Goodwill worth Zero or $93 Million?

Estate of Adell v. Commissioner, 2014 Tax Ct. Memo LEXIS 155 (Aug. 4, 2014)

In a lingering estate tax dispute, the estate and the Internal Revenue Service proposed numerous and wildly divergent valuations of the decedent’s 100% ownership interest in a C corporation. In its fair market value determination, the court had harsh words for the estate, noting the latter’s “conflicting expert reports and three different positions taken.” Ultimately, the court adopted the valuation the estate submitted with its original Form 706 filing but rejected the estate’s belated efforts to substitute it with a lower valuation. The opinion raises questions as to which party won or lost biggest in the fight.

Two-man operation. The decedent owned a for-profit cable company that provided uplinking services for one customer, a successful religious network known as “The Word.” The Word was organized as a nonprofit 501(c)(3) entity. The decedent was the company’s sole shareholder and in 2002 transferred his entire interest to a trust that he had set up on the same day. Before he died in 2006 he controlled the company and his son served as president. After the father’s death, the son became CEO of the company, in addition to president, and also became the personal representative of the estate and trustee of the family trust. When his sisters sued him in probate court he created a new company to provide The Word with the uplinking services it needed. The decedent’s company ceased operations in 2010.

The son never had an employment agreement or non-compete agreement with the decedent’s company. The Word was the son s brainchild He developed contacts with influential religious leaders, including the Rev Jesse Jackson, solicited content, and pursued broadcasting opportunities. Under a services agreement. The Word agreed to pay the company a monthly programming fee equal to “the lesser of actual cost or ninety-five percent of net programming revenue.” In reality, the company received at least 95 percent of The Word’s revenue each month and a few times as much as 100 percent. The company used the programming fee to pay its expenses, including a $20,000 rent payment to an S-corp the decedent owned. But by far the largest expense was compensation to the decedent and the son. In 2006, the year of death, the decedent received over $7.3 million and the son almost $1.3 million

The estate proffered three different values at three different times.

1. The estate. The estate’s original estate tax filing (Form 706) stated a $9.3 million date-of-death value. It was based on a valuation report from an experienced financial expert, who considered historical data appearing in the company’s financial statements, the services agreement between the company and The Word company’s bylaws, a schedule of compensation to the company’s officers, and management views regarding the business, industry, and prospects. His financial statement analysis showed a substantial sales increase during the historical period, from $7.9 million in 2002 to $15.9 million in 2006, and he found that there was an expectation that sales would increase from $18.5 million to $26 million during the projection period (2007 through 2011).

At the same time, the expert decided it was appropriate to adjust the company’s operating expenses. Most important he included an economic charge for the son’s personal goodwill to reflect the company’s dependence on the son’s personal relationships with the board of directors of The Word. Also, the expert explained, since the company did not have a non-compete with the son, a hypothetical buyer would only buy the company to the extent it was able to retain him. The expert determined that the economic charge for the son’s goodwill was anywhere from 37.2 percent to 43.4 percent of sales over the historical period and from 43.7 percent to 44.1 percent of sales over the projection period. In line with the company’s overall growth other operating expenses also would increase, he found. Taking into account the adjustments, the expert found that earnings before interest, taxes, depreciation and amortization generally increased over the historical period and projected they would reflect 12.1 percent of sales, or about $2.2 million in the first year of the projection period, to $3.1 million in the residual period. The analysis led him to conclude that the company expected to produce positive cash flow in the future and should be valued as a going concern. He used the discounted cash flow method {DCF) to arrive at the $9.3 million value.

Reset button. At trial, some five years later, the estate submitted a different valuation prepared by the same expert that proposed a lower value, $4 3 million. This figure resulted from a change in methodology, using an asset approach instead of an income approach. The first valuation was done in error, the expert explained. Some two years after preparing his original report he came to realize during a probate proceeding that he had failed to account for the limitation on the programming fee included in the services agreement. ‘”Although [the company] has generated profits in the historical period a hypothetical buyer of a company would not place any weight on the historical performance of the company given the terms of the agreement with … The Word.” His new understanding of the situation made it impossible for him to use the income approach, the expert said. Given the company’s inability to generate profit from its only customer and its lack of any other source of income with which to generate revenue, the expert opted to perform another valuation based on an adjusted book value approach.

