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Don't Give Up On Valuation Cases

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June 10, 2008

When a closely-held business changes hands, substantial tax dollars may be at stake. However, valuing such a company is an inexact science.

Therefore, if you or one of your clients inherits a family business, here are two important considerations:

  1. Get a thorough appraisal from a respected professional and go to court if necessary.
  2. Fight for a lower value for tax purposes, as long as you have a solid argument.

That's the lesson learned from the Estate of Simplot. In this case, the business contained both Class A voting shares and Class B non-voting shares. The estate held 23 percent of the voting stock in the Idaho company, which was involved in processing frozen food potatoes and other businesses. The IRS assessed a "control premium" and the Tax Court agreed. But the family fought back and lowered its tax bill.

Control Factors

The theory behind a control premium is that a buyer is willing to pay more for an interest in a company if the shares provide opportunities for controlling matters such as salary, dividends, contracts and mergers.

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Suppose a company is worth $1,000. If there are 100 shares of stock, each share has a pro rata value of $10. However, for an interest of 40 shares, it's likely a buyer would be willing to pay less than $400 because the 40 shares lack the power to control the company. If a buyer is willing to pay only $7 per share, this is a minority discount of 30 percent.

In relation to the minority value of $7 per share, a pro rata value of $10 per share may be considered a control premium of 43 percent: $10 is 143 percent of $7. If a hypothetical buyer would recognize a strategic opportunity, an additional value can be added to the control premium.

According to the Tax Court, a control premium was justified in the Simplot case. The reason: A hypothetical buyer of the shares would likely be a family member who could potentially control the company because there were only four such blocks of stock in existence. In essence, the buyer "would gain access to the inner circle," the court stated.

The estate appealed and the decision was reversed for three reasons (see box to the right).

The bottom line is that you can be aggressive in claiming valuation discounts if you have an expert appraisal. That's especially true if the shares are held by a family limited partnership (FLP), because such shares are illiquid and lack control.

In another case, an estate took a 40 percent discount on the valuation of shares held by an FLP. The IRS claimed the discount should be between 12.5 and 14.1 percent.

The Court listened to the experts for both parties and found the estate's appraiser was more convincing. Thus, it allowed the full 40 percent discount. (Estate of Elma Middleton Dailey, TC Memo. 2001-263)

Your chances of prevailing in cases like these are enhanced if your expert is competent, convincing, thoroughly documents opinions and has testified in other court cases.

Reasons for Reversal

The Appeals Court cited three factors:

  • The buyer was not really hypothetical. The fair market value was determined with regard to a specific buyer (another family member in this case). "In violation of the law, the Tax Court constructed particular possible purchasers," the Appeals Court stated.
  • The Tax Court also erred by valuing property not before it — the Class A voting shares that weren't owned by the estate. Under the tax law, property subject to valuation is limited to the property subject to taxation. In this case, that was only the estate's shares.
  • Even a controlling block of stock is not to be valued at a premium for estate tax purposes unless the IRS can show that "a purchaser would be able to use the control in such a way to assure an increased economic advantage worth paying a premium for." But the IRS did not make a persuasive case. (Simplot, 249 F.3d 1190,9th Cir. 2001)

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