Although the U.S. Tax Court recently handed the Michael Jackson estate a decisive victory regarding the estate’s tax liability, the court did not side with the estate on tax affecting, an issue that has preoccupied valuators, many of whom are proponents of the practice, for a long time.
Estate of Jones is distinguishable: Michael Jackson died in 2009. The tax dispute was over the fair market value of three contested assets at Jackson’s death: the value of Jackson’s image and likeness and the value of his interest in two music publishing assets. Each of the assets was held by a pass-through entity (PTE), “which means the Code imposes no tax on the income that these assets produce.” Rather, the income passes through to the owners, who pay tax on it at their individual rates. C corporations, on the other hand, are subject to entity-level taxes and investor-level taxes. Tax affecting seeks to reflect the tax implications to a hypothetical buyer.
At trial, the estate engaged four experts, two of whom collaborated on valuing the image and likeness asset. The Internal Revenue Service presented testimony from a single expert. As the court noted, all of the estate’s experts took tax affecting into account in their discounted cash flow analyses but all applied different tax rates. For example, the lead valuator of the image and likeness asset used a 35% rate based on the then-applicable corporate rate. For its part, the IRS objected to tax affecting.
The court noted that, “in the past, we’ve shied away from tax affecting because of these practical problems.” It noted that proponents of the practice have often pointed out that many potential buyers of PTEs, including S corporations, are C corps that would tax affect (at C corp rates) in calculating income to decide how much to pay for the asset. Opponents of the practice have claimed tax affecting produces an appraisal that gives no value to the benefit of S corp status.
Here, the estate’s experts argued that a C corp would be the only likely buyer for the assets. For example, in valuing Jackson’s image and likeness, the estate’s appraiser pointed out that any buyer would have to spend considerable money to rehabilitate the asset and defend its value. C corps historically have bought the image and likeness of other celebrities, he said. But the court said it was not convinced that a C corp was the more likely buyer. The same appraiser valued this asset at $3 million, which “is not a sum so large as to make it likely that only a C corporation would be able to buy it,” the court said. It noted there now exist many different (less restrictive) types of PTEs that have many of the same benefits as C corps when it comes to raising capital while avoiding double taxation. The court suggested the “gap between C corporations and other entities has narrowed over time.” The estate’s experts did not “persuasively explain” why those new PTEs wouldn’t be suitable buyers, the court said.
The court noted there seemed to be only one case where the Tax Court allowed tax affecting in a valuation, the 2019 Estate of Jones case. However, that case was distinguishable in that both parties’ experts agreed that a hypothetical buyer and seller would take into account the corporate structure. The parties only disagreed over how to account for this effect. Here, the estate’s experts themselves used inconsistent tax rates and they were met with opposing IRS testimony that, “at least on this very particular point,” was persuasive considering Tax Court precedent, the court said.
“This all leads us to find that tax affecting is inappropriate on the specific facts of the case,” the court said.
Stay tuned for more reporting on this important decision.
A digest of Estate of Michael J. Jackson v. Commissioner, T.C. Memo 2021-48 (May 3, 2021), as well as the court’s opinion will be available soon at BVLaw.