Tax Court Rejects IRS's Excessive Valuation of Estate's Closely Held Stock.
(Parker Tax Publishing August 21, 2014)

The valuation of closely held stock is often a contentious issue between an estate and the IRS, especially where the dollars at issue are large. Because there is no market for such stock, different methods may be used, and different factors considered, in determining stock value. This was the situation in Est. of Adell v. Comm'r, T.C. Memo. 2014-155 (8/4/14), where the IRS rejected an estate's $9.3 million valuation of its closely held stock and instead determined a date-of-death value of over $92 million. As a result, the IRS assessed an estate tax deficiency of almost $40 million and assessed millions more in penalties for substantial estate tax valuation understatements.

In a total defeat for the IRS, the Tax Court rejected the opinion of the IRS's valuation expert, noting that he did not factor in certain important details in his valuation for example, a key employee's goodwill that was personally owned independent of the corporation whose stock was being valued. Instead, the court held that the initial valuation of the stock on the estate's tax return (i.e., the $9.3 million) was the correct valuation. Additionally, since there was no estate tax deficiency, no penalties applied.

Background

In 1978, Franklin Adell decided to pursue an opportunity in television broadcasting. He applied for a television license, which he received 10 years later in 1988. At that time, he convinced his son, Kevin, to help him build a television station. With loans and money from his parents, Kevin built the television station WADL for his father.

In 1994, Mr. Adell formed STN Satellite Television Network, Inc. STN Satellite provided satellite uplinking services. Kevin hired a company to apply for an uplink license and the uplink license was issued to "STN." Kevin handled the day-to-day operations and began to learn about the uplinking business by providing satellite uplinking services on a contract basis for various customers. Subsequently, Kevin saw an opportunity to create STN.Com, a new entity to operate Mr. Adell's uplinking business.

Mr. Adell incorporated STN.Com in 1999, as a C corporation. He was STN.Com's sole shareholder until 2002, when he transferred his 100 percent interest in STN.Com consisting of 1,000 shares of common stock to the Adell Trust. From the date of incorporation through the date of Mr. Adell's death on August 13, 2006, STN.Com's board of directors included Mr. Adell, Kevin, and Ralph Lameti. Mr. Lameti, a CPA and a lawyer, did all of the accounting work for Mr. Adell and his family. Mr. Lameti's firm also provided accounting services for STN.Com. Kevin served as STN.Com's president, but he never had an employment agreement or a noncompete agreement with STN.Com. STN.Com's sole business purpose was to broadcast an urban religious program channel that Kevin named "The Word Network" (The Word).

To gain support for The Word, Kevin met with religious leaders in the Detroit area, including Bishop Charles Haywood Ellis, and Reverend Jesse Jackson, Sr., in Chicago. They agreed to help Kevin launch The Word. In October 1999, Mr. Adell, Kevin, Mr. Lameti, Rev. Jackson, and Bishop Ellis went to Los Angeles to meet with the president of DirecTV about The Word. Kevin presented his idea for a 24-hour urban religious program channel, and Rev. Jackson and Bishop Ellis explained the need for urban ministries to reach a national audience. The DirecTV representatives were interested in broadcasting The Word and asked Kevin to prepare a business plan.

Shortly thereafter, Kevin and Mr. Adell incorporated World Religious Relief as a Michigan nonprofit to operate as The Word. The Word and STN.Com signed a Services and Facilities Agreement (services agreement) in which STN.Com agreed to provide executive, management, legal, technical, supervisory, administrative, accounting, clerical, and other services and such facilities as The Word might reasonably require in order to effectively run its operations, as requested from time to time by the Board of Directors or the President of The Word. In consideration, The Word agreed to pay STN.Com a monthly programming fee equal to the lesser of (1) actual cost, or (2) 95 percent of net programming revenue received by The Word in a one month period. The parties agreed that the programming fee would not exceed STN.Com's actual direct costs and allowable indirect costs.

The services agreement was scheduled to terminate upon the earliest of:

(1) mutual written consent of the parties;

(2) termination of The Word's right to use the DirecTV channel;

(3) The Word's failure to pay the monthly programming fee within five business days after the due date; or

(4) The Word's exercise of an option to terminate the agreement if STN.Com failed to transmit The Word's programming to the DirecTV channel for a specified length of time. Mr. Adell signed the services agreement as president of The Word, and Kevin signed the agreement as president of STN Satellite

Despite the limitation of STN.Com's programming fee, STN.Com was a profitable company on the date of Mr. Adell's death and there was no indication that it would not continue being profitable thereafter.

Estate's Valuation of Stock

Mr. Adell's estate filed its original Form 706 in 2007 with a valuation report of the estate's STN.Com stock that was prepared primarily by Stout Risius Ross, Inc. and certified by Jeffrey Risius, on a date that was 10 months after Mr. Adell's death. In the valuation report, Mr. Risius used the discounted cashflow analysis of the income approach to determine that the fair market value of STN.Com's stock was $9.3 million. On the basis of Mr. Risius' valuation, the estate reported that the date-of-death value of the STN.Com stock was $9.3 million.

