Part 9: Valuations
By David A. Handler and Alison E. Lothes
Originally written for WealthManagement.com
In Adell v. Comm’r, T.C. Memo. 2014-155 (Aug. 4, 2014), the Tax Court upheld the valuation of a business interest owned by the estate of Frank Adell, in particular its accounting for the goodwill value of Frank’s son, Kevin, who ran the business almost single handedly.
Frank Adell formed STN, Inc. (STN) to provide satellite uplinking services. Kevin handled day-to-day operations as president. Frank and Kevin also formed a nonprofit, known as “The Word,” to broadcast a 24-hour urban religious program channel through DirecTV. Kevin was instrumental in gaining support for the channel by meeting with religious leaders and DirecTV. The Word and STN signed an agreement in which STN agreed to provide uplinking, services and facilities necessary to broadcast its programs, and The Word agreed to pay STN a monthly programming fee equal to the lesser of the actual cost of such services or 95 percent of net programming revenue, not to exceed STN’s actual direct costs and allowable indirect costs.
The Word’s programming was noncommercial. The primary source of its revenue (95 percent of which was paid to STN) was from broadcasting contracts that Kevin negotiated and entered into with ministers and religious organizations. The Word, and therefore STN, earned significant revenues. For example, STN’s gross receipts exceeded $15 million in 2006, the year Frank died. From those revenues, STN paid Frank and Kevin significant compensation. Frank was paid over $7 million in 2006 and Kevin over $1.2 million.
After Frank’s death, Kevin’s sisters filed lawsuits against Kevin in probate court in his capacity as trustee of Frank’s trust and personal representative of his estate. The probate litigation affected STN, so Kevin established a new company, International Broadcasting (IB), and transferred all of the uplinking equipment owned by STN, without consideration, to IB. He and all of STN’s employees, except one, resigned and became employees of IB, and The Word and IB signed an agreement identical to the one signed by STN and The Word.
The estate valued the interest in STN on its estate tax return at $9.3 million. On an amended return, the estate took the position that the STN date-of-death value was $0. The IRS issued a notice of deficiency asserting that the value was over $92 million. The gap in values narrowed by the time the parties went to trial. At trial, the IRS expert valued the interest at $26 million, and the estate valued it at $4.3 million.
The estate’s second report ($4.3 million) valued the company based on its adjusted book value (the asset method) because, under the services agreement, STN couldn’t generate a profit because the monthly fee was limited to the lesser of STN’s costs or 95 percent of The Word’s revenues. Even though The Word hadn’t been adhering to the agreement, so STN was, in fact, generating profits, the appraiser reasoned that a hypothetical buyer couldn’t disregard the terms of the agreement.
However, the court agreed with the original estate’s appraiser and the IRS appraiser who both valued the company by discounting its cash flows (the income approach). It held that because The Word hadn’t enforced the limitation on the fees under the services agreement, there was no expectation that it would do so, and a hypothetical buyer would expect the company to continue to be profitable.
The next issue was how to reflect Kevin’s value of goodwill. The estate’s original appraisal applied an economic charge for Kevin’s goodwill that ranged from $8 million to $12 million. This charge increased STN’s operating costs, which decreased profits. The IRS assumed that Kevin would be retained for an acceptable salary, which was 8.1 percent of sales or about $1.3 million for 2006. This much lower cost resulted in a higher overall value for STN.
The court noted that Kevin hadn’t signed a non-compete agreement and was free to leave at any time (which he, in fact, did, when he organized IB). The court found the estate’s economic charge for his personal goodwill adequately reflected the value of Kevin’s relationships, but found the IRS’ salary assumption wasn’t high enough (noting that Kevin stepped into Frank’s shoes, and Frank had earned between $2 million and $7 million before his death).
As a result, the court upheld the estate’s original valuation of $9.3 million. The opinion is interesting for its discussion of the goodwill that Kevin provided. However, lurking in the background is whether the charitable status of The Word is at risk because of its failure to enforce the fee limitation with its payments to STN and the large salaries paid to Frank and Kevin from STN.
Estate of James A. Elkins, Jr. v. Comm’r
Fifth Circuit reverses Tax Court and applies estate’s requested discount to fractional interests in art
In Estate of James A. Elkins, Jr. v. Comm’r, No. 13-60472 (Sept. 15, 2014), the Fifth Circuit reviewed the Tax Court’s opinion issued last year in Estate of James A. Elkins, Jr. v. Comm’r (140 T.C. No. 5, March 11, 2013). The estate valued James’ various partial interests in artwork by applying a 44.75 percent discount to the pro rata value of each partial interest. The IRS determined that no discount should apply and issued a deficiency notice. The parties stipulated the value of the artwork itself. Judge James S. Halpern of the Tax Court analyzed the willing buyer-willing seller test and the testimony by the experts but, in the end, determined that, in all likelihood, the other co-tenants (James’ children) would purchase a willing seller’s interest. Because the willing seller would likely be able to sell his interest to the co-tenants, the court held that a 10 percent discount would be appropriate to reflect the small uncertainties as to whether the children would purchase the interests and for what price.
The Fifth Circuit agreed with the Tax Court’s analysis in many respects but couldn’t accept its application of a 10 percent discount, mainly because there was no evidence or reasoning for that amount. First, the Fifth Circuit noted that the IRS had the burden of proof. The IRS “put all its eggs in one basket” by arguing that there should be no discount at all and didn’t provide evidence of any alternative discount that could apply. Therefore, the Fifth Circuit held, if the Tax Court wasn’t convinced by the IRS’ position, the judgment should have been for the estate. It held that the Tax Court had no evidentiary basis or factual or legal support for its 10 percent discount. It found that the estate’s experts weighed the relevant factors and characteristics of the co-tenants, and their opinions were credible. As a result, the estate was entitled to a refund of over $14 million, plus interest.
The Fifth Circuit noted that the Tax Court’s analysis of the willing buyer-willing seller test veered off track when it began to consider the motivations of James’ children as the co-tenants and their interest in buying out any hypothetical willing seller to consolidate their ownership. The Tax Court had held that a large discount wasn’t justified because a willing seller would know how interested the Elkins children would be in buying him out—and could capitalize on that knowledge. The Fifth Circuit reasoned the opposite would occur: It would be hard to resell the interest to the Elkins children or others, given how “sophisticated, determined and financially independent” the Elkins children were.
The Tax Court had held that IRC Section 2703(a) would apply to disregard the co-tenancy agreement for valuation purposes. However, while it didn’t directly address the issue of restrictions, the Fifth Circuit seemed to take them into account, as it noted that the restrictions on partition, alienation and possession “exacerbated” the willing seller’s ability to cash in on his investment.