Re: Case No. 16-C-795, Kress et al v. United States of America, United States District Court, Judge William C. Griesbach.
In the case James F. Kress and Julie Ann Kress v. United States of America, a couple sued to recover the overpayment of taxes related to gifts of minority-interest stock in a closely held S corporation, Green Bay Packaging, Inc. (“GBP”), made to their children and grandchildren in 2007, 2008, and 2009. The Court’s tax refund action found its way to the United States District Court (“Court”) where Judge Griesbach was asked to determine the fair market value of GBP. In this case, the taxpayer’s experts largely prevailed (as opposed to the IRS’ expert), resulting in a very favorable outcome for the taxpayer. The Court’s opinion also provided valuable insights for a host of valuation related issues, including but not limited to: (i) S-corporation (“S-corp.”) valuation considerations; (ii) the application of the guideline public company method; (iii) the valuation of non-operating assets from a minority shareholders perspective; (iv) and the development and application of a discount for lack of marketability (“DLOM”). We briefly summarize these insights and provide key takeaways for both appraisers and attorneys in the sections that follow.
S-Corp. Benefit
- The IRS expert tax-affected earnings stream and applied an S-corp. premium. This contradicts the historical IRS position that tax-affecting is not appropriate for S-corporations.
- The Court determined that in this case, the valuation of a minority shareholder of a family-owned subchapter S-corp., the S-corp. benefit was neutral.
- Notwithstanding the tax advantages, Court cited specific disadvantages of electing the S-corp. status, which included: (i) limited ability to re-invest in the company; and (ii) limited access to credit markets.
- Taxpayer’s experts did not consider the subject company’s S-corp. status to be a benefit to a minority shareholder because a minority shareholder cannot change the subject company’s S-corp. status.
- Taxpayer’s experts avoided the S-corp. issues by selecting a before tax financial metric in his application of the guideline public company method.
Guideline Company Method
- A robust set of guideline public companies is an important consideration when applying the Guideline Company Method.
- Guideline companies need not be a static set used over a five year period and can be adjusted to take into account fluctuations from one year to the next, as appropriate.
- The Court felt the IRS expert overstated the value of a minority-held share of GBP stock by applying multiples based on only two guideline public companies, one of which the court determined was an outlier and inappropriate for use. Ultimately, the Court stated that the IRS expert’s approach failed to consider appropriate comparable companies and did not adequately account for the effect of the economic recession.
Non-Operating Assets
- The Court determined that when valuing the entire business, the valuation method of adding back the full value of the non-operating assets is properly employed. However, if a minority shareholder has no control over the use or dissipation of the assets and cannot realize the value of the assets until the assets are liquidated (which there was no expectation of liquidation at the valuation dates), adding back the full value overstates the value attributable to a minority shareholder.
Discount for Lack of Marketability
- The Court determined the IRS expert’s reliance on the cost of an IPO resulted in the application of an incorrect discount for lack of marketability.
- This expert’s approach: (i) was not appropriate given the subject company did not expect to go public, (ii) did not take into consideration the difficulty of disposing the stock of a relatively small company in a capital intensive, mature, competitive business with no public interest, and resulted in a DLOM that was too low (~11%).
- Marketability discounts opined by the taxpayer’s experts were most supportable.
- Considered restricted stock and pre-IPO studies and conducted a qualitative factor analysis specific to GBP and the subject interest to develop a DLOM.
- Family transfer restrictions (which restricted transfers to parties other than family members) should be disregarded in this particular valuation purposes as no evidence was provided that similar restrictions are “common in the commercial world.”
Appraiser Takeaways
- While there are several important takeaways for appraisers from Kress v. U.S., this case highlights the importance of exercising sound judgment throughout the valuation process. The IRS expert’s approach was to “simply follow the numbers where they [led him].” As the Court pointed out, valuation of closely-held equity is a matter of judgment rather than mathematics. An appraiser should conduct ample due diligence and spend time with management to better understand the unique attributes of their business. Also, an appraiser should have well thought out reasons and rationale for the valuation approaches and methods employees. Done properly, the exercise of sound judgment can only enhance the credibility of your appraisals and may be a major factor for determining which expert the court will side with.
- Be thoughtful not only in your approach but also in the supporting narrative of your report (e.g., how have you factored current and expected industry conditions into your analysis?). Well-articulated rationale could be what sways a court in the end. In this case, the IRS expert did not adequately account for the economic recession in his analysis which resulted in the Court: (i) determining the IRS expert overvalued the stock; and (ii) favoring the analysis of the taxpayer’s expert who did account for the economic recession in his analysis.
- The income approach is not always required and depends on facts and circumstances. When possible, elements of the income approach should be considered when performing the market approach.
- Make sure that your philosophies and methodologies for determining your DLOMs are consistently applied across the spectrum of your work. In this case, the IRS expert selected a DLOM of ~11% for an operating company when in a prior court case he had selected a higher DLOM for the valuation of stock in a holding company. Inconsistencies as an expert in prior court cases, or engagement as a whole, will have opposing parties questioning your expertise.
Attorney Takeaways
- Work with the IRS and provide them with the documentation they seek in a timely and respectful manner. If done properly, this can be utilized to shift the burden of proof back to the Government. The shifting of burden is significant in the event of an evidentiary tie.
- IRS administrative documents showing the agency’s consideration of the issues presented in the case or their rationale for making its determinations have no bearing on the court’s de novo determination of the fair market value. The courts do not evaluate the procedures and evidence used in making a tax assessment but rather conduct a de novo review of the correctness of the assessment.
- Inconsistencies or discrepancies made by the IRS found in correspondence will not have an impact on the court’s review of the correctness of the assessment.
- Administrative communication just simply doesn’t matter in the eyes of the court.
- Federal Rule of Evidence 201 (“FRE201”) allows courts to take judicial notice of adjudicative facts that are either “generally known within the trial court’s territorial jurisdiction” or “can be accurately and readily determined from sources whose accuracy cannot reasonably be questioned.” The financial condition of the country in general and health of the stock market, in particular, were relevant to the question of what price a willing buyer would pay a willing seller as of January 1, 2009. As such, the court allowed newspaper and online articles to be submitted as evidence, both of which are not normally the types of evidence which courts take judicial notice of, given the movant satisfied FRE201.
Matthew Springer, MBA, ASA, ABV is a Director of Convergent Capital Appraisers, a business valuation firm headquartered in Houston, Texas.
If you have questions about how we can be of service to you, please give us a call or complete our online contact form. We would be glad to discuss your particular situation with you and work with you and your advisory group to help you achieve your particular estate, succession or business transaction planning objectives.
This article is an abbreviated discussion of complex topics and does not constitute advice to be applied to any specific situation. No valuation, tax or legal advice is provided herein. Readers should seek the services of a skilled and trained professional.