Tax Court Analysis of 2703 Issues Instructive to Planning for Valuation Discounts

Fractional interest discounts allowed

In Estate of Elkins v. Commissioner, the U.S. Tax Court sides with petitioners holding they were entitled to a ten percent discount from pro rata fair market value with respect to a decedent’s interest in various works of art.  In Fancher v. Prudhome, the Louisiana Court of Appeals upholds a trial court’s determination that using the Income Approach to value a withdrawing member’s share in an LLC was not applicable since future cash flow could not be assumed and the withdrawing member provided the majority of the company’s business. 

Estate of Elkins v. Commissioner

140 T.C. No. 5; March 11, 2013

U.S. Tax Court, Judge Halpern

After respondent IRS determined deficiencies in estate tax paid by petitioner taxpayers, co-executors of the estate of a decedent who was their father, petitioners sought review.  At issue was the total fair market value of decedent’s undivided fractional interests in 64 works of art, which interests were includable in his gross estate, and the proper application in that context of various estate tax provisions including IRC §2703.

Decedent and his wife—who predeceased him– owned 64 pieces of artwork.  Three works of art were transferred to a 10-year grantor retained income trust (GRIT). Various events, including the wife’s death, resulted in decedent inheriting her 50 percent interest in the GRIT while his original 50 percent interest passed to his three children.  Decedent disclaimed a portion of the interest in his wife’s 50 percent community property interest in the remaining 61 pieces and enjoyed possession of the whole collection under various contracts with the children. When decedent died, the IRS challenged petitioners’ claim that the fair market value of the artwork in decedent’s gross estate was properly discounted to account for restrictions on decedent’s interests imposed by the contracts, arguing that §2703 required them to be disregarded for valuation purposes. Petitioners answered that as the agreements only restricted sales of the art, not of a co-owner’s fractional interest therein, §2703 did not apply.  The court held that §2703(a)(2) applied; that there was no bar, as a matter of law, to an appropriate discount from pro rata fair market value of the value of the undivided fractional interests for estate tax purposes; and that the fair market value of each piece was properly discounted by 10 percent. The court held that petitioners were entitled to a 10 percent discount from pro rata fair market value with respect to decedent’s interest in the art. 

DAMAGES 

United States v. Anchor Mortgage Corporation

2013 U.S. App. LEXIS 5552; March 21, 2013

U.S. Court of Appeals for the Seventh Circuit, Judge Easterbrook

Defendants, Anchor Mortgage Corporation and its CEO, appealed from the U.S. District Court for the Northern District of Illinois, Eastern Division, where the judge, following a bench trial, found that they lied when applying for federal guarantees for 11 loans.  Under the False Claims Act, the district court imposed a penalty of $5,500 per loan, plus treble damages; with damages totaling about $2.7 million. One kind of false statement was the corporation’s representation that it had not paid anyone for referring clients to it, but in fact, it had paid at least one referrer.  Because the CEO knew that no “controlled business arrangement” was in existence, the district court did not commit a clear error in finding that he knew that the statements to the federal agency were false.

The court ruled that the district court properly imposed treble damages under 31 U.S.C.S. §3729(a)(1) rather than double damages under 31 U.S.C.S. §3729(a)(2).  Further, the statute did not cap damages for every violation just because a particular violation was reported. Sub-paragraph (A) refers to “the violation”; each had to be assessed separately.  Ruling that neither statutory language nor any policy favored gross trebling under 31 U.S.C.S. §3729(a), the district judge was required to recalculate the award using the net trebling approach.  The judgment was affirmed to the extent it found defendants liable, but it was reversed to the extent it adopted the gross trebling approach.  The case was remanded with instructions to recalculate the award under the net trebling approach.

Naylor v. Invacare Continuing Care, Inc.

2013 U.S. App. LEXIS 5684; March 18, 2013

U.S. Court of Appeals for the Sixth Circuit, Judge Cook

In a contract dispute concerning the sale of a medical equipment rental business’s assets, defendants appealed the U.S. District Court for the Western District of Tennessee’s bench trial judgment finding them liable for breach of contract, intentional misrepresentation, and violation of the Tennessee Consumer Protection Act (TCPA).  Plaintiffs cross-appealed the damages awarded. The district court properly decided plaintiffs’ claims.  Defendants breached the finder’s fee provisions of the asset purchase agreement by promising a consultant a finder’s fee in lieu of his usual profit-based quarterly bonus, regardless of its accounting-related motives for paying the fee. The district court’s factual findings as to the inadequate responses to plaintiffs’ requests for information were upheld, and it properly determined defendants violated plaintiffs’ verification rights under the accounts receivable repurchase provision. Defendants breached the escrow agreement by blocking the disbursement of the escrow funds in bad faith with an unsupported claim related to lost customer accounts.  Plaintiff company president’s reliance on the express representations in a negotiated contractual document was reasonable under the circumstances. Because the district court’s factual findings supported each element, it correctly found defendants were liable for intentional misrepresentation.  Defendants violated the TCPA for the same reasons a breach of contract and intentional misrepresentation were found.

The district court did find that some of the damages awarded were in error.  The district court’s liability findings, the release of the escrow funds subject to prejudgment interest at a rate of 10 percent, and the award of attorney’s fees were affirmed; but the district court’s awards of $210,000 in compensatory damages, $315,000 in punitive damages, and $3,000 for damage to rental beds were reversed.

