BOOK VALUE, RESTRICTIVE AGREEMENTS AND VALUATION EXPERTS:
CASE COMPARISON IN THE FEDERAL ESTATE TAX VALUATION OF CLOSELY HELD BUSINESSES
Law & Valuation
Text of Paper
Property that is transferred upon death is taxed through the federal estate tax. The gross estate includes all property owned and any death bed transfers. In order to determine the amount of the tax, the value of the gross estate must be determined. The estate is either valued at the date of death or at an alternative date of six months later, if there is a decrease in the value of the gross estate not due to the passage of time. The value of the estate is to be determined by the fair market value of the property involved. This can be difficult to determine for certain types of property, such as closely held business interests.
ISSUEHow are interests in a closely held business to be valued for estate tax purposes?RULEThe Internal Revenue Code and regulations promulgated pursuant to the Code set forth factors that should be examined when valuing these interests, such as the value of traded stock of similar business, net worth, outlook of the industry, good will, and numerous other factors.ANALYSISAs determining the value of closely held business interests can be difficult, the Internal Revenue Code and regulations promulgated pursuant to the Code help to determine the way to do this. According to the Code, the starting point for valuing nontraded stocks and securities is to examine stocks of similar or comparable businesses that are actively traded. The regulations expand on this by providing other factors, such as the company’s net worth, prospective earning power, dividend paying capacity, good will, economic outlook of the industry, and several other factors. The formula used, incorporating these factors, will vary on a case by case basis. Premiums and discounts may also be applied to a stock value. One example is a control premium, which may be added because controlling interests are worth more than other interests. Conversely, a minority interest may receive a discount, because buyers are not willing to pay as much for a noncontrolling interest, unless it has the attribute of being a swing vote, in which case it will not be discounted. Several other conditions may lead to premiums and discounts affecting the value of the interest. Another condition that factors into the valuation is a buy-sell restrictive agreement These agreements are only given valuation effect if it is a bona fide business arrangement, if its not a testamentary devicde, and if it is comparable to an arms’ length transaction.In Estate of Lauder, the United States Tax Court chose not to include a restrictive buy-sell agreement in the valuation of shares of a closely held corporation. This agreement was created because the Lauders wished to keep Estee Lauder (ELI), the company, in the family. When Joseph Lauder died, several thousand of his shares of ELI common stock were sold, and the estate and the IRS had a disagreement as to the value of the shares of stock. During the trial, the Lauders used two business valuation experts to determine the value of the stock at the time the shareholder agreement was put into effect. Shearson Lehman, the first expert used comparative market valuation, which involves comparing ELI with similar companies whose stock is publicly traded. The second expert, Dillon, Read, provided an opinion as to what the property discount for lack of marketability should be, using the dividend discount model. This compares the present value of a dividend stream paid by publicly traded cosmetic companies with the present value of a dividend stream paid by private companies. Several factors were used in this formula, such as the fact that Estee and Leonard are key person and that ELI had lower operating margins than its competitors. The IRS used two experts as well, Management Planning and Willamette Management Associates. Management Planning used a comparative valuation method. Willamette used four valuation methods, the capital market approach, the market data transactional approach, the adjusted net worth approach and the discounted net cash flow approach. The court concluded that the shareholder agreements were enforceable and met the bona fide business purpose required in the Regulations, but found that it was testamentary in nature, and therefore should not be included in the valuation. The court chose to accept the Shearson Lehman earnings-based approach, but rejected its multiples and all of the lack of marketability evidence and supplied its own figures. Then the case was remanded in order to determine the fair market value of the stock at Joseph’s death.In Estate of Hall, the value of stock in the closely held corporation Hallmark in the gross estate needed to be valued. Hallmark stock ownership was limited to the Hall family, Hallmark employees, and charities. There was an agreement containing stock transfer restrictions, which set the price of the stock as the adjusted book value. This figure also represented the value of employee participation in the profit sharing plan. Upon Hall’s death, the estate hired two business valuation experts to present evidence as to the value of the stock. First Boston Corp. chose to compare publicly traded companies who were industry leaders like Hallmark. Each stock price was discounted in order to produce an approximate private company stock value. Shearson Lehman was the second expert, and also compared Hallmark to other industry leaders and examined several factors. The IRS used one expert, PCA. This expert used a market comparison approach and the income capitalization approach. However, the market comparison was restricted to the only publicly traded company in the same industry as Hallmark, American Greetings. The income capitalization approach was used to measure fair market value by projecting future cash flow tha the asset will generate. In this case, the court found that the buy-sell agreement was enforceable and binding, and that therefore the fair market value of the stock could not exceed adjusted book value. The court criticized the IRS’ expert for refusing to consider the buy-sell agreement and for restricting the comparison to American Greetings. The court chose to adopt First Boston’s valuation analysis of the stock.Thus, two cases involving the estate of founding members of companies who were industry leaders who owned stock restricted by buy-sell agreements had very different outcomes, showing that stock valuation of closely held companies can be a very difficult and tricky process.
