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Ever since Gross v. Commissioner,1 the Tax Court has struggled with the valuation of pass-through entities, such as S corporations (S corps). The question is: Should the earnings of an S corp be tax-affected by imposing an assumed corporate tax rate (based on the taxes of similar C corporations (C corps), for example) to pre-tax earnings and then capitalizing those earnings in some way?
Recently, in Jones v. Comm’r,2 after a 20-year history of denying tax-affecting, one court agreed that it was allowable. However, just two years later, in Jackson v. Comm’r,3 another court didn’t find tax-affecting appropriate.
Now, here comes Cecil v. Comm’r,4 decided in early March, in which the court is again allowing tax-affecting in a valuation case. Cecil also provides another look at how the court weighs evidence on valuation discounts. Finally, the case is instructive in its treatment of the asset approach when valuing an operating business.
Gifts of Shares
The case revolves around gifts made by William A.V. Cecil, Sr. and Mary Ryan Cecil of Class A (voting) and Class B (generally non-voting) shares in the Biltmore Company (TBC) in November 2010. William’s mother was Cornelia Cecil née Vanderbilt, the only child of George W. Vanderbilt, who built the Biltmore House in the Blue Ridge Mountains in Asheville, N.C., between 1889 and 1895.
Today, TBC owns the Biltmore House, a national tourist attraction, and its surrounding acreage and operates a significant (1,300 employees) travel, tourism and historic hospitality business. Visitors to the historic estate can stay at its inn, shop at five retail outlets, eat at eight restaurants and engage in a variety of activities including tours, river rafting, fly fishing and equestrian training. The business generates significant revenue (about $70 million in 2010) and has been profitable every year since 1995, except for the recession year of 2008.
In total, the Cecils transferred to their children and certain trusts one share of Class A common stock and 9,337 shares of Class B common stock. The shares weren’t publicly traded and, beyond the normal illiquidity of privately held shares, were also restricted by the bylaws of TBC and its shareholders’ agreement.5 The Cecil family owned all of the shares of TBC and had adopted formal written policies aimed at perpetuating family ownership and management of the company and its historic assets.
After the gift, the Cecils filed Forms 709 for 2010, valuing the gifted shares at a total appraised value of $20.9 million based on a going-concern valuation.6 The Internal Revenue Service, on the other hand, in its notice of deficiency, disregarded the existence of TBC entirely and attributed no weight to its going-concern value, valuing the gifts instead based on the liquidation value of the company’s assets. The court’s opinion doesn’t specify the exact notice of determination (NOD) valuation, but based on the net asset value (NAV) method presented by the IRS expert at trial, it may have been more than $140 million. However, as we shall see, the IRS made a major climb-down before trial.
Valuation Battle
The taxpayers produced two appraisals from expert witnesses in court, both of whom appear to have valued the TBC shares at significantly lower values than those taken on the tax return. The valuation methods used by the taxpayers’ experts included the discounted cash flow (DCF) method under the income approach, the guideline public companies method and the similar transactions method under the market approach (both experts rejected the asset approach).7
Because the vast majority of the shares of TBC were gifted, for comparison, the total value of TBC (discounted) claimed on the gift tax return was approximately $22 million, while the total value implied by the taxpayers’ experts at trial was approximately $11 million.8
The IRS took a radically different view; first, its main expert, using the NAV method under the asset approach, relied on appraisals of some assets along with his own estimate of certain other assets (such as TBC’s many trademarks) to arrive at a total NAV of $146.6 million. He then applied discounts based on discount data to this number to arrive at a total value of $92 million.9
However, he also applied what he called the “discounted future benefits” method, which appears to be a standard DCF under the income approach. Using the DCF, he arrived at a value of approximately $15.2 million, but added non-operating assets to reach a total value of $36 million. Finally, he put almost all the weight on his DCF conclusion and took further discounts to arrive at a value of $4,000 per Class A share and from $3,066 (smaller blocks) to $3,276 (larger blocks) per Class B share. Running these numbers, this implies a total value for TBC of approximately $31 million.
