Articles By Lorraine Barton

Changes on Estate & Gift Tax Valuations

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There are two recent Tax Court cases that may impact estate and gift business valuations, the Estate of John F. Koons, III v. Commissioner, T.C. Memo 2013-94, and the Estate of William M. Davidson (court date pending).

In Koons, one of the issues was the selection of an appropriate discount for lack of marketability regarding an interest in an LLC. The IRS’s expert used a DLOM of 7.5%, and the taxpayer’s expert used 31.7%. Why the big difference? A stock redemption agreement was signed prior to death but not completed as of the valuation date that would give the owner substantial control over the LLC. The IRS expert assumed that the redemption would occur, but the opposing expert assumed it would not. Given the facts and circumstances surrounding the redemption, the court agreed with the IRS expert’s lower DLOM.

The case is being appealed to the 11th Circuit. The point in this case is that, if a post-valuation-date event is likely to occur, should it be taken into account in the valuation.

The Davidson case involves the use of self-canceling installment notes, or SCINs. While the case doesn’t have a court date yet, the IRS has filed a petition claiming that the estate is undervalued and owes up to $2 billion in taxes (yes, billion).

William Davidson is the late owner of the professional sport teams, the Detroit Pistons and the Tampa Bay Lightning, and also Guardian Industries (one of the country’s largest private companies). In addition to the undervaluation allegation, the IRS is questioning the SCIN technique of selling assets to heirs based on a payment schedule that includes a provision that cancels the payments when the seller dies. The recipients had to make payments to Davidson for those assets while he lived, but the debt they owed was canceled — and the assets theirs outright — when Davidson died.

While SCINs are legal, the IRS is claiming that the payments should have been higher because Davidson made errors in figuring his life expectancy, which caused the heirs to pay much less than fair market value; therefore, some of the assets qualified as gifts should be taxed. Very little has been written about the valuation of SCINs. But if the Davidson estate prevails in Tax Court, Their use will likely increase.

War over Workable Stock Appraisal Method

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Sullivan v Troser Management, Inc., 2013 N.Y. App. Div. LEXIS 1641 (March 15, 2013)

In nearly 40 years of banking and litigation support work we have reviewed hundreds of buy/sell agreements, many referencing the establishment of annual valuations. But it is extremely rare that owners actually establish that annual value. This New York case illustrates a worst case scenario when owners ignore their agreement to establish annual value.
Ten years of litigation over a shareholder buy-sell agreement between parties that never agreed on the value for the shares of a closely held corporation have taken the litigants through four rounds of appeal but not close to an answer as to the appropriate valuation method.
The plaintiff served as the defendant’s director of sales for the operation of a ski resort. In 1986, the parties made an agreement that promised him an 18% equity interest in the defendant’s closely held corporation if he remained employed until year-end 1991. Under a contemporaneous buy-sell agreement, the defendant had the option to buy back the plaintiff’s stock if, among other things, the employment ended.
The purchase price was to be “an amount agreed upon annually by the Stockholders as set forth on the attached Schedule A.” If the parties failed to establish an annual value, “the value shall be the last agreed upon value except that if no such agreed upon value is established for period of two years, the value shall be the last agreed upon value in- creased or decreased by reference … the company’s book value.” The agreement listed the plaintiff as a “stockholder.”
No Schedule A exists. In 2003, the plaintiff sued in state court (Supreme Court, Monroe County, which is a trial court) for specific performance of the stock issuance. Moreover, he requested an order that, once the stock was issued, the defendant had an obligation to repurchase it and a determination of the parties’ rights and duties under the buy- sell agreement. The trial court directed the defendant to issue 18% of its shares of stock to the plain- tiff, which the defendant subsequently did. The court also ordered the parties to execute the buy- sell agreement and fixed a price for the purchase.
Specifically, it valued the buy-back interest at an amount that aligned with a prior buy-out involving a different shareholder. Both sides appealed.
Volley of appeals. In 2005, the defendant sought dismissal of the complaint, arguing it was time- barred. The appellate court declined. At the same time, it granted the plaintiff’s request to overturn the lower court’s setting a price for the purchase of his shares.
In 2006, the trial court directed the defendant to repurchase the stock for approximately $110,000, based on the defendant’s claim that the method to value the stock was by prorating the value of its parent corporation among that company’s three subsidiaries. The plaintiff appealed, contending that the agreement required that the two stockholders of the defendant determine the value of the stock, not the owners of the parent corporation. He also provided a letter he had received from the defendant’s attorney in 1999 that specified a different valuation method. The appellate court ruled for the plaintiff.
In 2009, the trial court denied the plaintiff’s request for a determination that his shares “be valued on the basis of his percentage interest in the Defendant’s assets” in the event that the defendant exercised its option to buy back the shares. He advocated for the use of a net asset approach that  the state’s highest court had approved in a case about the buyout of a law firm partner pursuant to an agreement that provided for a future agreement among partners that never came into existence.
The plaintiff appealed, contending the agreement’s purchase price provision was unenforceable. The defendant presented other stock valuations. The appellate court said the plaintiff showed “as a matter of law that the stockholders have never agreed upon a value of the stock.”
Accordingly, there was no way to ascertain his share price in accordance with the terms of the buy-sell agreement. Evidence of stock valuations from other transactions was of no consequence because the plaintiff was not a party to them.
No uniform rule for valuing stock. In 2011, the trial court denied the defendant’s motion to set the stock purchase price at approximately $184,000 based on its expert’s calculation. The expert had used the same formula the plaintiff proposed in 2009.
The appellate court affirmed the denial. Its 2010 ruling notwithstanding, it stated it did not then require  a  net  asset  valuation,  a  method  the  High Court approved but did not mandate. The court clarified that its earlier decision established that the plaintiff’s shares had to be valued “on the basis of his percentage interest.” However, issues of fact as to what the appropriate method for valuing the defendants’ assets remained.
The court rejected the defendant’s claim that the buy-sell agreement’s reference to book value dictated its use to determine the price for the plaintiff’s shares. The parties never agreed on the value of the shares, and there was no adjustment to be made. “Book value does not come into play.” In this vein, it also noted that, even though, under pro- visions of the business corporation law, the plain- tiff had no right to the “fair value” of the stock, “it does not follow … that the plaintiff is entitled only to book value.”
There was “no uniform rule for valuing stock in closely held corporations,” the appellate court stated. A court must tailor the valuation method to a particular case, based on the evidence at trial.
The appellate court, however, agreed with the defendant that the trial court had erred in finding the defendant had exercised its option to buy back the shares. The plaintiff earlier had raised the issue in an inappropriate manner. A resolution of this question could wait until the defendant actually refused to buy the shares at the price the lower court set after a trial on the value of the shares, the appellate court concluded.

