From The Lawyer’s Business Valuation Handbook, Chapter 17
There is more definitive precedential case law in the general area of valuations for federal tax purposes than for any other business valuation purpose. Some issues are well settled, but decisions on other issues continue to evolve. This chapter attempts to distinguish which issues are well settled, nearly settled, or still in some stage of evolution.
There also are issues about which decisions seem to be conflicting (for example, discounts for lack of marketability for controlling interests). However, as Judge David Laro has explained:
Each valuation case is unique. Although guidance can be obtained from earlier cases, one case is rarely on point with another, and a significant differentiation of the facts can usually be made.1
Even among issues that are well settled in principle, there still is a lot of room for argument about magnitudes, especially in such areas as discounts for minority interest and lack of marketability. Chapter 15, “Discounts and Premiums,” addresses empirical data to support quantification of such discounts, and this chapter will discuss principles articulated by the courts regarding quantification of these factors and also magnitudes of discounts ultimately decided.
An understanding of valuations for federal tax purposes is also very important for valuations for many other purposes. Because of the extensive case law, Internal Revenue Service (IRS) Revenue Rulings, and other literature, valuation principles and decisions for tax purposes often are cited in valuation reports and court decisions for other purposes, especially marital dissolution, and also in bankruptcy courts.
Federal tax cases involving business valuations fall primarily into the following categories:
- Estate taxes
- Gift taxes
- Ordinary income and capital gains taxes
- Charitable contributions
- Transfer pricing
Although the standard of fair market value applies equally in all cases, the manner in which it applies can have extreme consequences for estate planning. Most important, for gift tax purposes each transfer is valued individually, while for estate tax purposes the entire amount in the estate is aggregated, regardless of how many different beneficiaries there may be. For example, if a 100 percent interest in a company is in an estate, it will be valued as a 100 percent control interest, even if it is willed equally to three beneficiaries. But if three gifts of one-third interests are made, each will be valued as a minority interest, benefiting from the well-settled principle that the minority interest is discounted compared to a pro rata portion of the value as a whole.
Also, if the estate holds more than one class of security, the combined effect of all may be aggregated for the purpose of valuation,2 but in some cases it is more appropriate to value only the subject voting shares, rather than valuing all voting shares of the company and deriving a pro rata value from that.3
Fair Market Value4
The standard of value for all federal tax cases is fair market value, defined by the Internal Revenue Service as:
the price at which the property would change hands between a willing buyer and a willing seller, when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of the relevant facts.5
There are many nuances to this definition, as discussed in a subsequent section. However, over several decades, the federal courts have developed seven standards that must be considered in determining fair market value. These are:
- Both the buyer and seller must be “willing.”
- Neither buyer nor seller is under a compulsion to buy or sell the item in question.
- Both the buyer and seller are hypothetical persons.
- Both the buyer and seller are aware of all facts and circumstances involving the item in question.
- The item in question is valued at its highest and best use, regardless of its current use (in the business valuation context, this usually means that investor value is maximized).
- The item is valued without regard to an event subsequent to the valuation date, unless such an event was reasonably foreseeable as of the valuation date or was relevant to the valuation.
- The transaction is for cash and will be consummated within a reasonable commercial time frame.6
To this day, one of the most instructive cases on fair market value of closely held stock for federal tax purposes is Central Trust Company v. United States,7 a lengthy, detailed discussion of valuation issues written more than 40 years ago. Although the reader must recognize that the structure of markets and financial theory and evidence have advanced in quantum leaps since that decision, it is still the most comprehensive tax case discussion of basic valuation issues and well worth reading today. One other case of comparable instructive detail and quality on valuation under the fair market value standard is Foltz v. U.S. News and World Report.8 It involves a class-action suit alleging undervaluation of retiring employee stock under the fair market value standard. Both these lengthy cases are available for downloading at www.BVLibrary.com.
