One of the thorniest issues faced by the executor of an estate holding an interest in a closely- held business is the valuation of that interest. As if the preparation of the estate tax return was not daunting enough, the executor also has to determine the fair market value of the business interest. Although the executor is expected to retain a professional appraiser to assist in the valuation, and is entitled to rely upon the appraiser’s conclusions, the executor cannot simply abdicate responsibility for the valuation reflected on the return. Indeed, under certain circumstances, the estate may be subject to significant penalties where the estate tax is underpaid because of a substantial understatement of the value of the estate, including the business interest. In order to assist the executor in assessing the reasonableness of an appraisal, the estate’s tax advisers need to be familiar with basic valuation principles and with their application to specific kinds of assets. A recent decision by the U.S. Tax Court highlights how important such guidance can be.

 Estate of Richmond

Estate of Richmond v. Comr, T.C. Memo 2014-26, involved the valuation of a 23.44% interest in a family-owned investment holding company that was taxed as a C corporation and personal holding company. The company was formed in 1928 and, from its inception, it sought to preserve and grow its capital, and to maximize dividend income for the family shareholders (of whom there were twenty-five). The ultimate objective of the company was to provide a steady stream of income to the descendants of the company’s founder. Consistent with that investment philosophy, the turnover of the company’s securities was especially slow (a complete turnover would take seventy years). As a result, a substantial part of the value of its portfolio consisted of untaxed appreciation. In fact, at the time of the decedent’s death, over 87% of the value consisted of untaxed appreciation, and almost 43% of its portfolio was invested in the stock of four corporations. Because of the large tax liability inherent in its portfolio, the company chose not to sell its securities and, thereby, diversify its assets.

At the time of her death, the decedent owned 23.44% of the issued and outstanding shares of the company’s stock. She could not unilaterally change the management or investment philosophy, unilaterally gain access to the corporation’s books, increase distributions from the company, cause the company to redeem her shares, cause the company to make any tax elections or to diversify its holdings.

The executors of the decedent’s estate reported her interest in the company at approximately $3.15 MM. In valuing the interest, the appraiser retained by the estate used a capitalization-of-dividends method.

The IRS disagreed with the reported value, claiming that the interest should have been reported at approximately $7.3 MM. In preparing its valuation, the IRS appraiser used a net asset value method, and then applied discounts for lack of control and lack of marketability (a portion of which reflected a discount for the built-in capital gain tax liability inherent in the portfolio).

At trial, the estate’s expert adjusted the estate’s valuation of the decedent’s interest upward, to approximately $5 MM. The expert also presented an alternative valuation methodology as a check; specifically, he started with the net asset value of the portfolio, then reduced it by 100% of the built-in capital gain tax liability inherent in the portfolio before discounting the decedent’s interest. This yielded a value of approximately $4.7 MM.

The Tax Court Weighs In

The Tax Court began its analysis by laying out the basic principles for valuing a closely held company. In that case, it said, actual sales of stock in the normal course of business within a reasonable time before or after the valuation date are the best criteria of market value. If there are no such sales, then the value is determined by taking into account the company’s net worth, earning power and dividend-paying capacity, with the weight to be accorded to each factor depending upon the facts and circumstances of each case. In general, it said, an asset-based method of valuation applies in the case of corporations that are essentially holding companies, while an earnings-based method applies for companies that are going concerns.

The Tax Court rejected the estate’s capitalization-of-dividends approach. It conceded that the approach may be appropriate where a company’s assets are difficult to value, but not where the company holds a portfolio of publicly traded securities that are easily valued. Instead, it decided that the value of the company was better determined by a net asset value approach, pointing out that the dividends approach essentially overlooks the fact that the company’s assets have ascertainable market values.

The Court then addressed the difference in the discounts applied by the experts in respect of the built-in capital gain tax liability inherent in the portfolio. The Court conceded that two Courts of Appeals have held that, in a net asset valuation, the value should be reduced dollar-for-dollar by the amount of such tax liability. It pointed out, however, that other Courts of Appeals, as well as the Tax Court, have not followed this approach. The Court explained that a prospective tax liability (which may be deferred as the stock is sold off piecemeal) was not the same as a debt that really does immediately reduce the value of a company dollar-for-dollar (like a promissory note that must be satisfied). Thus, the Court said, a 100% discount was unreasonable in this case because it did not reflect the economic realities of the company’s situation.

It admitted that the a buyer would not be wholly indifferent to the tax implications of built-in gain that constituted almost one-half of the value of the company’s assets, and agreed that some discount therefor was warranted. The Court then held that the most reasonable discount is the present value of the cost of paying off that liability in the future. The Court decided that a 20-to-30-year turn over period was more reasonable than the company’s historic 70-year period (especially in light of the fact that with the passage of time the ownership of the company would become more diffuse among heirs and legatees with less identification with the company’s historic philosophy and goals, with less knowledge of and affinity for one another, which would make them more likely to seek to diversify the company’s holdings), which yielded a final value of approximately $6.5 MM for the decedent’s interest in the company.

Finally, the Court determined that the estate did not act in good faith and with reasonable cause in reporting the value of the company on the estate tax return. Because the valuation reported constituted a substantial estate tax valuation understatement, the Court sustained the imposition by the IRS of a 20% accuracy-related penalty.

Conclusion

The Court’s decision illustrates just how important it is for the executor of an estate that includes an interest in a closely held business to examine the appraisal of that interest, to vet it with the other professionals that comprise the estate’s team (e.g., the estate’s accountant and its attorney), and to question anything in the appraisal report that the executor does not understand. That is not to say that the executor is not entitled to rely upon a professional appraiser, or that the executor must become one. It does mean that the executor should not accept the report blindly. It also means that the estate’s accountant and attorney must be in a position to assist the executor in understanding the report, in appreciating its strengths, and in identifying and redressing its weaknesses. They can only do this by being familiar with general valuation principles, including the application of various discounts, such as that for the tax liability inherent in certain assets.