In addition, the estate submitted a second expert’s opinion, prepared independently by an analyst working in the same firm as the first expert. This valuation also indicated a $4.3 million value based on the asset approach. In explaining his choice of methodology, the second expert echoed some of the reasons the first expert gave but added that the company’s executive compensation model also restricted the company’s earning potential. The services agreement. He said, provided that “any reduction in salaries would result in a dollar for dollar reduction in revenue for … the company.” In other words, a hypothetical buyer could not hope to increase profits by cutting executive compensation nor by giving himself or herself a high salary. Also, projected cash flow was uncertain considering the son did not have a non-compete agreement and could set up a new company to service The Word. The goodwill between the son and The Word was personal, the expert explained. For all of these reasons, the income approach was unsuited to determining the company’s fair market value.

In addition to the values in the expert opinions, the court says the estate claimed the stock value was zero in its original petition filed with the court. (The court’s opinion is inconsistent as to the exact point at which the estate first set down the zero value: besides mentioning the original petition, the court also says that the zero value first appeared in the estate’s second amended return.)

2 The IRS. The IRS, too, made significant adjustments to its values by the time the parties met at trial. After receipt of the estate’s Form 706 filing, the agency issued a deficiency notice that proposed a value of $92.2 million for the company. As the dispute between the estate and the IRS took its course, the IRS adjusted the value to nearly $86 million.

IRS deemphasizes goodwill. At trial, the IRS relied on an expert opinion that said the company was worth only about $26 million. This expert also used the DCF method and in fact substantially relied on the estate expert’s determinations in the estate’s first valuation. The difference in value between two valuations based on the same methodology came down to the treatment of the son’s personal goodwill. The estate’s expert applied an economic charge for the son’s personal goodwill – ranging from $8 million to $12 million over the projection period – that significantly increased the company’s projected operating expenses and decreased the projected net cash flow. In contrast, the IRS expert concluded a hypothetical buyer would be able to retain the son by paying an annual salary of approximately $1.3 million – 8.1 percent of sales in 2006. Consequently, the IRS expert s pro1ected net cash flow and the result ng overall value were much higher.

3. The court. First, the court dealt with the estate’s attempt to substitute the newer $4.3 million value. In the two subsequent expert reports for the $9.3 million value it reported in its original Form 706 filing.

Court bears down on goodwill. The court pointed out that the original value was an admission by the estate To replace it required the estate to show error, which it attempted to do by way of the expert’s clam that he mistakenly had failed to consider the limiting provision of the services agreement. The court was not persuaded. Even if the expert subsequently realized he had made a mistake, he incorrectly assumed the company was not profitable the court said. Reliable historical data and the expert’s discussions with management showed that on the date of death the company was profitable and it expected to generate a profit the future. And, even if The Word decided to enforce the programming fee limitation – which it had never done in the past – the company had equipment and expertise to augment the decreased sales revenue from The Word by providing uplinking services for other customers. If there was a risk, it lay in The Word’s ability to choose another uplinking provider. But, said the court, this risk did not make the company not profitable. A valuator could adjust for it, as the estate’s first expert had done by applying a 3 percent company risk premium in his original DCF valuation. Therefore, the court disregarded the proposed $4.3 million value.

But the court also found the IRS expert’s valuation flawed. While the court approved of the use of the discounted cash flow approach, it disagreed with the IRS expert’s handling of goodwill. The expert significantly undervalued the pivotal role the son played in operating both companies as well as the relationships he had forged with the ministers contributing to The Word. Many of the contributors did not even realize that there was a company that employed the son. They did business with him because they trusted him, not because of his affiliation with the company. He owned the asset of goodwill, the court said. There was no agreement that showed he had transferred his personal goodwill to the company. If he quit, he could compete directly with the company, the court pointed out. The estate expert’s use of an economic charge to account for the son’s personal goodwill was “high enough to account for the significant value of [the son’s] relationships.” the court concluded. For all these reasons, it adopted the estate’s original $9.3 million value.

Based on the court’ s finding, It ruled that there was no underpayment – much less a substantial underpayment triggering penalty under IRC Section 6662 – on the estate’s part.