One of the more lengthy discussions of the Tax Court’s posture in determining fair market value is contained at the beginning of the opinion in Estate of Furman, which case we suggest is instructive reading in general.9
Another case that is a good source for the modern history of fair market value is Bank One Corporation v. Comm’r.10
Fair Market Value Assumes Adequate Knowledge
Central Trust makes the point that “[F]air market value presupposes not only hypothetical willing buyers and sellers, but buyers and sellers who are informed and have adequate knowledge of the material facts affecting value.”11 In a 1999 case, for an example of this principle, Judge Laro rejected two sales proffered as evidence of fair market value, noting, “Neither seller was reasonably informed regarding the value of their stock. . . . Both took the offer . . . because it sounded like a good amount of money. Their testimony revealed that they were not knowledgeable sellers who aimed to realize the fair market value of their stock.”12
Must Consider Both Buyer and Seller—and Both Must Be Hypothetical
Quite a few Tax Court decisions have either modified or rejected an expert’s opinion of value because the expert focused solely, or unduly, on the buyer, with no or inadequate consideration given to whether the value would be acceptable to a hypothetical willing seller. For example:
(Petitioner’s expert) seems to have focused too much on the willing buyer portion of the fair market value definition. He failed to consider whether a seller, under no compulsion to sell, would discount the pro rata value of his interest by 40 or 50 percent in order to consummate the sale. [FN: we note that petitioner . . , a minority-interest holder under no compulsion to sell, testified that he would not sell his interest at the discount advocated by (petitioner’s expert).]13
Similarly, in another case:
(Taxpayer’s expert) focuses exclusively on the hypothetical willing buyer. (He) failed to consider whether a hypothetical seller would sell his or her interest in the partnership for $399,000. . . . Ignoring the views of the willing seller is contrary to this well-established rule.14
Of course, a transaction cannot take place at more than the highest price that some willing buyer will pay. Fair market value assumes market conditions as they exist at the date of valuation. Therefore, if the seller is really willing, the implication would seem to be that he or she must accept what the market will bear at the valuation date. The existence of a market implies both buyers and sellers,15 but it can be difficult to determine the market for a closely held company. For example, some buyers might be interested in continuing the business as their own, while others might be interested in the business as an investment. There also might be other buyers who see the business as offering synergies with other acquisitions or assets.16 Addressing this issue, some tax regulations require that the value of the property at issue be measured in the market where it would most likely be sold.17 To comply with this requirement, the attorney should instruct the business appraiser to analyze the marketplace to identify the most likely pool(s) of buyers. In any event, the “[s]election of the proper market for valuation purposes is a question of fact.”18
In any case, the lawyer would be well advised to be sure, in reviewing the report, that the willing seller part of the hypothetical willing buyer/willing seller combination is not ignored.
Finally, both the seller and the buyer must be hypothetical. In one case, the Tax Court’ decision was reversed because, according to the Court of Appeals, it based its ruling on speculation and imaginary scenarios that identified particular buyers, rather than hypothetical buyers.19
Qualifications of Appraisers
While the quality of evidence is of primary importance, the Tax Court also is very interested in appraisers’ qualifications when deciding on the relative weight to accord the respective experts’ testimony. For example, in Estate of Berg, the court’s opinion included lengthy discussions of the experts’ qualifications.
(Taxpayer’s first expert) is an experienced certified public accountant who has served on the faculty of several universities. He has also served as an expert witness in several cases that involved the determination of the effect of minority interest discount and lack of marketability discount. However, (he) has no formal education as an appraiser.
(Taxpayer’s second expert) is an experienced certified public accountant who has served as a professor at a university. (He) has no formal training as an appraiser, but has provided advisory services related to valuation of equity interest, mergers, acquisitions, leveraged buyouts, employee stock ownership plans, and litigation.
(IRS’s first expert), a professional appraiser, has completed courses sponsored by the American Society of Appraisers in research and analysis of business valuations, advanced valuation, and closely held business valuation. He is an associate member of the American Society of Appraisers, Business Valuation Section.
(IRS’s second expert), a professional appraiser, has completed an advanced business valuation seminar, a closely held corporations valuation seminar, four business valuation courses, and a business valuation strategy seminar. He is an associate member of the American Society of Appraisers, Business Valuation Section, and is a member of the Institute of Business Appraisers.
(IRS’s third expert), a professional appraiser, has completed courses in eminent domain valuation, going-concern valuation, and two courses in valuation of businesses and professional practices. He is a member of the American Institute of Real Estate Appraisers, an associate member in the American Society of Appraisers, Business Enterprise Section, and a member in the Institute of Business Appraisers.20
The Tax Court not only sustained the IRS’s position, but also invoked the underpayment penalty:
In addition, the expert reports submitted by petitioner were lacking in substance and analysis. The authors of the reports were not professional appraisers, had no formal education in the valuation of business enterprises, and were not members of any professional associations involved in the education and certification of appraisers.
Petitioner has failed to carry its burden of showing that respondent abused his discretion in determining that petitioner failed to show a reasonable basis existed for the valuation on petitioner’s 1986 estate tax return or that the claim was made in good faith. We therefore sustain respondent’s determination with respect to the addition to tax pursuant to Section 6660.21
In other cases, however, even though the reported amounts could trigger the Section 6660 undervaluation penalty, the Tax Court has refused to impose the penalty on the grounds that the taxpayer retained a qualified appraiser and submitted the amount shown on the return in good faith.
