Contributed by Sherrye Henry, Jr., Esq. Legal Editor for Business Valuation Resources, LLC.
Ringgold Telephone Co. v. Commissioner., T.C. Memo. 2010-103, 2010 WL 1850426 (U.S. Tax Ct.)(May 10, 2010)
BVR customers should take note of a series of decisions in the last few months which show a trend for an expert’s industry experience to trump professional background. One of the most interesting in this regard is Ringgold.
Ringgold, the taxpayer, provides telecommunications services in Georgia and Tennessee. Effective January 1, 2000, it converted from a C corporation to a Subchapter S corporation. Later that year, it began to market its 25% partnership interest in a private wireless telephone company, which in turn owned a 30% interest in another wireless company. To assess the amount of built-in capital gains the sale would trigger (pursuant to IRC Sec. 1374), the taxpayer retained a CPA, who appraised the 25% interest at $2.6 million as of the S Corp conversion date (Jan. 1. 2000).
The sale of the 25% interest was subject to a right of first refusal by the other partners. Six months later, one of those partners, BellSouth Mobility, Inc. (BellSouth), purchased the taxpayer’s interest for $5.02 million. Prior to the sale—by virtue of general and limited partnership interests in related companies, BellSouth effectively owned a controlling interest (63%) in the underlying assets; its acquisition of the taxpayer’s share bumped up its ownership to approximately 70%.
In its federal income tax filings for 2000, the taxpayer recognized a built-in capital gains tax on the sale based on its appraised value of $2.6 million. The IRS assessed a deficiency of nearly $1 million, however, based on its determination that the 25% interest had a fair market value (FMV) of $5.2 million as of the S Corp conversion date.
Court takes special note of the experts’ credentials. The taxpayer’s expert, a CPA/ABV, had valued telecommunication companies for over a decade. His firm currently averages 35 to 45 telecomm-related appraisals every year, and he devotes 25% to 75% of his time to telecomm appraisals. On the basis of his “substantial experience,” the court noted, he “was able to factor in the specific conditions and outlook of the telecommunications industry, as well as the economic outlook in general, existing on the valuation date.”
In particular, he appraised the 25% interest using four weighted approaches: a discounted cash flow (DCF) approach (50% weight); a guideline public company and a guideline transaction analyses (10% each); and a capitalization of income approach (30% weight). After applying the respective weights and a 5% discount for lack of marketability, he valued the taxpayer’s 25% interest at $2.7 million.
He also applied a distribution yield analysis, using the company’s net after-tax distributions for three years prior to the valuation date (1997 to 1999). Although he employed a 13.6% cap rate in his capitalization of income approach, he used a cap rate of 12.41% in his distribution analysis to reflect the 5% marketability discount, and reached a $3.2 million value for the taxpayer’s 25% interest. Weighting the business value and the distribution value equally (50%), he ultimately concluded a fair market value for the taxpayer’s asset of $2.98 million.
By contrast, the IRS expert, a CPA, was not credentialed in business valuation and only recently returned to the practice after a decade-long hiatus. Moreover, he had never valued a telecommunications firm. “Consequently, [the IRS expert] took a more mechanical approach to the valuation of the [taxpayer’s] interest, relying heavily on historic data without significant adjustment to reflect prevailing market conditions in the telecommunications industry,” the court found.
For instance, he used only three approaches—DCF, guideline company, and guideline transaction—to value the interest. In his DCF, he applied a 14% discount rate to ten years of projected cash flows (compared to the taxpayer’s expert, who used a range of 14.33% to 17.03%). He found the guideline companies resulted in a potentially overstated value, and gave this approach no weight, but weighted the DCF and guideline transaction approaches equally (50%). Interestingly, he also applied a 35% marketability discount to reach a final value of $5.15 million for the taxpayer’s interest.
The IRS expert did not consider the company’s distribution history. The IRS argued that such analyses are appropriate only when a company historically distributes nearly all of its net income. Further, in valuing closely held stock, it’s more important to use a company’s dividend-paying capacity (rather than its paid dividends) the IRS said—but the court disagreed, saying that dividend-paying capacity was paramount in valuing a controlling interest in a closely held company. When valuing minority interests, “dividends paid can be more important…because a minority shareholder cannot force the company to pay dividends even if it has the capacity to do so,” the court held.
Sale price as evidence of fair market value. The IRS urged the court to accept the “reasonably contemporaneous arm’s length sale” of the taxpayer’s interest to BellSouth as evidence of its fair market value. The court agreed that the sale was within a reasonable time (six months) after the valuation date, and that no intervening events affected value. The sale was at arm’s length, because BellSouth was an unrelated third party engaged in the normal course of business. Finally, BellSouth did not add a control premium to the sale price, because it already owned a majority interest in the operating partnership. (Notably, both parties conceded the sale price reflected a minority discount, and the taxpayer’s expert admitted that BellSouth “had no control element” or incentive in buying the 25% interest.)
However, based on his extensive experience in the industry, the taxpayer’s expert said that once BellSouth had a strategic interest in a target, it would do “whatever it takes to win,” including submitting a high bid to discourage other parties from exercising their rights of first refusal—in this case, the two other 25% partners. The court found his testimony credible, without any contradiction from the IRS. Consequently, it adjusted the July 2006 sale price to reflect BellSouth’s willingness to pay a strategic premium for the taxpayer’s 25% interest, and admitted the $5.2 million sale price as “probative but not conclusive” of fair market value.
The court also found the taxpayer’s expert to be “the more persuasive” of the two experts, based on his extensive experience in the telecomm industry and his inclusion of a distribution yield analysis. Although the court accepted his business and distribution-yield values, it also included the $5.2 million BellSouth sale in its analysis. After weighting all three values equally, it found the taxpayer’s 25% interest in the private telecomm company to be worth $3.73 million as of the valuation date, and entered judgment accordingly.