Estate of Richmond v. Commissioner

Guidance on How to Calculate the Built-in Capital Gains Tax?!

Estate of Richmond is well known among experienced valuation professionals for at least two reasons. First, the U.S. Tax Court was critical of the experts’ lack of credentials and the fact that the estate submitted an unsigned, marked-up report with the 706. Second, the U.S. Tax Court did not allow a 100 percent BICG tax reduction. Rather, the Court provided guidance regarding the extent of the BICG deduction. The author, an experienced valuation advisor, shares his views on both of these issues.

Estate of Richmond v. Commissioner
T.C. Memo 2014-26
February 11, 2014
Judge Gustafson

 

This case presents the United States Tax Court (“Tax Court”) with the following issues:

 

• What is the proper methodology to provide a Conclusion of Value as to the fair market value of the decedent’s interest in a closely-held holding company (of particular note is that the subject company was a C Corporation), the assets of which were solely comprised of marketable securities?

 

• How should the appraisal account for the built-in capital gains tax (liability) (“BICG tax”), which amounted to $18.1 million?

 

• What type of appraisal would excuse an accuracy-related penalty? Specifically, would the appraisal which was attached to the decedent’s Form 706, an unsigned draft valuation that was prepared by a non-(valuation) credentialed CPA, excuse such an accuracy-related penalty?

 

Factual Background

 

Decedent passed away in December 2005.  At the time of her death, she held a 23.44 percent interest in a closely-held holding company—a closely-held C Corporation—the sole assets of which were a portfolio of marketable securities.  The decedent’s interest represented the second largest ownership block; however, she was not in a position to unilaterally control the company (the valued interest was a non-controlling interest).  At the date of valuation, the company had a market value of equity $52.16 million, of which approximately $45 million represented unrealized appreciation.  The BICG tax on the unrealized appreciation was approximately $18.1 million.  The company did not actively trade its stock portfolio.  The company’s historical turnover suggested a 70-year liquidation horizon.

 

The estate retained a CPA and certified financial planner to provide a Conclusion of Value as to the fair market value of the decedent’s 23.44 percent interest.  Of particular import, is the fact that the CPA carried none of the well-recognized valuation designations.  The court opinion does note that the CPA had performed approximately 10 to 20 valuations.

 

By way of background, it is important to note that all valuations prepared for the IRS (whether for gift, estate, or income tax reporting purposes), must be prepared by a “Qualified Appraiser,” and the work-product must be a “Qualified Appraisal.”  I.R.C. § 170(f)(11), as well as 26 CFR 301.6501(c)-1(f)(3), defines a Qualified Appraiser as someone who:

 

1. Has earned their appraisal designation from one of the recognized appraisal credentialing bodies,
2. Regularly performs appraisals for which the individual receives compensation, or
3. Meets “other” qualifications as prescribed by the Secretary.

 

Further, a Qualified Appraisal is defined as:

1. An appraisal prepared by a Qualified Appraiser,
2. Meets the standards set forth by the organization from which the appraiser carries their designation.

 

Reviewing the three prongs of being certified as a Qualified Appraiser (listed above), it is readily apparent that the CPA in Richmond did not meet the first test, as he had no valuation credentials.  He did have a limited history of performing valuations for which he received compensations, and may pass the test of meeting “other” qualifications as set forth by the Secretary.  The judge’s view, in Richmond, will provide some insight into how the judiciary views appraiser qualifications.

 

The estate’s appraiser estimated the fair market value of the decedent’s interest under the capitalization of dividends method only.  His analysis set forth a conclusion of value of $3.15 million as to the fair market value of the decedent’s interest.  At first blush, the appraiser’s choice of an income approach seems out of sorts given that the subject company is a holding company.  The appraiser’s rationale for utilizing the capitalization of dividends method was however, well thought out.  His reasoning was that, in all previous shareholder buyouts, the share price was calculated under the capitalization of income method.

 

While the court opinion provides some insight into the appraiser’s thought process, the reader is left without full disclosure since the opinion does not include the appraiser’s full valuation report.  It is the author’s opinion that the use of the capitalization of income method is warranted in this case as one value indicator; however, the appraiser would have been better served by also producing a value estimate under the adjusted net asset value method.  The adjusted net asset value method is a much simpler, less subjective methodology to get to the undiscounted equity value of such an enterprise.  In fact, Revenue Ruling 59-60 suggests the use of the asset approach when valuing a holding company, even if the premise of value is Going Concern.  It is also the position of the author that an appraiser should produce as many value indications as possible.  Further, a thorough report will describe, in great detail, the appraiser’s thought process in selecting, utilizing, and weighting the various approaches and methods.

 

The estate’s appraiser submitted a draft report to the estate’s executors and tax return preparer.  Neither followed up with him, nor asked him to finalize the valuation.  The estate’s executors and advisors ultimately attached the unsigned draft valuation to the Form 706, which was sent to the IRS.  It should also be noted that the estate’s advisors had reviewed the draft report and that the copy which was sent to the IRS was a marked-up version.

 

After reading the above paragraph, readers may feel uneasy sending out draft valuations.  The author’s position on this matter is that the benefits of providing draft reports far outweigh the risks.  It is important the business owner and the advisory team understand the appraisal, and that they thoroughly read the draft report.  It is also important to communicate the dangers of sending an unsigned draft (marked-up) valuation to the IRS.  Read on to see how this issue ultimately played out for the petitioners in this case.

 

The IRS selected the Form 706 for audit, claiming a fair market value for the decedent’s 23.44 percent interest of $9.2 million.  The disparity in the values triggered a deficiency notice and a 40 percent gross valuation misstatement penalty, which amounted to approximately $1.14 million.