Thus, the case went from a $22 million versus $140 million valuation gap at the NOD stage, to a $11 million to $31 million valuation gap at trial. The court still had quite a valuation assignment!
Three Valuations Judgments
The court had three major valuation judgments to make in arriving at its opinion:
- To what extent should the asset approach be considered in this valuation exercise?
- Should TBC earnings be tax-affected in the income and market approaches?
- What valuation discounts are appropriate?
The asset approach. While many outside observers have viewed Cecil with anticipation, particularly for the tax-affecting decision, the decision on the asset approach was the most consequential here. If the court had held that the asset approach should apply, it would make a major difference as to the value. Valuation analysts working on the valuation of an operating company often face this problem: what to do when the company is worth more dead than alive?10
In its analysis of the asset approach, the court first notes: “In that TBC is an operating company whose existence does not appear to be in jeopardy, and not a holding company, we believe that TBC’s earnings rather than its assets are the best measure of the subject stock’s fair market value.”11
The court also found the IRS’ expert’s use of the asset approach to be inconsistent with appraisal standards as the holders of any of the gifted interests lack control and, thus, the ability to cause liquidation.12
The court also gave weight to the voting trust and shareholders’ agreement and testimony from family members and held that the liquidation of TBC is unlikely, as any one holder of the subject interests would have to:
- “acquire additional shares to cause TBC’s liquidation”;
- “convince other shareholders to vote for liquidation”; or
- “wait until the shareholders of their heirs decide to liquidate.”13
On this point, the Tax Court cited only one prior case from 1993, Estate of Ford,14for the proposition that “primary consideration is generally given to earnings in valuing the stock of an operating company, while asset values are generally accorded the greatest weight in valuing the stock of a holding company.” In another case from 2003, Hess v. Comm’r,15 the Tax Court held that “the value derived under the net asset value method is entitled to some weight in valuing” the stock of a manufacturer of metal processing machines or automation systems.16
Interestingly, many of the cases that consider the acceptance or rejection of the asset approach, which can strongly influence the result, involve timber interests. These are somewhat analogous to Cecil, in that the entities involved often have inadequate earnings compared with their asset values and could, in a liquidation, be worth considerably more. In a couple of cases also relevant on the pass-through issue, Giustina v. Comm’r17 and Jones, the result was extremely favorable to the taxpayer, in that the Tax Court ended up with concluded values far lower than the asset values of the companies at issue. For example, in Jones, the concluded fair market value was close to 5% of the asset value. Conversely, in Estate of Jameson,18 the Tax Court held that the asset approach was “most reasonable in a case like this one, where the corporation functions as a holding, rather than an operating, company and earnings are relatively low in comparison to the fair market value of the underlying assets.”19 However, in Jameson, the decedent held a controlling interest, rather than a minority. The revenue of the entity valued in Jameson was the result of harvesting and selling timber, not some additional value-added activity.
Tax-affecting. The court, after summarizing its 20-year long string of anti-tax-affecting decisions from Gross to Giustina, provided a deeper dive on the reasoning in Jackson and Jones. It noted that in Jones, “the parties agreed that a hypothetical buyer and seller would take into account the entity’s business form when determining the value of a limited partner interest” and that “the Commissioner disagreed with his experts,”20 and the experts mostly agreed that tax-affecting was appropriate. It was just the lawyers who disagreed.
In Jackson, however, the court didn’t find tax-affecting appropriate. While in Jones, the “experts agreed to take into account the form of the business entity and agreed on the entity type,”21 in Jackson, “we held that tax affecting would not be appropriate because the estate’s experts had not persuaded us that the buyers would be C corporations.”22 However, even in Jackson the court didn’t find that there’s “a total bar against the use of tax affecting when the circumstances call for it.”23
Thus, the Cecil court observed that:
each side’s experts . . . totally agree that tax affecting should be taken into account . . . and experts on both sides agree on the specific method that we should employ to take that principle into account, we conclude that the circumstances of these cases require our application of tax affecting.24
However, the court emphasized:
that while we are applying tax affecting here, given the unique setting at hand, we are not necessarily holding that tax affecting is always, or even more often than not a proper consideration for valuing an S corporation.25
It isn’t completely obvious what the court refers to as “the unique setting at hand,” but it could be a reference to this unanimity of experts, rather than to anything in particular regarding TBC and the circumstances of the subject interests being valued. Therefore, it seems likely that the court again will be inclined to rule against tax-affecting if presented with a situation in which experts disagree.