The IRS rejected the estate's $9.3 million valuation and issued a deficiency notice based on its valuation of the stock of over $92 million. When it became clear that the case was headed to the Tax Court, Mr. Risius prepared a second valuation report for the STN.Com stock which the estate submitted to the Tax Court. In the second valuation report, Mr. Risius valued the STN.Com stock using the adjusted book value method reflecting the liquidation or sale of assets instead of a discounted cashflow method. Another expert for the estate, Mr. Howard, also prepared a report and both reports came to the same conclusion: the appropriate valuation approach for the STN.Com stock on Mr. Adell's date of death was the asset approach and under that approach the fair market value of the STN.Com stock was $4.3 million.

As proof that the reported value on the estate's original return was erroneous, the estate relied on the terms of the services agreement. Specifically, the estate cited the provision in the services agreement that limited STN.Com's programming fee to the lesser of its actual cost or 95 percent of The Word's revenue. The estate argued that this provision prevented STN.Com from being profitable and therefore any valuation of STN.Com had to be based on the liquidation of its assets, its highest and best use. Under the asset approach, Mr. Risius accounted for STN.Com's lack of ability to generate a profit from its sole customer and the fact that STN.Com did not have any other source of revenue or other customers from which STN.Com could generate income. Accordingly, Mr. Risius valued the STN.Com stock using the adjusted book value method of the asset approach. Using the adjusted book value, Mr. Risius determined the STN.Com stock was worth $4.3 million on Mr. Adell's date of death.

The other expert, Mr. Howard, also found the income method was inappropriate because in addition to lacking a contractual guaranty of a specific return, STN.Com's projected cashflow streams from its only customer, The Word, were uncertain because Kevin did not have a noncompete agreement with STN.Com and could create a new company to replace STN.Com. Mr. Howard explained that the goodwill associated with the relationship between Kevin and The Word was personal to Kevin. Without an employment agreement with Kevin, Mr. Howard concluded that an income approach was not appropriate to determine the fair market value of the STN.Com stock. Instead, Mr. Howard said, the net asset value method was the appropriate valuation method because STN.Com had assets with values that could be determined. Using this valuation method, Mr. Howard determined that on Mr. Adell's date of death, the fair market value of 100 percent of the STN.Com stock was $4.3 million.

IRS's Valuation of Stock

Before the Tax Court, the IRS's expert witness, Mr. Burns, valued the STN.Com stock using the discounted cashflow method of the income approach. While the IRS initially proposed a value of over $92 million for the stock in its notice of deficiency to the estate, Mr. Burns determined that the value on Mr. Adell's date of death was approximately $26.3 million. In his valuation, Mr. Burns reviewed STN.Com's business operations, ownership structure, and financial performance. He also reviewed the services agreement and, like Mr. Risius and Mr. Howard, noted that the monthly program fee payable from The Word, STN.Com's only customer, to STN.Com was limited to the lesser of actual cost or 95 percent of net programming revenue received by The Word in a one month period. On this basis, Mr. Burns determined that the appropriate valuation method for the STN.Com stock on Mr. Adell's date of death in 2006 was the discounted cashflow method of the income approach. In support of his conclusion, Mr. Burns explained that STN.Com was a fairly young company as of the valuation date that had been profitable in each of the fiscal years preceding the valuation date.

Mr. Burns also addressed the importance of Kevin's relationship with The Word to STN.Com's continued business operations. Instead of applying an economic charge for Kevin's personal goodwill similar to one found in Mr. Risius' first valuation report, Mr. Burns concluded that a hypothetical investor would anticipate retaining Kevin as an officer of STN.Com and would need to compensate Kevin at an acceptable rate of 8.1 percent of sales. Mr. Burns noted that his assumed compensation level for Kevin of nearly $1.3 million in 2006 was significantly higher than Mr. Risius' estimate of $528,000 in his first valuation report.

Tax Court's Analysis

The Tax Court began by noting that, when considering expert testimony, it was not required to follow the opinion of any expert if that expert's opinion was contrary to the court's judgment. The court observed that the reported value on the estate's original return was an admission by the estate, and the lower value of $4.3 million could not be substituted without cogent proof that the reported value was erroneous. The court then reviewed the estate's arguments for the lower valuation and found them lacking.

Despite the limitation of STN.Com's programming fee, the court noted, STN.Com was a profitable company on the date of Mr. Adell's death and it was reasonable to conclude that it would continue to be profitable thereafter. The profitability of STN.Com was supported by five years of STN.Com's financial statements, which were prepared by Mr. Lameti's accounting firm, and by discussions with STN.Com's management during the year after Mr. Adell's date of death. Although The Word could have enforced the limitation on STN.Com's programming fee, the court said, it did not do so for the five years preceding Mr. Adell's date of death, or the four years thereafter. Moreover, management made no indication that The Word would enforce the limitation and, in fact, predicted that its sales would increase, resulting in expected capital expenditures that would enhance the value of STN.Com.