 

Procedural History and Trial Testimony

 

The IRS engaged an expert who was credentialed in business valuation.  He utilized the asset approach (adjusted net asset value method) to estimate the fair market value of the decedent’s interest.  The expert concluded that the fair market value of the decedent’s interest was $7.3 million (which was approximately 20 percent less than the value in the deficiency notice).  In arriving at his fair market value estimate, the expert applied a six (6) percent discount for lack of control (DLOC) as well as a 36 percent discount for lack of marketability (DLOM).  It should be noted that the 36 percent DLOM included a 15 percent BICG tax discount.

 

The estate engaged a certified business appraiser as their trial expert.  This expert, as with the appraiser that prepared the draft report, relied on the capitalization of dividends method.  The estate asked the Tax Court to adopt their expert’s calculation, not the value it had reported based on the draft valuation report.  Interestingly, the estate agreed to a value that was 60 percent more than the initial figure.

 

The estate’s trial expert also produced a fair market value estimate based on the asset approach (net asset value method).  The value determined by the estate’s trial expert under the asset approach, was largely a rebuttal to the IRS expert’s report; whereby the expert modified elements of the IRS expert’s valuation.  The most notable difference between the two experts was the fact that the estate’s trial expert deducted 100 percent of the BICG tax.  This reduced the Net Asset Value (NAV) of $52.2 million by approximately $18.1 million (100 percent of the built-in capital gains tax liability).  The expert then multiplicatively applied an eight (8) percent DLOC and a 35.6 percent DLOM, resulting in a fair market value estimate for the decedent’s interest of $4.7 million.

 

Tax Court’s Analysis

 

The first issue before the Tax Court was the issue of which valuation method was proper: (1) the capitalization of dividends method, (2) or the net asset value method.  The Tax Court stated the following relating to the estate’s trial expert’s use of the capitalized dividends method: “the expert ignored the most concrete and reliable data of value…the actual market prices of the publicly traded securities.”  The Tax Court further noted the NAV method starts out “on firm ground” with stock values that can simply be looked up.  Based on the aforementioned, the Tax Court ruled the asset approach (net asset value method) was the preferred valuation methodology in the case at hand.  Note, the Court did not state the capitalization of dividends method could not be used as a sanity check or to provide a second indication of value.

 

The Tax Court then moved to the issue of the BICG tax, noting: “no interested investor in the company would have been indifferent to the eventual $18.1 million tax liability.”  The Tax Court further noted: “the market would have demanded a discount and the fair market valuation had to reflect it.”  The Tax Court did not agree with the estate’s trial expert’s dollar-for-dollar BICG reduction, which was based on case law from the 5^th and 11^th Circuit Courts of Appeal.  The Tax Court made note that the decisions set forth by the 5^th and 11^th Circuits are not applicable in the case at hand since the case was appealable to the United States Court of Appeals for the Third Circuit[1].  The Tax Court further noted it has considered this treatment of the BICG tax: “plainly wrong in a case like the present one.”  The Court noted: “a prospective BICG tax liability is not the same as a debt that really does immediately reduce the value of a company dollar-for-dollar.”  The Tax Court was also not completely sold on the IRS expert’s 15 percent rate, but thought the $7.8 million figure was reasonable.  The Tax Court stated that the: “most reasonable discount is the present value of the cost of paying off the liability in the future,” citing Estate of Jensen, T.C. Memo 210-182.  The Tax Court arrived at a BICG adjustment between $5.5 million and $6.6 million, utilizing a 20- to 30-year holding period (despite the 70-year historic rate based on the actual portfolio’s turnover).

 

The Tax Court ultimately accepted the IRS expert’s $7.8 million BICG, since it was within the range of their own calculations.

 

Included in a footnote to the case was commentary noting that the BICG tax liability should be determined at the entity level, considering it is a liability of the company, and affects its net asset value.  Despite accepting the IRS appraiser’s value, they were critical (as noted above) of their appraisers applying a “discount” for BICG tax, rather than “normalizing” the balance sheet and accounting for the BICG as a contingent liability.

 

Finally, the Tax Court turned to the issue of the accuracy-related penalty.  The Tax Court began by clarifying that the applicable penalty rate was 20 percent of any portion of underpayment of tax—not 40 percent.  In the case at hand there was a “substantial” valuation misstatement because the amount reported on the Form 706 was less than 65 percent of the proper value.  In order to nullify the accuracy-related penalty, the estate had the burden of showing it acted both “reasonably” and in “good faith” with regard to the valuation of the decedent’s interest.  The Tax Court ruled that the estate did not act either reasonably or in good faith relying on a draft valuation prepared by an accountant who was not a certified appraiser (despite the fact the appraiser had some appraisal experience).  The estate argued the fact that four different appraisers generated four substantially different values illustrated how difficult it was to value the decedent’s interest; to which the Tax Court noted: this “further supports the importance of hiring a qualified appraiser.”

 

The Richmond case solidifies the importance of communicating your valuation credentials to your referral sources.  The case also echoes the importance of understanding your valuation engagement and using generally-accepted approaches and best practices when preparing a valuation report.

[1] It is important to note that the U.S. Tax Court will follow their own rulings on matters that have not been decided by the various U.S. Courts of Appeal.  As such, since the U.S. Court of Appeal for the Third Circuit had not yet ruled on the BICG tax issue, the Tax Court did not allow a dollar-for-dollar discount, which was consistent with previous Tax Court rulings on this subject.

Peter Agrapides is a Certified Valuation Analyst (CVA) and member of the National Association of Certified Valuators and Analysts (NACVA). He has prepared numerous valuations of companies, partnerships, and professional practices. Valuations prepared include: medical and dental practices, construction companies, retailers, wholesalers, and manufacturers in a number of industries. Mr. Agrapides can be reached at: (801) 273-1000, or by e-mail at: peter@fccval.net.