IntroductionThis paper will examine the methodology and techniques used in valuation of closely held business interests in the federal estate tax context. As a way of introduction, the paper begins with a description of the estate taxation framework. Next the paper will examine the treatment of closely held business assets by the Internal Revenue Code and Regulations. Lastly, a comparison of two estate tax cases where valuation was disputed are compared and examined.
The Federal Estate Tax SystemThe federal estate tax is a wealth transfer tax. The tax is measured by the amount/value of the property transferred. It is not a direct tax on the property itself, it is rather a tax on the act of transferring property. Many taxpayers escape the estate tax, it is imposed only on those estates whose tax base exceeds $650,000. This exemption is scaled to increase annually to a maximum exemption in 2006 of $1,000,000.
The estate tax base consists of the decedent’s gross estate and the taxable gifts made by the decedent after 1976. The gross estate consists of property in which the decedent had an interest in at the time of his death. This includes property owned by the decedent at the time of his death. The Internal Revenue Code takes a expansive view of what constitutes ownership. Included in the gross estate under “property owned” is life insurance policies, future interests, and causes of action for wrongful death as well as real estate and investment property. In essence any type of property is includable in the gross estate if the decedent held a beneficial ownership in the property.A second element of the gross estate includes Also included are so called “death bed transfers” gifts made by the decedent in contemplation of death. Designed to combat tax avoidance, Congress has included in the “gross estate” all transfers by the decedent which occur within three years of death.Because the estate tax is an excise tax on the privilege of transferring property, only the value of the property that is transferred is taxed. Moreover, the statutory framework does not contemplate consideration of the destination of the property.
Valuation Consideration in the Internal Revenue Code and RegulationsThe estate tax attaches at the moment of death. Therefore, the value of assets included in the “gross estate” is that of the date of the decedent’s death. The Internal Revenue Code also allows for an alternative valuation date. Under I.R.C. §2032 an executor can elect to value the all the assets in the estate six months after the date of death. The purpose of this alternative valuation date is to protect estates from sudden declines in market value of the decedent’s assets. Two special rules apply to the election of the alternative valuation date. First, the alternative valuation date may only be elected if the election actually produces a decrease in both the value of the gross estate and the amount of the estate tax payable. Secondly, changed in value during the six months which are attributable to the “mere lapse of time” will be disregarded. For example, property such as a patent which has a limited life and inevitably loses value with the passage of time. For such assets the alternative valuation election is not available; these assets are valued as of the date of death.
The valuation process is critical to the estate tax process; it is the value of the property determines the tax rate the estate will be subject to. While the estate tax statutes are not clear on what “value” means or how it is determined. The Regulations are somewhat more helpful. The Regulations equate “value” with “fair market value.” “Fair market value” is defined as: “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.” While “fair market value” is seen as the controlling guideline for valuation, the Regulations also contain special rules concerning the valuation of specific types of property--among them: stocks and bonds, household effects, life estates and future interests and life insurance contracts.
Despite the promulgation of regulations detailing how certain types of property should be valued, very often there is no obvious way to arrive at a “fair market value” for an asset. In this context this paper will examine the methodology used in valuing closely held business interests.Actively traded business interests represent little challenge in the valuation context. The “willing seller-willing buyer” framework actually works in reality to determine prices every day on financial markets. For example, an estate with 1000 shares of Microsoft stock will value that stock at the mean of the highest and lowest quoted selling prices on the valuation date. This is the easy case because identical property is easily identified and it is routinely traded.Closely held business interests are vastly more complicated to value. Because the stock is nontraded using the willing buyer-willing seller analysis is more hypothetical. I.R.C. §2031(b) http://www.fourmilab.ch/ustax/www/t26-B-11-A-III-2031.html mandates that the starting point for valuing nontraded stocks and securities is by reference to stocks of similar or comparable businesses that are actively traded. Because this too is a speculative measure, the Regulations expand the aspects of a closely held business that warrant the greatest attention in valuation.Where stock in a closely held business is being valued, considerations include: the company’s net worth, prospective earning power and dividend paying capacity and “other relevant factors”. “Other relevant factors” include:The good will of the business; the economic outlook in the particular industry; the company’s position in the particular industry and its management; the degree of control of the business represented by the block of stock to be valued; and the values of securities of corporations engaged in the same or similar lines of business which are listed on a stock exchange. . . . In addition to the relevant factors described above, consideration shall also be given to nonoperating assets, including proceeds of life insurance policies payable to or for the benefit of the company, to the extent such nonoperating assets have not been taken into account in the determination of net worth, prospective earning power and dividend-earning capacity.Given the broad array of considerations the Regulations propose when valuing closely held business interests the Internal Revenue Service issued Revenue Ruling 59-60 to act as a guide for the valuation of these assets. As a primary matter the Service recognizes that valuation of closely held business interests is an inexact science and a case-by-case approach is warranted. Therefore, there is no single formula for accurate valuation.
