The Tax Court recently issued its much-anticipated decision in Estate of Cecil v. Commissioner (T.C. Memo. 2023-24), applying tax affecting under the unique facts of the case.
The Court did note, however, that “we are not necessarily holding that tax affecting is always, or even more often than not, a proper consideration for valuing an S corporation.”
Here’s what taxpayers can consider from this ruling.
At question in Cecil was the value of gifts of noncontrolling, nonmarketable S corporation Class A (voting) and Class B (nonvoting) shares of The Biltmore Company (“TBC”), whose primary business activity includes the Biltmore House tourist attraction, along with associated hospitality and recreation enterprises. The Biltmore House, a large French Renaissance chateau, was constructed by George W. Vanderbilt between 1889-1895 during the so-called “Gilded Age” of rapid economic expansion.
Taxpayers (son and daughter-in-law to the heiress of the Biltmore House) challenged the IRS's $26 million deficiency action against gifts of TBC stock to family members.
One key issue considered in Cecil was the impact of tax affecting when valuing the S corporation stock. Tax affecting is a valuation approach that establishes the fair market value of pass-through entities by assuming a corporate tax rate (even though individual owners actually pay tax on pass-through income).
Courts have applied tax affecting based upon the facts and circumstances presented in each case. Traditionally, Courts have generally frowned upon tax affecting in business valuations, but the Tax Court concluded tax affecting was appropriate in the case of Estate of Jones vs. Commissioner, T.C. Memo. 2019-101.
Conversely, the Tax Court concluded in Estate of Jackson vs. Commissioner, T.C. Memo. 2021-48, that tax affecting was not appropriate. This inconsistent case law provides taxpayers and valuation experts with little judicial guidance on the appropriateness and applicability of tax affecting.
U.S. taxpayers and the valuation profession at large hoped that Cecil would finally resolve the issue of tax affecting and the proper valuation of S corporation stock. In the end, tax affecting in Cecil was adopted by the Tax Court, but seemingly for the fact that taxpayer’s experts and IRS’s experts all agreed it was appropriate.
The Court states:
As we observed in the Estate of Jackson, there is not a total bar against the use of tax affecting when the circumstances call for it. Now given that each side's experts... totally agree that tax affecting should be taken into account to value the subject stock [TBC], and experts on both sides agree on the specific method that we should employ to take that principle into account, we conclude that the circumstances of these cases require our application of tax affecting.
The Court, however, did not go into detail as to what specific facts and circumstances supported the use of tax affecting. Ultimately, the Court determined that the lowest estimated effective S corporation “premium” among the experts of 17.9%, compared to a competing opinion of 24.6%, was appropriate for the gifted TBC shares. It did not describe why one estimate was preferred to the other.
In addition, the Court accepted a 20% discount for lack of control from taxpayer’s expert and accepted rates of 19%, 22%, and 27% for lack of marketability from the IRS’s valuation expert. The Court’s opinion in Cecil was a victory for the taxpayers, who will be receiving significant refunds from the amounts reported on their gift tax returns.
Despite the complexity of the case, taxpayers and tax professionals can take away several lessons from the Estate of Cecil.
These lessons include:
Along with the issue of tax affecting, there are many other areas which can lead to valuation disputes between the taxpayer's valuation experts and the IRS's valuation experts. Valuation disputes include, but are not limited to:
The IRS may scrutinize valuation experts’ qualitative and quantitative approaches, along with their methodologies. Well-advised taxpayers should seek the advice of knowledgeable and experienced professionals who are able to provide credible valuation analyses.
The Court’s acceptance of the taxpayers’ testimony that they had no intention to sell the assets of TBC or their ownership interests therein is notable. The Court dismissed the IRS’s assertion that this testimony was self-serving and relied on it in reaching its conclusion.
The Court considered the restrictive ownership agreements in TBC and the organized nature in which the family defined and nurtured its intent to ensure that a specific lineage would enjoy continuous ownership and related benefits of the business enterprise. The adjusted net asset value of TBC was considerably higher than indications of value determined by the expert’s analysis of the income of the enterprise and in comparing its operating metrics to similar companies and transactions.
The IRS generally may not revalue a prior gift in determining the available applicable credit if the gift was adequately disclosed on a gift tax return and the statute of limitations to assess the gift tax has expired.
Recognizing the IRS is on the lookout in reviewing gift tax and estate returns, taxpayers should confirm that they have met the regulatory hurdles for adequate disclosure on gift tax returns (See Treas. Reg. §301.6501(c)-1(f)).
Taxpayers’ failure to adequately disclose gifts on gift tax returns allows the IRS the opportunity to re-value gifts (potentially many years after the fact). Once again, valuation experts and tax professionals can aid taxpayers with preparing valuation reports and advise taxpayers on the adequate disclosure requirements.
The Cecil case is a helpful reminder to taxpayers of the importance of obtaining a proper appraisal from qualified appraisers, and to document all relevant factors used by the appraiser in determining value.
There are a number of factors that go into a valuation and the tax implications for gift or estate taxes. A knowledgeable advisor can help you be more prepared.
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