What the Tax Court Wants to See
In Your Expert Report
This article includes tips for preparing an expert report but is not intended to be all inclusive. In addition to these points, remember to carefully consider professional standards, including those that are non-binding, and any code of ethics. Also prepare your report with the expectation of a Daubert motion or similar challenge to your qualifications and/or methodology.
The Federal Rules of Civil Procedure give specific requirements for expert witness reports. In addition, published Tax Court opinions often include criticism of expert reports, thereby providing guidance on what the court prefers to see in the future. Their opinions have repeatedly pointed out that in Tax Court, an expert’s report serves as his or her direct testimony. Any additional direct testimony in the courtroom is usually limited to little more than the experts identifying themselves and their reports. Therefore, the contents of the reports are critical.
The Report
Rule 26 of the Federal Rules of Civil Procedure includes the “Duty of Disclosure” which involves disclosing the identity of expert witnesses and their opinions. Rule 26(a)(2)(B) says, “Except as otherwise stipulated or directed by the court, this disclosure shall, with respect to a witness who is retained or specially employed to provide expert testimony in the case or whose duties as an employee of the party regularly involve giving expert testimony, be accompanied by a written report prepared and signed by the witness. The report shall contain a complete statement of all opinions to be expressed and the basis and reasons therefor …” Notice the breadth of the wording in complete statement of all opinions.
The Facts
In the Federal Rules of Evidence (FRE), Rule 702 says that expert testimony is to “help the trier of fact to understand the evidence or to determine a fact in issue.” It adds that the analyses and opinions must be “based on sufficient facts or data.”
In addition to emphasizing the importance of sufficient facts and data, the rules demand broad disclosure. Rule 26(a)(2)(B) requires expert reports to contain “the data or other information considered by the witness in forming the opinions; any exhibits to be used as a summary of or support for the opinions …” Notice that it refers to information considered and not just what was relied upon. Exhibits in the report would include demonstratives to be used in the courtroom.
A 2022 opinion dealing with the unreasonable compensation issue included a reminder that the court may reject “expert witness findings based on the expert’s failure to disclose underlying data.” See Clary Hood, Inc. v. Commissioner, T.C. Memo 2022-15 (4th Circuit 2023), which cited Wycoff v. Commissioner, T.C. Memo. 2017-203, at *42-*43. In Clary Hood, the court criticized a report saying that it “lacked necessary supporting calculations and did not include all underlying data, leaving us unable to verify the veracity of its findings and conclusions.”
Assumptions
It is common to include a list of assumptions toward the back of a report. In addition, other assumptions may be included, but perhaps not identified as such, within other sections of a report. To the extent that an assumption is out of the ordinary, the court may want a report to say why the expert relied on that assumption to help evaluate whether the expert was biased.
In addition, the distinction between facts, assumptions, and opinions should be clear. A reader wants to know whether they are reading a fact, an assumption, or an opinion when they see statements such as, “This company is a leader in the industry.”
Approaches and Calculations
FRE Rule 702(d) requires that “the expert has reliably applied the principles and methods to the facts of the case.” Reports are expected to disclose and explain all methodologies used. It may also be advisable to mention any other approaches that were considered but not used and say why they were not used. Courts have assumed that anything not mentioned in the report was not considered by the author. In addition, opposing counsel has been known to argue that experts did not do any more research and analysis than that which was specifically mentioned in the expert’s time records and invoices.
Computations and analyses should be shown within a report, and should be explained if not easy to follow. Yet reports often omit these important disclosures. For example, in Clary Hood, the court said that one report “compared petitioner’s book-value return on equity to the benchmarked public companies’ market returns without accounting for cash dividends and without credibly establishing a correlation between these separate performance measurements.” Regarding another expert report in that same case, the court wrote, “supporting calculations used to reach key findings and conclusions were conspicuously absent from the report and underlying data sources were not adequately disclosed.” However, the court expressed that another expert’s report “contained detailed disclosures of data sources relied upon, methodologies used, and supporting calculations.”
Some judges have expressed, at least verbally, a desire for reports to be easier to read. One preference is for calculations to be included within the body of a report when practical. This is to reduce the number of times a reader must shift between the text and the addendums. (We are also told that some judges prefer at least 12-point font for the main text and 11-point font for footnotes. This includes schedules attached as addendums.)
In Aspro, Inc., v. Commissioner, T.C. Memo 2021-8, Aff’d No. 21-1996 (C.A. 8 Cir.), one expert was excluded in large part because he relied on his personal experience and knowledge rather than applying appropriate principles and methods. Another expert in that case was excluded after failing to “articulate what principles and methods he used” and basing his conclusions on “personal belief rather than expert analysis.”
Basis for Opinions
The Clary Hood opinion includes a reminder that “While an expert can be qualified on the basis of his experience, he cannot cite his experience as the sole basis for his opinion.” Here, the court cited Feinberg v. Commissioner, T.C. Memo. 2017-211, at *9, aff’d, 916 F.3d 1330 (10th Cir. 2019), in which the court excluded the testimony of an expert who did not provide sufficient data to show that “the opinions expressed are based on anything other than his own conjecture.”
