A Review of Appraising and Tax-Affecting Closely Held Businesses

Estate of Aaron U. Jones v. Commissioner

Timothy K. Bronza, Andrew R. Comiter, Abigail R. Earthman and Kelly M. Perez

The Estate of Jones is a groundbreaking United States Tax Court case that holds that it is appropriate to tax-affect when valuing S corporations for federal gift tax purposes if the facts of the case and the accompanying valuation so support.  Jones also addresses a fundamental issue regarding the method of valuing interests in a business that has both significant business operations and assets of substantial value, such as lumber operations and timberland ownership.  The issue involves the appropriateness of using earnings-based approaches (i.e., an income approach or a market approach), an asset-based approach, or a weighting of the two approaches.  Inevitably, the approach chosen has a significant dollar impact on the value ascribed to a particular entity interest, as was the outcome in Jones.

In 1954, Aaron Jones founded a timberland and lumber operation in Oregon.  Mr. Jones ultimately decided to split his timber and lumber operations into two entities: Seneca Sawmill Company (“SSC”) and Seneca Jones Timber Company, L.P. (“SJTC”).  Mr. Jones established SSC as an S corporation and SJTC, as a limited partnership.  SSC owned a 10% interest in SJTC and served as its general partner in exchange for its contribution of timberland.  Judge Cary Pugh, who authored the opinion for the Tax Court, reviewed the lumber and timberland operations of SSC and SJTC in detail, illustrating the purposes and functions of each entity.

According to the facts presented, the business operations of SSC and SJTC were quite interrelated. For example, SSC purchased 32% of its logs from SJTC.  SJTC practiced sustained yield harvesting and sold, through trading arrangements, approximately 90% of its logs to SSC. SJTC and SSC were joint parties to a third-party credit agreement, and SSC and SJTC transferred money to and from each other in the form of loans/receivables.  The entities operated out of the same headquarters and the same management team ran both opearations.

Moreover, as is typically found with family owned businesses, there were significant restrictions on the transferability of SSC’s  shares and SJTC’s limited partner units. Both were subject to Buy-Sell Agreements that imposed several restrictions, including: (1) any transfer causing the company to lose its status as an S Corporation/Partnership would be null and void; (2) each respective company had a right of first refusal if the shareholder/partner intended to transfer the shares/limited partner units to a non-family member; and (3) the other shareholders/partners had the option to purchase the shares/limited partner units if the respective company didn't exercise its right of first refusal at "fair market value," which was required to be determined based on expected cash distributions, lack of marketability, lack of control and lack of voting rights.

Below are some of the key takeaways from the Jones decision:

  •  Jones is groundbreaking in that it is the first published opinion by the United States Tax Court that held it is appropriate to tax-affect when determining the value of an interest in an S corporation
  • Judge Pugh's opinion distinguished Jones from Gross and Gallagher indicating that the opinions of taxpayer experts in those cases were rejected not because they tax-affected, but fatally, because they did not consider any S corporation benefit.  Therefore, if an appraiser is going to tax-affect, it is highly advisable that they consider any benefit (or in some situations detriment) associated with S corporation status. Judge Pugh distinguished Giustina from Jones on tax-affecting in that tax-affecting was rejected by the Court because the taxpayer's expert's method was faulty.
  • In determining the appropriate approach to value in Jones, Judge Pugh considered both the income and the asset approach to value, concluding that the income approach was appropriate due the interrelationship of the two entities being valued and the likelihood of the assets being sold. In her determination that the income approach was the sole appropriate approach, Judge Pugh concluded there was no likelihood that the assets would be sold by the general partner. In reaching this conclusion Judge Pugh cited the 9th Circuit Court of Appeals opinion in Giustina that remanded the case back to the Tax Court with instructions to weigh the valuation of a limited partnership interest in a timber entity as follows: 100% to the income approach and 0% to the asset approach. If the Estate had lost in Jones, the opinion would be appealed to the 9th Circuit.
  • Jones stands for the proposition that is appropriate to consider the application of both earnings based and an asset approach for the valuation of an interest in an entity that has characteristics of both an operating entity and an investment holding entity. If an appraiser fails to consider both approaches or considers the approaches yet fails to provide sufficient explanation of this consideration in their report that could result in a weakened position for the value conclusion

 In Jones, it is clear that Judge Pugh was impressed with the thoroughness and diligence that the appraiser displayed in performing its valuation.  Careful consideration of the issues addressed in Jones by legal counsel and a business appraiser at the onset of a valuation engagement will lead to a well-supported conclusion, as well as minimize examination risk in scenarios where tax affecting and selection of the appropriate valuation approach(es) have a material impact on the value asserted.