ValueLinks Newsletter

July 8, 2007

Robert Dallas, Petitioner v. Commissioner of Internal Revenue, Respondent

United State Tax Court, T.C. Memo 206-212, September 26, 2006

This case, by now well known to many Estate practitioners, addresses a number of issues:

(1) Whether to Tax-Affect S Corporation Earnings

The Tax Court has once again decided against tax-affecting the income stream of a subject entity that has chosen to be taxed as a Subchapter S corporation under the Internal Revenue Code.  Despite the position of the IRS and its prior success on this issue, many valuation analysts believe that tax affecting Subchapter S earnings is correct.    Petitioner’s expert testimony to support a tax affect of S corporation earnings included (1) he has always tax-affected S corporation income; (2) an informal pole at a recent conference showed 90 to 95 percent of responding appraisers tax-affect S corporation income; (3) the American Society of Appraisers (ASA) Board rejects any application for certification if the candidate submits test answers or reports for review that do not tax-affect S corporation income; (4) his experience is that all bankers, investment bankers, and business brokers use tax-affecting in estimating the value of S corporation stock; and (5) his firm uses tax-affecting in valuing S corporation stock held by employee stock ownership plans (ESOP) that it submits to the Department of Labor.  The Tax Court ultimately gave little weight to above rationale and indicated, “there is insufficient evidence to establish that a hypothetical buyer and seller would tax-affect [Sub S] earnings and … tax-affecting is not appropriate.”  If valuation analysts are to convince the IRS that tax effecting is appropriate for an S corporation income stream better financial models and evidence will need to be presented.

(2) Reasonable Compensation

A common adjustment to subject entity earnings for valuation purposes is the compensation paid to closely held business owners.  In the majority of circumstances, owner/shareholders of closely held corporations compensate themselves in excess of what they might otherwise earn should they seek employment elsewhere.  The closely held owner is, in effect, taking profits in the form of salary.  Respondent, IRS, contended that the subject’s earnings should be increased on the assumption that Dallas family officers are unreasonably compensated.  The Tax Court took a similar position on this issue regarding testimony and support presented by the experts, stating, “the record does not contain the quality of factual analysis customarily used by courts in deciding whether compensation is reasonable.”  It again appears that the analyst did not provide the Tax Court with the necessary support on which to consider a reasonable compensation adjustment.

(3) Appropriate Discount for Lack of Marketability

The taxpayer’s expert’s report concluded that a 40 percent discount for lack of marketability was appropriate, citing his own firm’s database of restricted stock studies.  The Court was not moved by this evidence, noting that the restricted stock transactions that took place around the valuation date had considerably lower discounts than the overall average discounts cited in the studies, and were also lower than the discounts from the earliest years.  It should be noted that the Court gave “little weight” to this expert’s report because he was “unfamiliar” with his report at trial.  As such, the Court sided with the IRS and applied a 20 percent discount for lack of marketability.

(4) Proper Valuation Treatment of Self-Canceling Notes

At trial it came up that the taxpayer’s attorney noticed that self-canceling notes were valued incorrectly, but did not say so in court.  The attorney argued at trial that the notes were not meant to be self-canceling and any representation thereof was merely a “drafting mistake.”  The Court was not moved by this line of reasoning and summarily dismissed the argument; thus accepting the IRS’ value in full.

(5) Proper Treatment of a Share Adjustment Clause

Each stock sale agreement contained the following share adjustment clause:

In the event that the value of the Shares is finally determined in any IRS proceeding to be greater than [X] per share, the number of shares purchased and sold hereunder shall be reduced by the quotient of the purchase price divided by the value per share determined in such proceeding.  In such event, Buyer shall transfer to Seller, for no additional consideration, the number of Shares which is equal to the difference between [Y] minus the quotient determined under this Section 1.3.

The Court rejected the clause stating that the taxpayer conceded on the issue by failing to respond to the IRS’ argument in its opening brief, which stated that share adjustment clauses are void because that are against public policy.