By David Rudman, CPA/ABV, CVA – Sigma Valuation Consulting, Inc.
On March 25, 2019, the US District Court – Eastern District of Wisconsin issued a decision in Kress v. United States where Chief Judge William C. Griesbach relied heavily on the taxpayer’s expert in valuing non-controlling interests in an operating S-Corporation called Green Bay Packaging, Inc. (“GBP”). In the taxpayer’s expert report, GBP was tax affected at the equivalent of a C-corporation with no S-corporation premium, and the Court accepted this position.
For years, the valuation industry and taxpayers have been fighting a series of cases beginning with Gross v. Commissioner (TCM 1999-254) in 1999, the Estate of Gallagher v. Commissioner (TCM 2011-148) in 2011 among others, which did not support tax affecting when valuing pass-through entities such as S-corporations.
Unlike these prior decisions, in Kress, the US District Court accepted the taxpayer’s valuation report, whereby GBP was fully tax affected as a C-corporation, supporting the position that valuation experts have been arguing for many years. While the US District Court’s decision in Kress may not have the same weight as that of the US Tax Court, it should be instructive to other courts considering the issue in the future.
In the Kress case, the original appraiser tax affected the earnings of the S-corporation in appraisals filed as of December 31, 2006, 2007, and 2008. The Court accepted the fair market value was as filed by the taxpayer, with only minor adjustments to the applied discounts for lack of marketability (DLOM).
In their respective reports, both the IRS’s independent appraiser at trial and the taxpayer’s expert tax affected GBP’s S-corporation earnings as if it were a C-corporation. This is important because the IRS has held the position in recent years that pass-through entity earnings (S-corporations, LLCs and Partnerships) should not be tax effected because they do not pay a corporate level of taxes. In the Kress case, this was not an issue as both appraisers tax effected the earnings of GBP, an S-corporation. The IRS’s expert applied a pass-through benefit in its application of the income approach, where the taxpayer’s expert did not.
In its conclusion, the Court did not accept the S-corporation premium (pass-through benefit) put forth by the IRS’s valuation expert, resulting in almost a complete valuation victory for the taxpayer. The conclusion also represents an important point of inflection in the controversy over tax-affecting pass-through entities and applying a premium for pass-through entity status.
Over the last 10 years, the subject of pass-through entities receiving a premium associated with their pass-through tax status has been a heavily debated topic. In the Kress case, such a premium was not applied by the Court. While not all concur, we believe that today, most valuation experts have concluded that pass-through entities deserve a premium when compared to otherwise identical C-corporations. Nonetheless, we highlight that the gifts in the Kress case were from 2006, 2007 and 2008, prior to the pass-through tax benefit gaining full traction in debate within the valuation community. It will be interesting to see if prevailing thought and application changes in the future.
Section 2703 (a): Impact of Family Transfer Restrictions
In the Court’s opinion, family transfer restrictions in GBP’s Bylaws were the subject of considerable discussion as they related to the discount for lack of marketability. The court ultimately found that Kress had not met its burden of proof to show that the restrictions were not a device to diminish the value of the transferred assets, by failing to pass one of the three prongs of the established test on this subject. Of all the expert reports prepared in this case, only the Taxpayer’s expert considered family restrictions, which had a small impact on the determination of its marketability discount. Despite its lengthy analysis, the Court found that the issue was not overly significant from a valuation perspective. In its final analysis, the Court only deducted 3% from the DLOMs, settling in the range of 25% and 27%, depending on the year of gift being considered.
Clearly, for all gift and estate tax appraisals where the IRS is arguing for no tax affecting of S corporation earnings, and for a premium in the valuation of pass-through entities relative to otherwise identical C-corporations, the Kress case will be an important reference for taxpayers.