Premiums and DiscountsIn addition to the above factors considered in valuation, there are a number of premiums and discounts that are often applied to a stock value. A “control premium” may be added to the value of the stock. A block of stock which represents a controlling interest in a company has a greater value than the value derived above. Similarly, a block of stock which represents a noncontrolling minority interest may call for a discount in value. The rationale behind the discount is that a buyer in the real world would take into account this minority interest when determining a price to pay for the stock. Indeed, the Tax Court has recognized that while the sum of the parts cannot equal more than the whole- that is the majority block with the control premium and the minority block with the discount, should not equal more than 100 percent, the sum of the parts can equal less than 100 percent.
Even where a block of stock represents a minority interest a discount is not always warranted. Consideration must be given to “swing vote” attributes. The value of a minority interest may be increased where it can be coupled with another minority block to create control of the business. In this case a “swing vote” attribute can effectively offset an otherwise allowable minority discount.
The Internal Revenue Service and Courts recognize that often the willing buyer- willing seller approach can lead to unrealistically high values, as such a lack of marketability discount is often applied. Reasoning that investors seek out assets which are easy to sell and which have a ready or existing market. Accordingly, interests which would be difficult to sell are given a discount. The purpose behind this discount is to equalize an investment in closely held stock with stock that is publicly traded.
In certain situations, a “key person” discount will be allowed. The IRS defines a “key person” as an individual whose contribution to a business is so significant that there is certainty that future earning levels will be adversely affected by the loss of the individual. The loss of a “key person” can have a depressing effect on stock values. Such a discount will be applied only when: 1) whether the claimed individual was actually responsible for the company’s profit levels; and 2) if there is a key person, whether the individual can be adequately replaced.
Real World Examples of Buy-Sell Agreements and Valuation
A. Estate of Lauder
Expert Valuation Testimony
Court’s Treatment of the Valuation Evidence
Stock Transfer Restrictions
Adjusted Book Value
Expert Valuation Opinions
The price-to-earnings ration arrived at by Shearson was adjusted by 20 percent to account for the negative effects of the Crown Center litigation. The expert arrived at a value of $3.16 per share for all classes of Hallmark common stock. This value was discounted by 36 percent for lack of liquidity, to $2.02 per share. The share value was further reduced because of the restrictions on sale to $1.60 share.
The IRS employed one expert in business valuation, Philadelphia Capital Advisors(PCA). The expert used both a market comparison approach and the income capitalization approach.
The income capitalization approach measures fair market value by projecting future cash flow that the asset will generate. Here the PCA expert added noncash depreciation charges Hallmark’s net income. No adjustments were made for noncash charges for deferred taxes or estimated cash needed for future capital expenditures. Combining an equity discount rate and a debt discount rate, the expert arrived at a cost of capital discount which was applied to the projected cash-flow.
The same formulas were used in a separate analysis by PCA to calculate the minority share valuation of the Hallmark shares. This appraisal arrived at a value per share of $4.49. This per share value was discounted by 5 percent to reflect lack of voting rights (for the class A and class C stock) and an additional 5 percent discount was applied to reflect the costs of taking Hallmark public. Arriving at values of$4.27 for minority class C, and 44.49 for class B stock, the PCA expert gave no consideration to the transfer restrictions.
Court’s Discussion of the Valuation Testimony
 See infra notes 4-13.
 See infra notes 13-42.
 See infra notes 42-93.
 Regis W. Campfield et al., Taxation of Estates, Gifts and Trusts ¶1049 (20th ed. 1997). See also , I.R.C. §2001 (1998). http://www.fourmilab.ch/ustax/www/t26-B-11-A-I-2001.html
 I.R.C. s. 6018(a)(1) http://uscode.house.gov/uscode-cgi/fastweb.exe?getdoc+uscview+t26t28+1800+0++%28%29%20%20AND%20%28%2826%29%20ADJ%20USC%29%3ACITE% I.R.C. § 2010 (c) http://uscode.house.gov/uscode-cgi/fastweb.exe?getdoc+uscview+t26t28+1052+0++%28%29%20%20AND%20%28%2826%29%20ADJ%20USC%29%3ACITE% I.R.C. § 6018(a)(4) http://uscode.house.gov/uscode-cgi/fastweb.exe?getdoc+uscview+t26t28+1800+0++%28%29%20%20AND%20%28%2826%29%20ADJ%20USC%29%3ACITE% I.R.C. §2033, http://www.fourmilab.ch/ustax/www/t26-B-11-A-III-2033.html §2034 http://www.fourmilab.ch/ustax/www/t26-B-11-A-III-2034.html Id.
