In an ingenious move, the U.S. Tax Court, ruling on an Oregon gift tax dispute, accepted the taxpayers’ tax-affected valuations of pass-through entities (“PTE”) without overturning Gross. The Tax Court’s decision is an all-out win for the taxpayers and comes on the heels of Kress, in which a federal district court adopted the taxpayers’ tax-affected valuations of an S corp.

The decedent, Aaron Jones, who died in 2014, founded two closely related companies. Seneca Sawmill Co. (“SSC”), a lumber manufacturer, was an S corporation; Seneca Jones Timber Co. (“SJTC”), which owned and managed tree farms and supplied the timber for SSC, was a limited partnership.

In 2009, as part of his estate planning, the decedent transferred blocks of shares and limited partnership units to his three daughters. In 2013, the Internal Revenue Service (“IRS”) issued a notice of deficiency of gift tax of nearly $45 million. The taxpayers asked the Tax Court for review. Both parties offered expert valuations for SJTC. For SSC, the IRS only offered a rebuttal expert report. The focal point of the court’s detailed opinion is the valuation of SJTC. The experts disagreed on methodology—whether the company was an operating company that should be valued under an income approach, as the taxpayers’ expert did (using a discounted cash flow analysis (“DCF”)), or a natural resources holding company, as the IRS expert argued, using a net asset value approach. (The IRS accepted the taxpayer expert’s approach .) The court found the asset approach was inappropriate because it was not likely that SJTC would sell its timberland.

Experts don’t disagree on tax affecting: In critiquing the taxpayer expert’s DCF valuation, the IRS argued the taxpayers’ expert should not have tax affected earnings in projecting net cash flow. The expert used a 38% rate (combined state and federal rate). He also calculated a premium to capture the benefit to the partners from dividend tax avoided, estimating the implied benefit in past years and considering an empirical study on S corp acquisitions.

The IRS, citing Gross and later cases, argued tax affecting was improper where SJTC had no tax liability on the entity level and there was no evidence the company would become a C corporation. Absent a showing that two unrelated parties dealing at arm’s length would tax affect, the outcome improperly favored a hypothetical buyer over the seller. In contrast, the estate, citing Bernier, argued that a zero tax rate on the entity level inflated the value of an interest in SJTC. A hypothetical buyer and seller would take into account that the individual partners had to pay income tax, at ordinary levels, regardless of whether SJTC made cash distributions.

The court said both parties in effect recognized that a hypothetical buyer and seller would consider SJTC’s business form but disagreed about how to do this. The IRS’ own experts did not defend a proposed zero tax rate, only the lawyers did, the court said.

Further, the court found that Gross and other Tax Court rulings that disallowed tax affecting could be distinguished from the instant case. The court noted that the Gross court was presented with a stark choice: 40% or 0% corporate tax. The Gross court did not believe the 40% rate reflected the benefit to the owners from avoiding dividend tax and, “on the record of the case,” decided that a 0% rate properly reflected the savings to the owners, the court in the instant case said.

It noted that the situation here was different. The taxpayers’ expert took into account both the tax burden and benefit to SJTC’s owner. The expert’s “tax-affecting may not be exact, but it is more complete and more convincing than respondent’s zero tax rate,” the court said.

Takeaway: Arguing for a zero tax rate, as the IRS has frequently done, seems a losing proposition. The U.S. Tax Court recognizes there are tax consequences to PTE owners that valuation experts must wrestle with, by quantifying the burden and benefit related to flow-through status.

Difficult times for the ESOP community. In a much-anticipated opinion in the Vinoskey ESOP case, the trial court recently ruled in favor of the Department of Labor on all remaining claims, finding the defendant trustee and company’s owner caused the ESOP to overpay for company stock by $6.5 million. This ruling comes close on the heels of the 4th Circuit’s Brundle decision, which upheld the trial court’s liability and damages findings against the trustee.

Suspect ‘discretionary choices’: The flashpoint was a 2010 transaction in which the owners of a successful Virginia company sold the remaining 52% of company stock to an ESOP for $406 per share. A 2009 appraisal valued the stock at $285 per share. The DOL argued the $406-per-share price exceeded fair market value (FMV). The trustee breached its fiduciary duties to the plan by failing to scrutinize the underlying appraisal, and the owner/seller was liable for accepting a price he knew exceeded FMV.

The trial court agreed. Its analysis was guided by the Brundle decisions, in which the 4th Circuit stressed that the ESOP trustee had to act “solely in the interests” of the plan participants. In the instant case, the trustee failed on multiple fronts, the court found. It pointed to testimony from the trustee’s key representative that the goal was a deal that was fair to both the seller and the ESOP. This and similar comments signaled “divided loyalties,” the court found. It also observed that the trustee never engaged in any negotiation at all over the price. Rather, the trustee’s first offer to buy was $406 per share, i.e., the final price. As the court saw it, the trustee “had significant leverage to make a lower initial offer, since [the owner/seller] was plainly eager to close the deal before the agreed-upon closing date.”

The court focused on a “guesstimate” that a company representative had emailed to the trustee and ESOP appraiser early in the process, which put the value of the planned transaction at about $21 million. The court noted that many of the ESOP appraiser’s “discretionary choices were geared toward” developing an appraisal that matched the estimate. For example, the appraiser, in his capitalization of cash flow analysis, used an “unusually low discount rate,” an inexplicably low cap rate, and a working capital assumption that did not align with the historical rate, the court found. It also questioned the appraiser’s decision to add back certain costs based, to some extent, on the appraiser’s assumption that, by owning 100% of company stock, the ESOP would in fact have control over the company. This assumption was mistaken, the court found. It noted that the company’s existing corporate structure and leadership rules, explained in ESOP plan documents and corporate bylaws (which the trustee reviewed), made it impossible for the ESOP to have complete control. The court noted that the final transaction documents did not provide for a change to the existing rules. The trustee did not press for the changes. The court found a discount for lack of control was justified.

The court acknowledged that representatives of the trustee did in fact review a draft appraisal and raise a number of concerns. However, the trustee did not “follow through” on whether the appraiser dealt with the issues in his final report, the court said. It called the diligence process “rushed and cursory.” The trustee had the burden of showing that the ESOP did not pay more than “adequate consideration” for the stock and it failed to do so, the court concluded.