In an ingenious move, the U.S. Tax Court, ruling on an Oregon gift tax dispute, accepted the taxpayers’ tax-affected valuations of pass-through entities (PTE) without overturning Gross. The Tax Court’s decision is an all-out win for the taxpayers and comes on the heels of Kress, in which a federal district court adopted the taxpayers’ tax-affected valuations of an S corp.
The decedent, Aaron Jones, who died in 2014, founded two closely related companies. Seneca Sawmill Co. (SSC), a lumber manufacturer, was an S corporation; Seneca Jones Timber Co. (SJTC), which owned and managed tree farms and supplied the timber for SSC, was a limited partnership.
In 2009, as part of his estate planning, the decedent transferred blocks of shares and limited partnership units to his three daughters. In 2013, the Internal Revenue Service (IRS) issued a notice of deficiency of gift tax of nearly $45 million. The taxpayers asked the Tax Court for review. Both parties offered expert valuations for SJTC. For SSC, the IRS only offered a rebuttal expert report.
The focal point of the court’s detailed opinion is the valuation of SJTC. The experts disagreed on methodology—whether the company was an operating company that should be valued under an income approach, as the taxpayers’ expert did (using a discounted cash flow analysis), or a natural resources holding company, as the IRS expert argued, using a net asset value approach. (The IRS accepted the taxpayer expert’s market approach valuation.) The court found the asset approach was inappropriate because it was not likely that SJTC would sell its timberland.
Experts don’t disagree on tax affecting: In critiquing the taxpayer expert’s DCF valuation, the IRS argued the taxpayers’ expert should not have tax affected earnings in projecting net cash flow. The expert used a 38% rate (combined state and federal rate). He also calculated a premium to capture the benefit to the partners from dividend tax avoided, estimating the implied benefit in past years and considering an empirical study on S corp acquisitions.
The IRS, citing Gross and later cases, argued tax affecting was improper where SJTC had no tax liability on the entity level and there was no evidence the company would become a C corporation. Absent a showing that two unrelated parties dealing at arm’s length would tax affect, the outcome improperly favored a hypothetical buyer over the seller. In contrast, the estate, citing Bernier, argued that a zero tax rate on the entity level inflated the value of an interest in SJTC. A hypothetical buyer and seller would take into account that the individual partners had to pay income tax, at ordinary levels, regardless of whether SJTC made cash distributions.
The court said both parties in effect recognized that a hypothetical buyer and seller would consider SJTC’s business form but disagreed about how to do this. The IRS’ own experts did not defend a proposed zero tax rate, only the lawyers did, the court said.
Further, the court found that Gross and other Tax Court rulings that disallowed tax affecting could be distinguished from the instant case. The court noted that the Gross court was presented with a stark choice: 40% or 0% corporate tax. The Gross court did not believe the 40% rate reflected the benefit to the owners from avoiding dividend tax and, “on the record of the case,” decided that a 0% rate properly reflected the savings to the owners, the court in the instant case said.
It noted that the situation here was different. The taxpayers’ expert took into account both the tax burden and benefit to SJTC’s owner. The expert’s “tax-affecting may not be exact, but it is more complete and more convincing than respondent’s zero tax rate,” the court said.
Takeaway: The U.S. Tax Court recognizes there are tax consequences to PTE owners that valuation experts must wrestle with, by quantifying the burden and benefit related to flow-through status.
Stay tuned for follow-up reporting on other aspects of this important case.
A digest of Estate of Aaron Jones v. Commissioner, T.C. Memo. 2019-101 (Aug. 19, 2019), and the court’s decision will be available soon at BVLaw.