By David Rudman, CPA/ABV, CVA – Sigma Valuation Consulting, Inc.
Synopsis
In May 2009, Aaron Jones gifted his interests in an S corporation and limited partnership that together owned a lumber and timber business to his three daughters and to his family trusts for their benefit. In his gift tax return, he reported the gifts with a total value of about $21 million. In contrast, the IRS notice of deficiency asserted a value of about $120 million and a gift tax deficiency of about $45 million.
The Tax Court agreed with the taxpayer’s appraiser value conclusion of approximately $24 million, which resulted in a gift tax of less than $2 million.
The two important issues addressed in this case are presented below:
1. Income Approach or Asset Based Approach: In this situation, there is an ongoing business operation, and the facts are clear that the timber business would not be liquidated and the transferee would have no ability to force the liquidation. As a result, the timber business would be valued under the income approach rather than the asset based approach, even though the asset approach, which normally sets a floor to the range of value, yielded a much higher value.
2. Tax-Affecting: The Tax Court concluded that “tax-affecting” the earnings of the S corporation and limited partnership was appropriate in determining the valuations of the entities under the income approach. The Tax Court has been reluctant to accept tax-affecting following its decision twenty years ago in Gross v. Commissioner.
Basic Facts
1. Introduction. In 1954 Aaron Jones founded Seneca Sawmill Co. (SSC), a lumber manufacturing business. In 1986 the Company elected to become an S corporation. Over time as SSC carried out its operations, it went on to purchase its own land and in 1992 formed Seneca Jones Timber Co. (SJTC), an Oregon limited partnership, to hold timberlands intended to be SSC’s inventory. SSC was the 10 percent general partner of SJTC, with both entities operating under same management team and headquartered in Eugene, Oregon.
2. The 2009 Gifts. On May 28, 2009, pursuant to succession planning that started in 1996, Mr. Jones formed seven family trusts. SSC voting and non-voting shares were gifted to these family trusts and SJTC limited partnership interests were gifted to Mr. Jones’s three daughters.
3. Gift Tax Valuation Dispute. In the 2009 gift tax return, Mr. Jones reported the value of his gifts, which the IRS asserted to be far less in the notice of deficiency to Mr. Jones. The valuations of SSC voting and non-voting stock, and the SJTC limited partnership interest per the gift tax return and the IRS’s notice of deficiency are presented below.
A petition was filed in the Tax Court by Mr. Jones in 2013. He died in September 2014 and was represented by his estate and personal representatives in court. The Estate engaged another appraiser, Robert Reilly, whose appraisal applied the discounted cash flow (DCF) method in determining the value of gifts at a much lower value than that of the asset approach. Further, the IRS also engaged an appraiser who determined the value of the SJTC by employing an asset approach, the net asset value (NAV) method. The values determined by both the appraisers are presented below.
Court’s Opinion
In November 2017, a four-day trial was held in Portland, Oregon, and Judge Pugh’s opinion in Estate of Jones v. Commissioner, T.C. Memo. 2019-101, was issued August 19, 2019. Judge Pugh accepted all the values determined by Mr. Reilly.
The Tax Court’s opinion on the two important issues discussed previously are presented below.
1.Income or Asset Based Approach for SJTC
STCJ has aspects of both an operating company (STCJ plants trees and harvests and sell logs) and an investment or holding company (STCJ’s timberlands are its primary assets and will increase in value over time) resulting in a dispute between the parties as to whether SJTC should be valued using an income or asset-based approach.
The Court was of the view that the less likely SJTC is to sell its timberlands, the less weight should be assigned to an asset-based approach. Further, SJTC and SSC were closely aligned and interdependent. Therefore, the Court concluded that an income-based approach is more appropriate for valuation of SJTC rather than asset-based approach.
2. Tax Affecting
The concept of tax affecting refers to the steps in the valuation of a closely held business that seeks to adjust for certain differences between pass-through entities and C corporations. Often with operating companies, a pass-through entity is an S corporation, but tax-affecting can be applied in the context of LLCs and partnerships too. In the given case, Mr. Reilly tax affected the earnings of SJTC and SSC by applying the SEAM model (S Corporation Economic Adjustment Model, developed by Daniel R. Van Fleet.
Two issues were raised by the IRS on the tax affecting. The IRS argued along the lines of tax affecting cases of Gross v. Commissioner, T.C. Memo. 1999-254, aff’d, 272 F.3d 333 (6th Cir. 2001), Estate of Gallagher v. Commissioner, T.C. Memo. 2011-148 etc. In these cases the basic assumption of tax affecting, which assumes that companies (SSC & SJTC) will lose their pass-through status and will be taxed as C corporations was rejected.
However, the Court explained that the above cases did not prohibit tax-affecting the earnings of a flow-through entity per se. Instead the Judge viewed the issue as fact based and noted that the Court in those cases had simply concluded that tax affecting was not appropriate for various reasons on the facts of those cases. In the present case, Mr. Reilly presented a detailed analysis of tax affecting with a pass-through benefit developed using the SEAM model, his adjustment of tax affecting was accepted.
Finally, a victory for the taxpayer and also for business valuation professionals who have been arguing the appropriateness of tax affecting pass-through entities for years.