October, 2006 | Issue 10
The ground continues to shift on the matter of “tax affecting” earnings when performing a valuation of an S corporation for estate and gift tax purposes. In Robert Dallas v. Commissioner, T. C. Memo 2006-212 (September 28, 2006), the Court utterly rejected tax adjustments made by two reputable business appraisal firms in coming up with a value for the stock of Dallas Group of America (DGA), an S corporation.
The Transaction
Robert Dallas (Petitioner) transferred about 55% of the non-voting stock of DGA, a chemical manufacturer, to trusts established for the benefit of his sons. The transfer was made in exchange for cash and promissory notes signed by his sons. In establishing the transfer price, Petitioner and his sons agreed to be bound by a value for DGA stock to be determined by a third party appraisal. On November 29, 1999, Mr. Dallas transferred 8,000 shares of stock to the trusts, which were valued by the independent appraiser at $620 per share. On November 29, 2000, he transferred 5,912 shares of stock to the trusts. These were valued by the parties at $650 per share
The IRS Steps In
The IRS audited Petitioner’s gift tax returns and asserted that the stock had been transferred for consideration less than fair market value, and that therefore, gift tax was due. The IRS believed that the stock was worth $907 per share on November 29, 1999 and $906 per share on November 29, 2000. The parties ended up in Tax Court.
Petitioner’s Valuation Arguments
Petitioner presented two valuation experts in court. Both made an adjustment to the company’s earnings to reflect the amount of corporate income taxes that the company would have to pay if it weren’t an S corporation. (S corporations don’t pay corporate income taxes). One appraiser reduced the company’s projected earnings by 40% to reflect such taxes; the other reduced earnings by 35%. They argued that such an adjustment was appropriate because (i) DGA’s S corporation election could be ended at any time, and (ii) some potential buyers of DGA are C companies who would not be able to take advantage of the S election. They reasoned that such a hypothetical buyer would similarly tax-affect DGA’s earnings.
One of the Petitioner’s appraisers also argued that tax-affecting the earnings of S corporations for purposes of performing an appraisal was by far the predominant practice in the appraisal and investment banking professions.
Petitioner also pointed to a recent Delaware Chancery S-corporation valuation case which supported at least partial tax affecting, Delaware Open MRI Radiology Associates, P. A. v. Kessler, 898 A. 2d 290 (Del. Ch. 2006). See also Hempstead Business Valuation Notes E-Letter No. 3.
The Court Speaks
The Tax Court essentially turned aside the Petitioner’s arguments in favor of tax affecting earnings, pointing out that “there is no evidence in the record that DGA expects to cease to qualify as an S corporation.” He also rejected the application of the reasoning of the Delaware case to this matter, pointing out that the Delaware case was a fair merger price case and “reflected equitable considerations, including the possibility that in a merger minority shareholders might be squeezed out. ‘Fair value’ in a minority stock appraisal cases is not equivalent to ‘fair market value’.”
The Court ultimately determined a value of $751 per share for the 1999 value and $801 per share for the 2000 value.
Conclusion
The Gross case first put under serious scrutiny the practice of tax affecting earnings when valuing an S company (Gross v. Commissioner, T. C. Memo. 1999-254). The Dallas case extends that scrutiny. What should be kept in mind, however, is that not all S companies are the same with respect to shareholder distribution practices, merger prospects and other factors bearing on shareholder return. In order for an S corporation valuation to withstand challenge, it must include a nuanced analysis of the particular company’s situation and how it would influence the behavior of a hypothetical buyer of the stock.