In Midwest Eye Center, S.C. v. Commissioner, T.C. Memo 2015-53, the court addressed a large bonus paid to an ophthalmology surgeon. After another doctor had left the Eye Center, the surgeon who owned 100% of the practice increased the number of surgeries he performed. As one would expect, the number of hours worked can be a factor in determining reasonable compensation. However, the Eye Center did not provide the court “any methodology to show how [his] bonus was determined in relation to these responsibilities.” Simple logic was not enough.
Other Required Disclosure
Rule 702 states that an expert can be qualified by “knowledge, skill, experience, training, or education.” Accordingly, Rule 26(a)(2)(B) requires expert reports to show “the qualifications of the witness, including a list of all publications authored by the witness within the preceding 10 years; the compensation to be paid for the study and testimony; and a listing of any other cases in which the witness has testified as an expert at trial or by deposition within the preceding four years.”
Although the FRE do not elaborate on what is a publication, this would logically include articles published in print and in online newsletters. The list of publications may also include PowerPoint slides and handouts provided at presentations to professional groups. At least currently, many expert reports do not include LinkedIn postings or blogs from the expert’s own website.
The disclosure of compensation usually includes hourly rates, and perhaps the total amount paid to the expert’s firm as of the date of the report. Although not requested in the FRE, statements of independence are commonly included in reports since objectivity is a necessary ingredient.
Business Appraisal-Specific Item—Tax Affecting Earnings of a Flow-through Entity
In the valuation of an ownership interest in an operating company organized as a pass-through entity, such as a Subchapter S corporation or entity taxed as a partnership, the Tax Court has allowed or disallowed tax affecting of either pretax earnings or the discount rate depending on the facts and circumstances of the particular case. Illustrations include the following:
Gross v. Commissioner, T.C. Memo. 1999-254 (widely considered the beginning of the current debate on tax affecting): The Tax Court recognized the need for consistent matching of either the pre-tax or post-tax level of the cash flows and discount rates, adding that since IRS’ valuation expert assumed a pre-tax discount rate, “he made no error in failing to tax affect the expected cash-flow.”
Wall v. Commissioner, T.C. Memo. 2001-75. See also Estate of Giustina v. Commissioner, 586 F. App’x 417 (9th Cir. 2014), rev’g and remanding T.C. Memo. 2011-141. The Tax Court disallowed tax affecting due to its inconsistent use in conjunction with pre-tax rates of return on taxable investments.Â
Dallas v. Commissioner, T.C. Memo. 2006-212; The Tax Court disallowed tax affecting since it was based on the presumption that an S corporation would lose its S corporation status after a sale.
Estate of Gallagher v. Commissioner, T.C. Memo. 2011-148, slip op. at 32, supplemented by T.C. Memo. 2011-244; The Tax Court disallowed tax affecting due to the appraiser’s failure to explain his reasoning for tax affecting.
Estate of Aaron U. Jones v. Commissioner, T.C. Memo 2019-101: The Tax Court recognized tax affecting pre-tax earnings from pass-through entities (PTEs) (like S corporations) where the tax affecting included consideration of the company’s flow-through status. Accordingly, proper application of post-tax discount rates to the earnings of an S corporation requires: 1) the tax affecting of the S corporation’s earnings and 2) the application of an S corporation premium (aka PTE tax adjustment, or C to S Method).
Estate of Jackson v. Commissioner, T.C. Memo. 2021-48: Estate’s experts used inconsistent tax rates and failed to convincingly explain their assumption that a C corporation would be the buyer of the assets at issue, rather than pass-through entities. The Tax Court concluded that tax affecting was inappropriate “on the specific facts of this case” but specified that it does “… not hold that tax affecting is never called for.”
Cecil v. Commissioner, T.C. Memo 2023-24: The Tax Court allowed tax affecting, noting that as it “… observed in the Estate of Michael Jackson, there is not a total bar against the use of tax affecting when the circumstances call for it.”
Conclusion
This article includes tips for preparing an expert report but is not intended to be all inclusive. In addition to these points, remember to carefully consider professional standards, including those that are non-binding, and any code of ethics. Also prepare your report with the expectation of a Daubert motion or similar challenge to your qualifications and/or methodology.
This article is not intended to be, and should not be used as, a substitute for legal advice.
Stephen Kirkland, CPA, CMC, CFF, is a compensation consultant and expert witness at Atlantic Executive Consulting, LLC. He serves as an expert witness in cases involving potentially unreasonable compensation.
Mr. Kirkland may be contacted at (803) 724-1414 or through ReasonableComp.biz, at Stephen.Kirkland@AECG.biz.
Bruce Wood, MTx, CPA, ABV, CVA, has been with BW Arpeggio since its founding in 2022. He has practiced in the valuation realm for the last 20 years of his 30+ year career helping clients in financial services. Through his work as BW Arpeggio’s leader for tax-related business appraisals, valuations, disputes and litigation, Mr. Wood routinely supports tax controversy attorneys in resolving tax-related business valuation disputes in U.S. Tax Court and in IRS appeals and audits. He also enables estate and gift attorneys to achieve favorable results for their clients in the realm of estate, gift, and trust tax planning and compliance.
Mr. Wood may be contacted at (678) 350-9538 or by e-mail to bwood@bradyware.com.
