still busy challenging pre-TCJA valuations (for the most part), we are waiting to see what comes through after these challenges are complete

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QUESTIONS?

Continuing Professional Education (CPE) Credits

BKD, LLP is registered with the National Association of State Boards of Accountancy (NASBA) as a sponsor of continuing professional education on the National Registry of CPE Sponsors. State boards of accountancy have final authority on the acceptance of individual courses for CPE credit. Complaints regarding registered sponsors may be submitted to the National Registry of CPE Sponsors through its website: www.learningmarket.org

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• CPE credit may be awarded upon verification of participant attendance

• For questions, concerns or comments regarding CPE credit, please email the BKD Learning & Development Department at training@bkd.com

CPE Credit

THANK YOUFor more information:Shaun Duffin, CPA/ABV, ASA

Partner

Forensics & Valuation Services

Indianapolis | 317.383.4149 | sduffin@bkd.com

Alex Brandon, ASA, ABV

Senior Managing Consultant

Forensics & Valuation Services

St. Louis | 314.231.5544 | abrandon@bkd.com