In the end, it’s somewhat unclear how the court resolves the tax-affecting issue. Reference is made to “tax-affecting” percentages of between 17% and 25%” (the court adopts one of the appraisers’ 17% figure), but these are S corp premiums (developed by the S Corporation Economic Adjustment Model.26) It isn’t explicitly stated in the opinion at what tax rate the various appraisers tax-affected the pre-tax income of TBC. Presumably, all the appraisers used the same tax rate, so the court felt it was unnecessary to address the issue.
Valuation discounts. The court applies a discount for lack of control of 20%. It rejected the (higher) discount of the IRS expert because it was based on real estate limited partnership and closed-end fund data. These databases are in turn based on trading in holding companies, while TBC is an operating company.
For the lack of marketability discount, the taxpayers’ experts applied discounts from 25% to 30%, while the IRS’ expert applied a discount in a range between 19% and 27%, depending on voting rights and size of the block.
The court first rejected the analysis of one of the taxpayers’ experts, because it was based on: (1) studies of restricted stock that were too old (apparently, the data was mostly from the 1970s and 1980s), (2) studies of pre-initial public offering transactions, which the expert had admitted were unreliable, and (3) a put option analysis, which the court noted produced a range of discounts from 11.6% to 22.6% and stated “we cannot fathom how that analysis supports his final discount rate of 30%.”27
Finally, because the IRS’ expert had differentiated between smaller and larger blocks and between differing voting rights, the court felt that these discounts were appropriate. Interestingly, the court rejected the application of a voting rights discount (again, based on old studies) because each expert already accounted for “valuing a nonvoting minority interest.”28
Note here that the valuation date in Cecil was well prior to the 2017 passage of tax legislation that significantly lowers the corporate tax rate applicable for C corps. Most of the pass-through premiums calculated by applicable models are to some extent derived from the lower effective taxation of shareholders in S corps and other pass-through entities, due to the elimination of double taxation (shareholders in C corps paying, effectively, taxes both at the corporate level and at the shareholder level when post-tax income is paid out as dividends). Thus, when for example in the SEAM model, the applicable C corp tax rate is reduced, the premium is reduced as well.29 For many S corps, especially many service companies, as well as those subject to limitations on the deductions due to lower wages, the economic benefits of holding S corp shares as opposed to C corp shares may have been reduced.
Refund for Taxpayer
In the end, the court accepted one of the taxpayers’ expert’s conclusions before tax-affecting and before discounts. Discounts are applied at the levels opined at by the taxpayers’ expert for lack of control and at the IRS’ expert for lack of marketability. The court didn’t land on an exact value conclusion, but it appears that final judgment will be entered at a value substantially below the value on the Form 709, so this taxpayer will be getting a very nice refund!
Endnotes
1. Gross v. Commissioner, T.C. Memo. 1999-254.
2. Estate of Jones v. Comm’r, T.C. Memo. 2019-101.
3. Estate of Jackson v. Comm’r, T.C. Memo. 2021-48.
4. Estate of William A.V. Cecil, Sr., v. Comm’r and Estate of Mary R. Cecil, v. Comm’r, T.C. Memo. 2023-24 (Feb. 28 2023).
5. The bylaws provided for one vote per each of seven Class A shares, with majority voting for the board of directors. The board declared dividends by majority vote. Under the shareholders’ agreement, shareholders could transfer shares to any other shareholder or to any lineal descendant of such shareholder. Transfers outside of the family required written notice to each other shareholder, all of who may then purchase such shares according to a formula clause. Furthermore, a voting trust agreement provided that any vote to sell any land, structure, asset or stock of the Biltmore Company (TBC) required the vote of two-thirds of the family trustees.