With thousands of well-qualified business appraisers available and with recognized business valuation standards in place, as discussed in Chapter 2 on business valuation professional credentials and professional standards, it seems amazing that lawyers present so many unqualified “experts” with inadequate evidence and methodology before the U.S. Tax Court (or any court, for that matter). All too typical is this U.S. Court of Appeals opinion:
The Tax Court rejected (taxpayer’s expert’s) entire opinion, emphasizing his lack of qualifications and the deficiencies in his methodology. We do not find the Tax Court clearly erred in rejecting (taxpayer’s expert’s) opinion.22
In Kohler v. Comm’r,23 the Tax Court gave no weight to the opinions of the IRS’s expert who, although a chartered financial analyst (CFA) with a doctorate, was not credentialed in business valuation and did not provide USPAP certification. The court also looked unfavorably at the expert’s innovative, but unsupported, financial model. In Estate of Thompson v. Comm’r,24 the Tax Court criticized the experts for both parties, finding that they were inexperienced and that their valuations generally lacked credibility. Conversely, in Caracci v. Comm’r,25 the court rejected the taxpayer’s attempt to challenge the IRS’s expert’s qualifications as “nonsensical and border[ing] on the frivolous” where the expert was a certified public accountant and a principal in a business valuation firm who had conducted numerous business valuations.
In Estate of Josephine Thompson v. Comm’r,26 the Tax Court rejected both parties’ valuations and, while declining to impose an underpayment penalty, criticized the estate’s decision to hire an accountant and lawyer from Alaska (the estate was in New York) with relatively little valuation experience.
This chapter was updated from the first edition by Noah J. Gordon, legal counsel for Shannon Pratt Valuations, Inc. Mr. Gordon is a regular contributor to valuation and legal publications.
1. Hon. David Laro, Judge Laro’s views on “fair market value,” Judges & Lawyers Business Valuation Update, MAY 1999, AT 1–3. Full text of address before the AICPA National Business Valuation Conference (Nov. 17, 1998) available at www.BVLibrary.com.
2. Ahmanson Found. v. United States, 674 F.2d 761 (9th Cir. 1981).
3. Estate of Simplot v. Comm’r, 249 F.3d 1191 (9th Cir. 2001).
4. For an extensive discussion available on the nuances of fair market value in the federal tax valuation context, see Jay E. Fishman, Shannon P. Pratt & William J. Morrison, Standards Of Value: Theory And Applications 35–85 (John Wiley & Sons 2007).
5. Rev. Rul. 59-60.
6. Hon. David Laro & Shannon P. Pratt, Business Valuation and Taxes: Procedure, Law, and Perspective 9 (John Wiley & Sons 2005).
7. Central Trust Co. v. United States, 305 F.2d 393 (Ct. Cl. 1962).
8. Foltz v. U.S. News and World Report, Inc., 106 F.R.D. 338 (D.C. Cir. 1984).
9. Estate of Furman v. Comm’r, T.C. Memo. 1998-157 (1998).
10. Bank One Corp. v. Comm’r, 120 T.C. 174, 2003 U.S. Tax Ct. LEXIS 13, 120 T.C. No. 11 (2003), rev’d and remanded, 2006 U.S. App. LEXIS 20430 (7th Cir. 2006).
11. Central Trust Co. v. United States, 305 F.2d 393 (Ct. Cl. 1962).
12. Estate of Kaufman v. Comm’r, T.C. Memo. 1999-119 (1999).
13. Moore v. Comm’r, T.C. Memo. 1991-546 (1991).
14. Estate of Lehmann v. Comm’r, T.C. Memo. 1997-392 (1997).
15. See, e.g., Walter v. Duffy, 287 F.41 (3d Cir. 1923).
16. Roger J. Grabowski, Identifying Pool of Willing Buyers may Introduce Synergy to Fair Market Value, Shannon Pratt’s Business Valuation Update, Business Valuation Resources 7, No. 4 (April 2001).
17. See, e.g., IRS Treas. Regs., Estate Tax Reg. § 20.2031-1; IRS Treas. Regs., Gift Tax Reg. § 25.2512-1.
18. Leibowitz v. Comm’r, T.C. Memo. 1997-243 (1997).
19. Estate of Simplot v. Comm’r, 249 F.3d 1191 (9th Cir. 2001).
20. Estate of Berg v. Comm’r, T.C. Memo. 1991-279 (1991).
22. Estate of Ford v. Comm’r, 53 F.3d 924 (8th Cir. 1995).
23. Kohler v. Comm’r, T.C. Memo. 2006-152 (2006).
24. Estate of Thompson v. Comm’r, T.C. Memo. 2004-174 (2004).
25. Caracci v. Comm’r, 118 T.C. 379, 118 T.C. No. 25, 2002 U.S. Tax Ct. LEXIS 25 (2002).
26. Estate of Josephine Thompson v. Comm’r, T.C. Memo. 2004-174 (2004), aff’d, 499 F.3d 129 (2d Cir. 2007).