Just as film critics predict that a movie they see today will be a contender in next year’s Oscar race, we venture to say that the Tax Court’s recent Estate of Richmond opinion will be one of the most important valuation decisions of 2014. It deals with a number of hot topics: dividend capitalization versus net asset value (NAV) approach, discounting for BICG tax, and how to avoid an undervaluation penalty.
The scenario: At the time of her death in December 2005, the decedent owned a 23.44% interest in a family-owned investment holding company (C corp) most of whose assets were publicly traded securities. The total assets then were worth nearly $52.16 million, of which $45 million—or 87.5% of the portfolio’s value—was unrealized appreciation. The built-in capital gain tax (BICG tax) on the unrealized appreciation was over $18.1 million.
The executors retained an accounting firm to value the company stock for purposes of reporting estate tax. The CPA who did the initial appraisal was a member of various professional groups and the author of numerous valuation reports—but he was not a certified appraiser. The estate used his unsigned draft report to declare on Form 706 that the decedent’s interest was valued at $3.15 million. In sharp contrast, an auditor for the IRS determined the interest was worth over $9.2 million. This assessment prompted a deficiency notice and the estate’s petitioning the Tax Court for review. At trial, both sides gave expert testimony as to the fair market value of the decedent’s interest.
The IRS expert used a discounted NAV approach. Broadly speaking, he began with the stipulated net asset value of $52.16 million to calculate that the decedent’s interest was worth $12.2 million. He then applied a 6% discount of lack of control (DLOC) and a 36% “marketability” discount that included a 15% discount for the BICG tax. He concluded the decedent’s interest was worth approximately $7.3 million—about 20% less than the value in the deficiency notice. The estate’s trial expert was different from the valuator doing the first appraisal. He was a certified business appraiser and valuation analyst, who used the capitalization-of-dividends method. Based on historical data, he assumed an annual 5% increase in dividend payments, which would continue indefinitely. He found the market rate of return for a company with a similar profile was about 10.25%, resulting in a capitalization rate of 5.25%. Dividing the decedent’s expected dividend return for the following year by the cap rate, he arrived at a present value of about $5 million for future dividends. Alternatively, the expert provided a valuation based on the NAV method; it essentially critiqued and modified elements of the IRS expert’s valuation. For example, he proposed a 100% BICG tax discount.
‘Standing on firm ground’: At the start of its analysis, the Tax Court noted that dividend capitalization was one legitimate way to value a business and “may be entirely appropriate where a company’s assets are difficult to value.” But this approach rests “entirely on estimates about the future.” And, the court continued, “even small variations in those estimates can have substantial effects on the value to be determined.” By relying on dividend capitalization, the estate’s expert “ignored the most concrete and reliable data of value … the actual market prices of the publicly traded securities” in the company’s portfolio, said the Tax Court. By contrast, the NAV method begins “by standing on firm ground—with stock values one can simply look up.” A potential investor would have known that the company held assets whose value was easily attainable and would take those values as a starting point.
Next, the court dove into the “difficulties and uncertainties” going along with the NAV—determining the applicable discounts, including one for the BICG liability. It agreed that a BICG discount was appropriate but rejected the estate’s proposed dollar-for-dollar reduction as “plainly wrong in a case like the present one.” Also, the estate cited circuit case law that was not controlling. The IRS expert’s calculation method was equally “problematic,” said the court, but his $7.8 million bottom line was “reasonable.” It adopted a 7.75% discount for lack of control and a 32.1% discount for lack of marketability. A secondary issue—but one that resonates with valuation professionals—was what type of appraisal may excuse an undervaluation and exempt the taxpayer from any accuracy-related penalty. The short answer: one prepared by a certified appraiser.