It’s been seven years since the wealthy Wechslers filed for divorce in New York. Their single largest asset: Wechsler & Co., Inc., a private C Corp holding company with a net asset value (NAV) of nearly $71 million. All three experts on the case (a neutral appraiser as well experts for each of the parties) agreed that this was the appropriate “baseline” value for the company that held only securities (but ceased trading on all but its own accounts as of the divorce filing). At trial, both the neutral expert and the husband’s expert urged the court to apply Dunn v. Comm’r (5th Cir. 2002) to account for embedded taxes. That is, consistent with the Dunn case and the NAV method, the court should assume a sale of the company on the valuation date (date of divorce filing) and reduce its baseline value by 41.74%—the combined, effective rate of state and federal taxes.
By contrast, the wife’s expert offered the Tax Court’s decision in Jelke v. Comm’r (2005), which rejected dollar-for-dollar discounts for embedded taxes but was then on appeal to the Eleventh Circuit. Notably, the wife’s expert did not ask the divorce court to apply the IRS’s approach in Jelke, which essentially determined a present value of taxes due on the assets over a projected sales period. Rather, her expert calculated the historical rate of annual taxes paid by the holding company by comparing its average annual taxes to its average annual gross revenues (i.e., before expense and overhead deductions). The trial court, in a “comprehensive, thoughtful and painstaking 129-page opinion,” adopted this approach—reducing the baseline value by an 11% historical rate, and the husband appealed.
There were many reasons for rejecting the ‘historical approach.’ Both the neutral and husband’s expert “vehemently” disagreed with this approach. The 11% historical tax rate was a “meaningless percentage to apply to the capital gains,” ignoring the difference between an effective tax rate and an incremental rate. Neither expert had seen this approach before—nor had the wife cited any authority for its use. By the time of appeal, the Fifth Circuit had also reversed Jelke and adopted Dunn. To complicate matters, the IRS had challenged many of the company’s compensation deductions, which if successful would “skew” the historical approach. (In fact, the IRS obtained a substantial reduction of the compensation claims in Wechsler & Co. v. IRS (Tax Court 2006)).
For these reasons and several more, which the New York appellate court articulates in its own thoughtful, comprehensive opinion, it reduced the baseline value of the company by the combined effective rate of 41.74%, citing not only Dunn and Jelke but also Valuing a Business by Shannon Pratt and Alina Niculita (5th Ed. 2008), available at BVResources.
Look for a complete abstract of Wechsler v. Wechsler, 2008 NY Slip Op 7983 (October 21, 2008) in the December 2008 Business Valuation Update™. Keep in mind: the full-text of all court cases, from Dunn and Jelke to reasonable compensation and divorce are available at BVLaw™.