The U.S. Tax Court (“Court”) recently issued Tax Court Memorandum 2023-24 with respect to Estate of Cecil v. Commissioner. This long-awaited decision relates to 2010 intra-family stock transfers of the Biltmore Company (“TBC”) and has been in deliberation since 2016. TBC was formed in 1932 and owns the famed Biltmore House constructed by George W. Vanderbilt between 1889 and 1895. In 1995, TBC instituted a long-range plan to become a multi-day destination, expanding the operations to include hotels, restaurants, retail stores, and various other outdoor activities. In 2010, TBC reported approximately $70 million in revenue from sources including five retail outlets, eight restaurants, landscaping, tickets and tours, as well as outdoor activities like river rafting, fly fishing, equestrian training, timber production and farming.
The case addresses two important issues valuation practitioners have battled with the Internal Revenue Service (“IRS”) routinely over the years: (1) tax affecting pass-through entities; and (2) the use of the income versus asset approach for an asset-intensive operating business with no intent to liquidate. Each of these issues is addressed in the following sections.
Tax Affecting Pass-Through Entities
the issue of tax affecting pass-through entities has been a hot topic since the 1999 Court case of Gross v. Commissioner (“Gross”). In Gross, the Court ruled in favor of the IRS position that tax affecting earnings of an S-corporation was inappropriate for valuation purposes. Since then, the IRS has maintained that stance, successfully arguing it in several cases. A notable exception in favor of tax affecting occurred in 2020 with the decision in Estate of Aaron U. Jones v. Commissioner.
In practice, many valuation practitioners tax affect the earnings of an S-corporation at a corporate rate to arrive at a C-corporation equivalent. A separate adjustment is then made to reflect the net benefits or detriments of the entity being taxed as an S-corporation. This is referred to in the valuation community as the S-corporation Equity Adjustment Model (“SEAM”) and is addressed further below.
in Cecil, the taxpayers’ two experts valued TBC’s stock using a combination of income and market approaches, and both tax affected earnings. The IRS expert valued the company’s stock using a combination of an income approach and an asset approach. Of significant relevance is that all of the experts tax affected the income using the discounted cash flow method and experts for both sides applied the SEAM adjustment. This forced the Court to accept tax affecting and the use of the SEAM approach. The Court specifically addressed this issue, though, stating “we emphasize, however, that while we are applying tax affecting here, given the unique setting at hand, we are not necessarily holding that tax affecting is always, or even more often than not, a proper consideration for valuation of an S corporation.” Thus, while the decision is viewed as a victory for the taxpayer, it will not definitively put the issue to rest.
Income Approach Versus Asset Approach
The IRS’s expert was the only one who utilized an asset approach in valuing TBC’s stock. The Court was unpersuaded by his opinion given that TBC was an operating company expected to remain as a going concern. Liquidation was considered unlikely, which was enough to convince the Court to disregard this methodology.
Interestingly, this decision references the Uniform Standards of Professional Appraisal Practice as follows: “In developing an appraisal of an equity interest in a business enterprise with the ability to cause liquidation, an appraiser must investigate the possibility that the business enterprise may have a higher value by liquidation of all or a part of the enterprise. However, this typically applies only when the business equity being appraised is in a position to cause liquidation.”
The Court recognized that the size of the interests being valued did not meet the criteria above and liquidation was unlikely, stating its view that a hypothetical buyer’s options were to: (1) acquire enough additional shares to enable liquidation; (2) convince other shareholders to vote for a liquidation; or (3) wait until the shareholders or their heirs decide to liquidate. The Court considered each of these three events unlikely to occur. In making that assessment, the Court considered testimony from the family that it had no intention of selling shares or liquidating and that shareholder/voting trust agreements documented how the petitioners, their children, and grandchildren aspired to keep TBC in their family by restricting transfer of stock outside of family. Finally, the court acknowledged that TBC had been family-owned since its incorporation in 1932.
Summary
Since the Gross case in 1999, the issue of tax affecting has been argued before the Court many times. The tides appear to have shifted towards its acceptance with the Estate of Jones case in 2020 and with Cecil in 2023. Even so, the Court clearly stated in Cecil it was not necessarily holding that tax affecting is always appropriate.
The issue of valuing an asset-intensive operating company using an income approach was accepted by the Court in Cecil. The rights associated with the size of the block in question, the intent of the shareholders to keep the shares in the family, and TBC’s existence as a going concern for over 90 years were factors taken into consideration.
Cecil will likely prove to be a pivotal decision by the Court that will influence how these issues are dealt with going forward. The case illustrates the importance of having a well-documented valuation analysis that considers all aspects of owing a minority interest in a privately-held company.
Joe is a Managing Director at Empire Valuation Consultants. He is an Accredited Senior Appraiser (ASA) of the American Society of Appraisers and a Certified Public Accountant (CPA).
He has over 25 years of business experience in public accounting, internal audit, alternative investment management and business valuation. His valuation practice is focused largely on estate and gift planning, corporate recapitalizations and employee stock ownership plans (ESOPs). Joe has been deposed and testified as an expert witness on a variety of valuation related matters, and he has successfully negotiated estate tax settlements with the Internal Revenue Service.
Joe has lectured on valuation topics to professional and educational organizations including the ESOP Association, the New York State Society of CPAs, Nationwide Financial and the University of Rochester Simon Business School. He has participated as both a panelist and judge at various student-related presentations at the University of Rochester and St. John Fisher College.