Stockton East Water District v. United States

2013 U.S. Claims LEXIS 130; February 28, 2013

U.S. Court of Federal Claims, Judge Miller

The U.S. Court of Federal Claims allowed the award of $2.268 million, but denied any award of expectancy damages for overhead.  The district court awarded the plaintiffs consequential damages based on what the court characterized as “stranded” overhead costs incurred by plaintiffs as part of construction of a water conveyance system that it was required to construct but  did not use. The U.S. Court of Federal Claims reasoned that the plaintiffs would have been required to construct and maintain the system whether or not the contract had been breached.  The Court of Federal Claims further ruled that the costs were not caused by the breach. 

MARITAL DISSOLUTION

Russell v. Russell

2013 Ark. App. LEXIS 150; February 27, 2013

Court of Appeals of Arkansas, Judge Brown

In the divorce action, the trial court did not err under Ark. Code Ann. §9-12-315(a)(1)(A) (2009) in finding that the wife’s interest in the husband’s share of a family business was $272,875, and in ordering the husband to pay her $11,370 per month for 24 months due to the unequal property division.  The parties stipulated as to the amount of the business the husband owned.  The trial court had competent evidence before it to show the fair market value of the husband’s interest. The trial court’s decree simply required the husband to give the wife half the value of what he already owned.  The judgment was modified to reflect that the trial court’s award to the wife was a division of property and not alimony.  The judgment was affirmed and modified.

In re Marriage of McDermott

2013 Iowa Sup. LEXIS 17; March 1, 2013

Supreme Court of Iowa, Judge Wiggins 

The Iowa Court of Appeals, in appellee wife and appellant husband’s divorce case, reduced an equalization payment of $1 million that the trial court ordered the husband to pay to the wife, to $250,000.  The appellate court did not alter the child support obligation regarding income and health insurance costs, but did modify the provision dealing with the children’s extracurricular expenses.  The Iowa Supreme Court then granted further review.

During the marriage, the husband worked the family farm.  The couple had six children. Eventually she, a physical therapist, became their primary caregiver.  The husband generated income through the farm.  In doing so, he received assistance from his relatives.  Twelve years after the marriage, the wife filed for divorce.  The trial court distributed the marital property, awarding most of the property to him and assigning all debts to her. His share of the marital assets was in excess of $2.1 million, but hers was less than $150,000.  The trial court ordered him to make an equalization payment to her of more than $1 million. It ordered her to pay monthly child support.  The appellate court lowered the equalization payment to $250,000.

The state supreme court found that: (1) the trial court’s equalization payment was proper, as the items received from the husband’s relatives to benefit the farming operations were neither Iowa Code §598.21(6) (2009) inheritances or gifts, but were to benefit the whole family; (2) the husband was entitled to a credit for one-half the health insurance benefits he pays; and (3) the award of child support was proper.  The state supreme court vacated the appellate court’s judgment lowering the equalization payment, affirmed the trial court’s property distribution, and affirmed its child support award and mandate that each party pay half of the children’s extracurricular expenses. However, it remanded the case to the trial court to enter an order giving the husband a deduction for one-half the health insurance benefits he pays, conditioned on his timeliness of payments.

SHAREHOLDER DISPUTE

Carsanaro v. Bloodhound Technologies, Inc.

201 Del. Ch. LEXIS 69; March 15, 2013

Court of Chancery of Delaware, Judge Laster 

Plaintiff common stockholders filed suit against defendants, a company, various members of the board and others, alleging that venture capitalists (VCs), inter alia, diluted the value of the stockholders’ equity ownership in the company.  The stockholders challenged the dilutive transactions, the allocation of merger proceeds to management and the fairness of the merger. Defendants filed motions to dismiss the action.  The stockholders, who all held common stock, claimed that after the company raised its initial rounds of venture capital financing, the VCs obtained control of the company’s board of directors.  Further, they alleged that the VCs financed the company through self-interested and highly dilutive stock issuances, such that upon sale of the company, the stockholders discovered that their overall equity ownership had been greatly diluted. The court found that the exercise of jurisdiction over non-resident defendants was proper under Del. Code Ann. tit. 10, 3104(c) and due process.  It also held that claims were validly stated with respect to breach of fiduciary duty (BFD), and violation of Del. Code Ann. tit. 8, §242(a), and also with respect to the amendment of the charter.  As for the aiding and abetting claims, those survived but the constructive fraud claim was repetitive of the BFD claims.  The company was not a fiduciary to the stockholders, such that BFD claims against it did not survive.  The court rejected defenses of standing, as direct claims were stated, and the statutory bar of Del. Code Ann. tit. 8, §124.  Other defenses, however, including defendants’ ability to exercise a redemption right, laches, and exculpation, did not warrant dismissal. The court granted dismissal of the claims of BFD against the company, some statutory claims, and claims of constructive fraud.  The remainder of the dismissal action was denied. 

Fancher v. Prudhome

2013 La. App. LEXIS 318; February 27, 2013

Court of Appeal of Louisiana, Judge Williams

The income approach to valuation of a withdrawing member’s share in an LLC was not applicable because the LLC’s future cash flow could not be assumed given the withdrawing member’s role in providing almost all of its business; book value of the assets was properly used to arrive at the LLC’s value under La. Rev. Stat. Ann. §12:1325(C).  The trial court was not clearly erroneous in finding that the other two members did not act with reckless disregard of the best interests of the LLC in violation of La. Rev. Stat. Ann. §12:1314 by agreeing to a loan that was necessary to keep the company operating.  The judgment of the trial court was affirmed.

Peter H. Agrapides, MBA, AVA, is a Principal at Western Valuation Advisors, which has offices in Salt Lake City, Utah and Las Vegas, Nevada. Mr. Agrapides’ practice focuses primarily on valuations for gift and estate tax reporting. He has experience valuing companies in a diverse array of industries. These engagements have ranged from small, family owned businesses to companies over $1billion.

This review was originally published in the May/June edition of the Value Examiner.