Proving Goodwill in Like-Kind Exchange

Deseret Management Corp. v. United States, 2013 U.S. Claims LEXIS 987 (July 31, 2013)

IRS discovers DCF is a ‘double-edged’ sword. “Use at your own risk” is the lesson a financial expert for the IRS learned when she used the discounted cash flow (DCF) method to bolster the agency’s argument that the taxpayer was liable for appreciable goodwill related to a like-kind exchange.
Station swap: The plaintiff owned KZLA, the only country-music FM station in the Los Angeles market, but, when the station kept underperforming in a fast-growing market, it agreed to a station swap with another communications company. The exchange value of the assets was $185 million. The value of KZLA’s tangible assets was approximately $3.4 million, and the value of all its intangible assets, excluding the station’s FCC license and goodwill, was about $4.8 million. An appraiser calculated the value of the FCC license using the “residual fair market value” method—subtracting the value of the tangible and intangible assets from the $185 million exchange value and assigning the difference (the residual) to the FCC license. The appraiser assigned no value to goodwill claiming that: (1) legal precedent held that “broadcast stations do not possess any goodwill”; and (2) KZLA, in particular, “does not possess any other traditional manifestations of goodwill.” The license was worth nearly $176.8 million, the appraiser said.
Under I.R.C. Section 1031, a taxpayer may defer recognition of gain or loss from qualifying exchanges of like-kind property. But, under Treas. Reg. Sec. 1.1031(a)-2(c)(2), a business’s goodwill is not of a like kind to the goodwill of another business. Therefore, the nonrecognition provision does not apply. The IRS issued a deficiency notice claiming there was a goodwill value of $73.3 million on the transaction date. Ultimately, the plaintiff sued in the Court of Claims for a refund.
The court found indications of goodwill but required the IRS to show whether the goodwill was appreciable or negligible. The agency’s expert tried to isolate the income attributable to the FCC license by performing a discounted cash flow (DCF) analysis of the station, treating it as a startup. She created projections for the revenue, operating cash flow, and net free cash flow that KZLA could reasonably be expected to achieve in the market, based on past performance, market operating and financial benchmarks, as well as the performance of other radio stations in the Los Angeles market. Discounting the net free cash flow to present value, she then extracted the value for KZLA’s license. She initially found it was worth $131.4 million, which left a residual value of goodwill of $45.4 million. After correcting for errors in her cash flow projections and working capital calculation, she lowered the amount to $36.5 million.
No goodwill: The plaintiff’s rebuttal experts highlighted three errors that if corrected would increase the license value to $179.6 million, leaving no portion of the purchase price to assign to goodwill. The court agreed and in a detailed chart showed that the effect of the proposed adjustments was that there simply was nothing left for goodwill. “[T]the use of discount calculations to value goodwill represents a double-edged sword in that the numbers can demonstrate the presence or the absence of goodwill,” the court concluded.