How Much Is A Breaching Partner Worth?

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When you operate a business with another person, New York considers you to be in a general partnership unless you form an entity like a corporation or limited liability company. Without a written Partnership Agreement, you can leave the partnership at any time. However, if you and your partners enter into a Partnership Agreement, then as with any contract, you need to follow its terms in order to lawfully terminate the partnership.
In the event that a partner dissolves the partnership in contravention of the Partnership Agreement, New York Partnership Law Section 69(2)(a)(II) permits the non-breaching partners to have a claim for damages for breach of the Partnership Agreement. In addition, Section 69(2)(b) permits the non-breaching partners to continue the partnership business.  Under Section 69(2)(c)(II),  the  partner who wrongfully dissolved the partnership is entitled to be paid the value of his interest in the partnership, not including the partnership’s “good will” (i.e., some of the intangible assets of the business, such as its trade name, reputation and client base), less any damages caused by his breach, and thereafter to be released from the liabilities of the partnership.
In a case that William Quackenbush, ASA, MCBA, ABAR provided expert witness testimony, there was a 3-person partnership, the partnership agreement of which provided that the partnership would continue for 50 years. For various reasons, two partners voted to dissolve the partnership before that time, which was a breach of the Partner- ship Agreement. This led to a lawsuit commenced by the “non-breaching partner.” The non-breaching partner elected to continue the partnership business under Section 69(2)(b). Therefore, the breaching partners were entitled to be paid their interest in the partnership. But, Partnership Law Section 69 does not specifically provide for the method of valuation of a partner’s interest.
So, how do you value the breaching partner’s interest? In a case of first impression in the non- breaching partner’s attorney successfully argued that fair market value of the partnership’s assets is the correct valuation method to determine the value of the partner’s interest in the partnership business.
Here, the non-breaching partner argued that the breaching partners’ interests should be valued at book value based upon the accounting principles commonly used by the partnership. However, the non-breaching partner was the person primarily responsible for the financial books and records of the partnership for the tenure of the business, and employed book value accounting principles for its records. He also argued that the Partnership Agreement provided for an exiting partner to receive book value for his interest.
The non-breaching partner’s attorney argued that the Partnership Agreement did not govern this situation because it only provided for a partner to be paid book value for his interest in the event that the partner retired or died, or the business was liquidated and sold following the retirement or death of a partner and the remaining partners choose not to continue the business. None of these events occurred because the breaching partners voted to dissolve the partnership and the non-breaching partner elected to continue the business.
The non-breaching partner’s attorney collaborated with a CPA and William Quackenbush, ASA, MCBA, ABAR, the managing director of Advent Valuation Advisors. Both experts testified that book value accounting is not a valuation convention, but an accounting convention that significantly depreciates an entity’s assets and does not reflect the company’s true value. Mr. Quackenbush opined that the language of Section 69 supported a fair market valuation. Both Mr. Quackenbush and the CPA also testified that the poor bookkeeping practices of the partnership prevented a true market value analysis. Mr. Quackenbush testified that the partnership’s recorded value of the machinery and equipment and inventory needed to be adjusted to fair market value to reflect a realistic value of the company.
Ultimately, the Appellate Division, Second Department, adopted the arguments asserted by the non-breaching partner’s attorney, holding that, “The Supreme Court did not improvidently exercise its discretion in using fair market value to determine the value of each defendant’s interest in the subject partnership pursuant to Partnership Law Section 69 (2). It is undisputed that the defendants wrongfully dissolved the subject partnership. The parties’ partnership agreement did not limit the interest of a partner who wrongfully dissolved the partnership to book value, and book value is an accounting method that does not reflect fair market value of an asset.”