Tax Court Addresses Gift Tax Valuation of Interdependent Closely-Held Companies

(Parker Tax Publishing August 2019)

In an estate's petition to review the IRS's determination of a $44 million gift tax deficiency arising from the decedent's lifetime gift transfers to his daughters of equity interests in two closely-held companies, a sawmill company and a timber company, the Tax Court held that the estate appropriately valued the transferred interests in the timber company using an income approach rather than an asset-based approach because there was no likelihood that the timber company would sell its timberlands given that the sawmill's continued operations depended on the continued ownership of the timberlands. The court rejected the IRS's assertion that the relationship between the companies should be disregarded because they were separate legal entities and found that the companies were closely aligned and interdependent so it was appropriate to take their relationship into account. Estate of Jones v. Comm'r, T.C. Memo. 2019-101.

Background

In 1954, Aaron Jones established Seneca Sawmill Co. (SSC), an Oregon lumber mill taxed as an S corporation. Jones was SSC's president, CEO, and chairman of the board. In 1989, Jones began buying timberland in order to reduce SSC's reliance on timber from federal lands. In 1992, Jones formed Seneca Jones Timber Co. (SJTC), a limited partnership, and contributed the purchased timberlands in an exchange for an interest in SJTC. SJTC's timberlands were intended to be SSC's inventory. SJTC became SSC's largest supplier of logs, and almost 90 percent of SJTC's harvested logs were purchased by SSC.

Jones owned the bulk of the shares or units of the companies. SSC and SJTC, while separate legal entities, operated in tandem in furtherance of SSC's sawmill business. SSC owned a 10 percent interest in SJTC and, as the sole general partner of SJTC, made all management decisions and had full control over its business. SSC's management team managed SJTC and SJTC paid SSC a fee for administrative services. SJTC and SSC were joint parties to a third-party credit agreement. Bank loans were reported on SJTC's books because its timber served as collateral. The management team applied borrowed cash where it was needed, and documented it as a loan from SJTC. When SSC generated revenue by selling processed logs, it transferred money as a loan or receivable to SJTC to repay the loans SJTC took out against its timber.

In 1996, Jones began to create a succession plan to ensure that his family business remained operational in perpetuity. As part of the plan, he formed several family and generation-skipping trusts to which interests in the companies would be transferred as gifts. On May 28, 2009, Jones gave blocks of stock in SSC to the trusts and made gifts to each of his three daughters of blocks of 10,267.67 SJTC limited partner units and 10,256 shares of nonvoting stock. Jones's daughters assumed liability for the gift tax and estate tax associated with transfers.

Jones filed a Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, for the 2009 tax year, along with valuation reports for SSC and SJTC valuing the SSC voting shares at $325, SSC nonvoting shares at $315, and the SJTC limited partnership units at $350. In 2013, the IRS issued a notice of deficiency in which it determined the value of SSC voting shares at $1,395, SSC nonvoting shares at $1,325, and SJTC limited partnership units at $2,511. The IRS determined a deficiency in gift tax of $44,986,416. Jones died in 2014. His estate challenged the notice of deficiency in the Tax Court.

Both the estate and the IRS submitted expert valuation reports. The estate conceded a small part of the IRS's deficiency, valuing the SJTC units at $380, the SSC voting stock at $390, and the SSC nonvoting stock at $380. The IRS's expert report increased its valuation of the SJTC limited partnership units to $2,530. The estate also provided a valuation of the SSC stock and the IRS submitted a rebuttal critiquing that valuation.

The primary dispute between the parties was whether SJTC should be valued using an income approach or an asset-based approach. The estate treated SJTC as an operating company that sold logs and therefore valued it as a going concern. The estate said that an asset-based approach was inappropriate because there was no likelihood that SJTC would sell its underlying assets, i.e., its timberlands. The estate explained that under the partnership agreement, SJTC's limited partners could not force a sale of its timberlands and that SSC, which had the authority to force such a sale, would never do so because its continued operations relied on SJTC's timber. The IRS responded that SJTC was a natural resource holding company and, therefore, the value of its timberlands should be given primary consideration. The IRS also said that because SJTC and SSC were separate legal entities, the court should ignore their interdependent relationship.

Analysis

The Tax Court adopted the estate's valuations after concluding that an asset-based approach was not an appropriate method for valuing SJTC because there was no likelihood of a sale of SJTC's timberlands. The court found that SJTC had aspects of both an operating company and an investment or holding company because, while its timberlands would retain and increase in value even if the company was not profitable on a year-to-year basis, it was also an operating company that expended significant time and effort in planting trees and harvesting and selling logs. Thus, the court looked to the likelihood of a sale of SJTC's underlying assets because it said that would determine the relative weight it should give an asset-based approach. According to the court, the less likely SJTC was to sell its timberlands, the less weight should be assigned to an asset-based valuation.

The court found that SSC's continued operation as a sawmill company depended on SJTC's continued ownership of timberlands and there was no likelihood that SSC, as SJTC's general partner, would direct SJTC to sell its timberlands while SSC continued operating as a sawmill. In the court's view, SJTC and SSC were so closely aligned and interdependent that, in valuing SJTC, it was appropriate to take into account its relationship with SSC and vice versa. The court said that doing so did not ignore the status of the companies as separate legal entities but rather recognized their economic relationship and its effect on their valuations.

The Tax Court rejected the IRS's challenges to the estate's valuation reports. The court found that the estate correctly considered revised financial projections SSC produced for 2009 in determining SJTC's net cash flow, as they were the most current as of the valuation date. The court found that the estate properly tax-affected SJTC's earnings by taking into account the tax burden on its owners because it found a hypothetical buyer would consider the fact that SJTC's partners would be taxed at ordinary rates on its income whether or not it made any distributions. The court further found that the estate appropriately treated the intercompany debt and interest income and expense as operating income and expenses because doing so captured the companies' relationship as interdependent parts of a single business enterprise. In valuing SSC, the court found that the estate properly treated intercompany debt as part of SSC's operations, treated SSC's 10 percent general partner interest in SJTC as an operating asset, and tax-affected the valuation of SSC.

For a discussion of gift tax valuation, see Parker Tax ¶220,545.

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.

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