The Tax Court concluded that a hypothetical willing seller and a hypothetical willing buyer could not ignore the historical performance of STN.Com's profits on Mr. Adell's date of death, and notwithstanding the programming fee limitation, STN.Com was indeed a profitable company. Thus, the court said, an income approach was the most appropriate method to determine the value of the STN.Com stock because the business' best value was as a going concern. Thus, it rejected the estate's valuation of the stock based on the liquidation value of the company's assets.

With respect to the IRS's valuation, the court noted that the most significant difference between Mr. Risius' first valuation report and Mr. Burns' valuation report was their treatment of the intangible value that Kevin provided STN.Com. While both Mr. Risius and Mr. Burns recognized that the success of STN.Com depended on Kevin's relationships with The Word and its customers, they accounted for that value differently. The court noted that, in his first report, Mr. Risius applied an economic charge for Kevin's personal goodwill that ranged from $8 million to $12 million over the projection period, thereby increasing STN.Com's projected operating expenses and decreasing its net cashflow. Mr. Burns, however, determined that a hypothetical willing investor would be able to retain Kevin for an acceptable salary, which he determined to be 8.1 percent of sales, or approximately $1.3 million in 2006. Mr. Burns' approach resulted in a higher estimate of STN.Com's projected net cashflow, and thus a higher valuation of the STN.Com stock.

The court noted that Kevin did not transfer his goodwill to STN.Com through a covenant not to compete or other agreement and Kevin was free to leave STN.Com and use his relationships to directly compete against his previous employer. If Kevin quit, the court observed, STN.Com could not exclusively use the relationships that Kevin cultivated; thus, it was not appropriate to attribute the value of those relationships to STN.Com. Accordingly, the court concluded that Mr. Risius properly adjusted STN.Com's operating expenses to include an economic charge of $8 million to $12 million for Kevin's personal goodwill an amount high enough to account for the significant value of Kevin's relationships. On the other hand, the court stated, the IRS's expert not only failed to apply an economic charge for Kevin's personal goodwill but also gave too low an estimate of acceptable compensation for Kevin, i.e., $1.3 million in 2006. This was especially so, the court said, because Kevin had stepped into the position of Mr. Adell, who had previously been paid over $2 million and $7 million of compensation in each of the five years before his death.

Conclusion

In the end, the Tax Court gave no weight to the expert valuations that the estate submitted at trial, except for the consistent treatment of the underlying value of STN.Com's assets. The Tax Court also found that the IRS's expert was not persuasive because he did not reasonably account for Kevin's personal goodwill.

The Tax Court therefore found that the estate failed to introduce any evidence or present any arguments that would persuade it that the value reported on the estate's original tax return was incorrect. Thus, the court concluded that Mr. Risius' first valuation report on the STN.Com stock included with the original estate tax return was the most creditable because it properly accounted for Kevin's personal goodwill and appropriately used the discounted cashflow analysis of the income approach to value the STN.Com stock. The Tax Court thus concluded that the fair market value of the STN.Com stock owned by the estate on August 13, 2006, was $9.3 million. In addition, since there was no understatement of estate tax liability, the Tax Court held that no penalties applied. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

Parker's Tax Library - An Affordable Professional Tax Research Solution. www.parkertaxpublishing.com

We hope you find our professional tax research articles comprehensive and informative. Parker's Tax Library gives you unlimited online access all of our past Biweekly Tax Bulletins, 22 volumes of expert analysis, 250 Client Letters, Bob Jennings Practice Aids, time saving election statements and our comprehensive, fully updated primary source library.

Try Our Easy, Powerful Search Engine

A Professional Tax Research Solution that gives you instant access to 22 volumes of expert analysis and 185,000 authoritative source documents. But having access won’t help if you can’t quickly and easily find the materials that answer your questions. That’s where Parker’s search engine – and it’s uncanny knack for finding the right documents – comes into play

Things that take half a dozen steps in other products take two steps in ours. Search results come up instantly and browsing them is a cinch. So is linking from Parker’s analysis to practice aids and cited primary source documents. Parker’s powerful, user-friendly search engine ensures that you quickly find what you need every time you visit Our Tax Research Library.

Dear Tax Professional,

My name is James Levey, and a few years back I founded a company named Kleinrock Publishing. I started Kleinrock out of frustration with the prohibitively high prices and difficult search engines of BNA, CCH, and RIA tax research products ... kind of reminiscent of the situation practitioners face today.

Now that Kleinrock has disappeared into CCH, prices are soaring again and ease-of-use has fallen by the wayside. The needs of smaller firms and sole practitioners are simply not being met.

To address the problem, I’ve partnered with a group of highly talented tax writers to create Parker Tax Publishing ... a company dedicated to the idea that comprehensive, authoritative tax information service can be both easy-to-use and highly affordable.

Our product, the Parker's Tax Library, is breathtaking in its scope. Check out the contents listing to the left to get a sense of all the valuable material you'll have access to when you subscribe.

Or better yet, take a minute to sign yourself up for a free trial, so you can experience first-hand just how easy it is to get results with the Pro Library!

Sincerely,

James Levey

Parker's Tax Library - An Affordable Professional Tax Research Solution. www.parkertaxpublishing.com