6. The gifts were one share of Class A stock from Mary Cecil, valued at $3,308, and 9,337 shares of Class B stock from William Cecil, valued at $2,236 per share. The Cecils split the gift and reported each a taxable gift of $10,438,766 (the math doesn’t quite work out, so presumably there’s rounding in some of the numbers). Dixon Hughes did the appraisal attached with the Form 709.
7. David Adams, of Adams Capital, applied the discounted cash flow (DCF), guideline public companies (GPC) and similar transactions methods and arrived at a value of $1,614.71 per Class A share and $1,019 per Class B share. George Hawkins, of Bannister Financial, applied the capitalization of net cash method and GPC method and arrived at a value of $1,131 per Class A share and $1,108 per Class B share.
8. TBC had 10,000 shares outstanding, seven Class A shares and 9,993 Class B shares. Based on an average per share value of $1,063 per share, this implies a value of $10.6 million. (However, the court’s opinion is unclear on whether the value applied by George Hawkins, ibid., is his final concluded value, or just the value from the GPC method.)
9. Two databases were used: closed-end funds and real estate limited partnerships (RELPs). Both of these data sources are widely used in the valuation profession as indicators of discounts for lack of control and (to some extent, for RELPs) lack of marketability. Confusingly, the Tax Court opinion describes this as “multiples” applied. However, applying price (P)/net asset value (NAV) multiples to an NAV is really just the inverse of discounting. Thus, the court appears to have discounted the NAV by 37% ($92 million divided by an NAV of $146.6 million is an average “effective” P/NAV of 0.63, or a discount of 37%).
10. The Tax Court’s memo doesn’t provide TBC’s profit margins, except that it notes consistent positive earnings (except for 2008). However, its return on assets can’t be very high, given that the value estimates from the asset approach are so much higher than the value estimates from the income and market approaches (which are based on company profits or cash flow).
11. Cecil, supra note 4, at p. 27.
12. Uniform Standards of Professional Appraisal Practice Standards Rule 9-3 is cited. The rule cautions that the approach should be used only when the interest being valued has the ability to “cause liquidation.”
13. Cecil, supra note 4 at p. 28.
14. Estate of Ford v. Comm’r, T.C. Memo. 1993-580. Estate of Ford involved several holding companies and one operating company and focused mostly on whether it was appropriate to use the income approach when valuing a holding company. This approach was rejected.
15. Hess v. Comm’r, T.C. Memo. 2003-251. The Tax Court also held that “in deciding the relative weight to give to the net asset value in valuing a corporation, we must consider the extent to which the company is actively engaged in producing income as opposed to simply holding property for investment,” Hess, at p. 26 (citingEstate of Andrews v. Comm’r, 79 T.C. 938).
16. Ibid.
17. Estate of Giustina v. Comm’r, T.C. Memo. 2011-141.
18. Estate of Jameson, T.C.M. 1999-43.
19. Ibid., at p. 39.
20. Cecil, supra note 4 at p. 26.
21. Cecil, supra note 4 at p. 28.
22. Ibid.
23. Cecil, supra note 4, at p. 27.
24. Ibid.
25. Ibid.
26. See, further, The Van Vleet Model, Business Valuation & Taxes: Procedure, Law & Perspective, edited by Shannon P. Pratt and U.S. Tax Court Judge David Laro(1st ed., New York: 2005). The SEAM model calculates a premium for a pass-through entity using the following variables: (1) the C corporation (C corp) effective income tax rate; (2) the individual ordinary income tax rate; (3) the capital gains tax rate; and (4) the income tax rate on dividends.
27. Cecil, supra note 4, at p. 32.
28. Cecil, supra note 4, at p. 31.
29. In addition to the SEAM approach, I’ve also seen used, and applied in similar circumstances: (1) a direct capitalization model incorporating both short and long-term pass-through benefits, (2) a simple DCF analysis of only the pass-through benefits applicable to avoiding the double taxation of dividends (as was prepared in Jones, supra note 2), and (3) an analysis of empirical data on acquisitions of S corps and the relative valuations of S corps versus comparable C corps (as was also presented in Jones). Presenting multiple methods are one possible way to surmount the hurdle presented by the Tax Court’s long history of anti-tax-affecting decisions.