While Tax Court Memorandum Decisions may not be cited as precedent the case of Estate of Louise Paxton Gallagher v Commissioner (T.C. Memo 2011-148), dealing with an estate tax valuation, is instructive in summarizing some Tax Court as well as Judge Halpern views about valuation.  The subject company was a Kentucky LLC treated as an S Corporation for tax purposes.  Some aspects of business valuation (BV) discussed in the decision are:

1. Valuation is a question of fact to be determined by the court.  The court can accept one expert’s opinion over the other or make its own findings on value considering all of the content of both expert reports in evidence.  The Court has wide latitude in adopting any value within the “range of values suggested by the evidence taken as a whole” and is not limited to findings traceable to specific testimony.
2. If the expert is qualified by the court, his or her written report is usually accepted in to evidence as testimony.
3. A business value stated in an estate tax return is an admission which becomes part of the evidence the court will consider in deciding valuation issues by a preponderance of the evidence (proponent of fact must prove that it is more likely than not true).
4. The court did not decide the case on the petitioner’s failure to meet the burden of proof but on the merits.  That is, the court found sufficient evidence from which to make a finding of value.  Many cases in tax court, although not as many with valuation issues, are decided against the Petitioner who fails to meet the initial burden to go forward first to introduce credible evidence with regard to relevant financial issues and to demonstrate cooperation with IRS and compliance with record keeping requirements as required by IRC Section 7491(a).
5. The best evidence of value is “arm’s-length sales near the valuation date of reasonable amount of the stock.”  Rarely is the best evidence available, however.
6. One alternative to the best evidence is to analyze “the value of publicly traded stock in comparable corporations engaged in the same or a similar line of business (Guideline Company Method), as well as by considering certain factors that an informed buyer and seller would consider.” (Referring to the benchmark Rev. Rul. 59-60).  The Court discussed application of the Guideline Company Method under the Market Approach to valuation.   Large privately held companies offer the best analogy with public company data.  Smaller mom and pop business are a horse of another color.  The buyer of public stock is a passive investor while the owner of a small business in the real world must work the business if it is to succeed. Compensation adjustments for employment of a manager do not reflect that many laid off managers are buying businesses for a job.  Also the reasonable compensation adjustment does not reflect that an owner must work much harder and longer hours than those with salaried positions reported on databases that provide reasonable compensation comparables.  Does increasing the number of comparables, as the Court suggests, adequately compensate for the essential dissimilarity between most public companies used as comparables and small privately held businesses? The Court concluded that the four companies used by one of the experts were not similar to the subject company and use of the Guideline Company Method in this case was inappropriate.
7. A redemption agreement that limits the number of shares that can be redeemed in any given year, absent restrictions on transferability, does not alone establish a lack of market for shares.
8. The Court accepted the use of post valuation date financial statements ( June 30 versus the May 30 valuation date) finding that a hypothetical buyer’s due diligence might have uncovered the statements which the expert testified more accurately depicted market conditions on the date of valuation (sounds like mumbo-jumbo logic).
9. The Court accepted so-called “normalizing” adjustments to eliminate non-recurring credits or charges.  This is nuts and bolts business valuation theory although recent events in the world should teach us that non-recurring events or outliers do happen with regularity if we look at a much broader pattern (Chaos Theory).  Should a utility operating nuclear power plants consider the Japan meltdown as a normalizing adjustment?
10.  The Court discussed the Discounted Cash Flow Method under the Income Approach to Valuation employed by both experts who disagreed in its application. One bone of contention concerned the propriety and method of tax-effecting future corporate earnings for the burden of assumed future tax rates for the subject company, an S Corporation. The BV theory supporting tax-effecting suggests that the underlying data for the DCF Method is obtained from public company data which is after tax.  The Court rejected tax- effecting S Corp earnings finding that “the tax benefit is the principle benefit enjoyed by S Corporation shareholders” and that benefit should be considered in valuation.  Further, “We will not impose an unjustified fictitious corporate tax rate burden on… future earnings.”  The court today could equally say the same about the entire DCF Method.  Today public companies often must restate past earnings no less project future earnings given the huge uncertainties surrounding the world and its economies.  In theU.S.we do not know that the present structure of our tax system will remain stable; in fact, we know that changes are on the horizon.  An important part of the DCF Method is the growth rate. The growth rate if you believe politicians is tied to tax rates whether or not applied at the corporate level.   Estimates of growth in our present uncertain environment are poppycock. 

Given, the vagaries of projections, the court often making a finding of value that falls  somewhere in between what the opposing experts opine.   The company involved in this case was valued by the experts between $28.2 and $40.9 million. The Court determined the value for estate tax purposes to be 32.6 million.

The need for business valuations in agreements and litigated disputes with IRS and others has created an industry that devotes itself seriously to business valuations.  The industry has developed credentials, standards, and methodologies for tackling these projects.  But, we should not get so caught up in theoretical discussions that we forget that the industry was need created, not science created.  The values derived are highly speculative and some of the methods employed have underlying premises that are suspect.  We attempt to objectify the process by using for example the build-up method to arrive at a discount rate under the earnings approach.  But, part of the build-up process, specific company risk, being subjective, renders speculative the entire result.  We refer to empirical IPO stock studies but overlook that IPO studies reflect a short-term investment horizon while the small business hypothetical buyer looks to the long-term horizon as well as basic differences between IPO offerings and private company sales. We accept comparables from private data bases, massaged with regression analysis, overlooking that these sources do not often include basic important information that is necessary to evaluate the meaning of the price.  Tax Court judges are intellectuals and the theoretical discussions about BV are fascinating but we should be mindful of the inherent difficulty with predicting what will happen tomorrow no less two or four or five years from tomorrow.  I do not deprecate the BV industry, populated with serious, capable professionals.  I am reminding that the job of prediction is a highly tenuous vocation and quite often results in mud on the prognosticator’s face.

© 2011 by Robert S. Steinberg

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