 Treas. Reg. §20.2033-1 (1963). http://frwebgate.access.gpo.gov/cgi-bin/get-cfr.cgi?TITLE=26&PART=20&SECTION=2033-1&TYPE=TEXT
 I.R.C. §2035 (1983). http://www.fourmilab.ch/ustax/www/t26-B-11-A-III-2035.html
 Estate of Harrison, T.C. Memo 1987-88.
 Estate of Chenoweth, 88 T.C. 1577 (1987).
 Goodman v. Granger, 243 F. 2d 264 (3d Cir. 1957).
 I.R.C. §2032 http://www.fourmilab.ch/ustax/www/t26-B-11-A-III-2032.html
 Campfield, supra note 4 at ¶9013.
 I.R.C. §2032 (c) http://www.fourmilab.ch/ustax/www/t26-B-11-A-III-2032.html
 I.R.C. §2032 (a)(3) http://www.fourmilab.ch/ustax/www/t26-B-11-A-III-2032.html
 Treas. Reg. §20.2032-1(a)(3) (1994).http://frwebgate.access.gpo.gov/cgi-bin/get-cfr.cgi?TITLE=26&PART=20&SECTION=2032-1&TYPE=TEXT
 Treas. Reg. §20.2031-1(a) (1965) http://frwebgate.access.gpo.gov/cgi-bin/get-cfr.cgi?TITLE=26&PART=20&SECTION=2031-1&TYPE=TEXT
 Treas. Reg. §20.2031-2 (1992). http://frwebgate.access.gpo.gov/cgi-bin/get-cfr.cgi?TITLE=26&PART=20&SECTION=2031-2&TYPE=TEXT
 Treas. Reg. §20.2031-6 (1994). http://frwebgate.access.gpo.gov/cgi-bin/get-cfr.cgi?TITLE=26&PART=20&SECTION=2031-6&TYPE=TEXT
 Treas. Reg. §20.2031-7(1994). http://frwebgate.access.gpo.gov/cgi-bin/get-cfr.cgi?TITLE=26&PART=20&SECTION=2031-7&TYPE=TEXT
 Treas. Reg. §20.2031-8 (1974). http://frwebgate.access.gpo.gov/cgi-bin/get-cfr.cgi?TITLE=26&PART=20&SECTION=2031-8&TYPE=TEXT
 Treas. Reg. §20-2031-2(b) (1992). ). http://frwebgate.access.gpo.gov/cgi-bin/get-cfr.cgi?TITLE=26&PART=20&SECTION=2031-2&TYPE=TEXT
 Treas. Reg. §20-2031-2(f) (2) (1992). http://frwebgate.access.gpo.gov/cgi-bin/get-cfr.cgi?TITLE=26&PART=20&SECTION=2031-2&TYPE=TEXT
 Rev. Rul. 59-60, 1959-1C.B.237.
 Id. at §3 ¶1.
 Estate of Chenoweth, 88 T.C. 1577 (1987).
 Id. See also, Ward v. Commissioner, 87 T.C. 78, 106 (1986).
 campfield, supra note 4 at ¶11,065.
 Estate of Chenoweth, 88 T.C. 1577 (1987).
 Tech. Adv. Mem. 9436005 (May 26, 1994). Citing Estate of Bright v. United States, 658 F.2d 999 (5th Cir. 1981).
 Campfield supra note 4 at ¶11,071.
 Central Trust Co. v. United States, 305 F. 2d 292 (Ct. Cl. 1962).
 Estate of Adams, 79 T.C.M. 938, 958 (1979).
 Department of the Treasury, Irs valuation Training for appeals officers coursebook, §9-11 (1998).
, Id. at §9-12.
 Campfield, supra note 4, ¶11,091.
 I.R.C. §2703(b) http://www.fourmilab.ch/ustax/www/t26-B-14-2703.html
 64 T.C.M 1643 (1992).
 I d.
 Id. Citing Estate of Bischoff, 69 T.C. 32 (1977).
 Estate of Hall, 92 T.C. 312, 313 (1989).
 Id. at 314.
 Id at 315.
 Id. at 315-6.
 Id. at 315.
 Id. at 316.
 Id. at 317.
 Id. at 319.
 Id at 320.
 Id at 321.
 Id at 324.
 Id at 325.
 Id at 326.
 Id. at 328.
 Id. at 315.
 Id. at 330.
 Id. at 331.
 Id. at 332.
 Id., at 333.
 Id. at 334-5.
 Id. at 335.
 Id. at 338.
 Id. at 339.
 Id . at 340.
 Id. at 341.
 Id. at 342.