Holding companies with built-in capital gains - John M. Leask II CPA/ABV, CVA

Viewpoint on Value
July/August 2014
Holding companies
with built-in capital gains
Tax Court case
addresses key
valuation issues
Choosing between
lost profits and lost value
Are shareholder advances
bona fide debt or equity?
The cost approach:
An integral piece of the
valuation puzzle
E-mail: Mac@LeaskBV.Com
Holding companies with built-in capital gains
Tax Court case addresses
key valuation issues
he Estate of Richmond has been called a must-read
case for valuation guidance in 2014. The IRS
and taxpayer started out more than $6.1 million
apart. But the Tax Court slowly worked through the
major sticking points — including how to select the
appropriate valuation methodology and how to handle
the company’s built-in capital gains tax liability — to
arrive at a value substantially higher than was origi-
nally indicated on the estate tax return.
Appraisers narrow the value gap
When she died in December 2005, the decedent
owned a 23.44% interest in PHC, a family-owned
holding company with a net asset value of approxi-
mately $52.1 million. The value of the interest per
her estate tax return was approximately $3.1 million,
based on an unsigned draft appraisal report issued
by PHC’s accountant. The IRS issued a deficiency
notice that valued the estate’s PHC stock at $9.2 mil-
lion and assessed a valuation misstatement penalty.
By the time the parties appeared in Tax Court, both
sides had hired business valuation experts. And the
difference between their positions had narrowed to
only about $2.3 million.
largely publicly traded stocks, including Exxon
Mobil, Merck & Co., General Electric Co. and
Asset-based approach
Pfizer. The market values of these stocks could be
readily ascertained on any date. According to the
appropriate for holding companies
court opinion, publicly traded stock prices take into
The estate’s expert valued the decedent’s interest
account the market’s judgment regarding each stock’s
in PHC at about $5 million, using the capitalization
projected income stream.
of dividends method. The IRS’s expert valued it at
$7.3 million, using the net asset method.
The Tax Court opinion states: “In general, an asset-
based method of valuation applies in the case of cor-
The estate’s expert used a subset of the income
porations that are essentially holding corporations,
approach to value PHC, because the company had
while an earnings-based method applies for corpora-
consistently paid dividends over its 35-year his-
tions that are going concerns.”
tory. In addition, nine PHC stock transactions had
occurred from 1971 to 1993 that had been based on
Built-in capital gains tax liabilities
the capitalization of dividends method.
addressed at the entity level
The IRS’s expert used the asset-based (or cost)
When a C corporation’s assets increase in value over
approach, because PHC’s underlying assets were
time, the company becomes liable for capital gains tax,
but only upon the sale of the assets. PHC is a C cor-
Substantial valuation
poration that would owe approximately $18.1 million
misstatements are costly
in built-in capital gains tax if it were sold. Both sides
A “substantial misstatement” occurs when the value
agreed that a hypothetical investor would factor in this
reported on the estate tax return is 65% or less of the
liability when purchasing an interest in PHC.
“correct” value, under Internal Revenue Code Section
6662. The penalty for a substantial misstatement is
20% of the amount by which your taxes are underpaid.
When a C corporation’s
A “gross misstatement” occurs when a value reported
assets increase in value over
on a tax return is 40% or less of the correct value.
Gross misstatements result in a 40% penalty.
time, the company becomes
liable for capital gains tax.
The minority, nonmarketable value of the estate’s
interest in PHC was $3.1 million — less than half of
the Tax Court finding of $6.5 million. So, the estate
qualifies for a 20% substantial valuation misstate-
The Tax Court rejected the estate’s dollar-for-dollar
ment penalty. The Tax Court upheld the penalty
adjustment for built-in capital gains tax, because a
because the value reported on the estate tax return
sale of PHC’s assets wasn’t imminent. It also rejected
was “essentially unexplained.” The fact that the estate
the IRS expert’s approach, which added a 15% incre-
expert’s value was included in an unsigned draft
mental discount for built-in capital gains tax into his
report was contrary to establishing a credible value.
discount for lack of marketability.
Learn a lesson from Richmond
Instead, the court decided to apply an entity-level
adjustment, rather than to increase the discount for
The estate wound up owing significantly more tax
lack of marketability. Assuming a holding period of
than it had originally planned. But Richmond wasn’t
20 to 30 years, the Tax Court determined that the
a complete IRS victory. The Tax Court ruling rep-
present value of the built-in capital gains tax liability
resents a compromise between two widely divergent
was approximately $7.8 million.
appraisal opinions. l
Exception to misstatement penalties
The IRS allows an exception to its valuation misstatement penalties if a taxpayer can demonstrate that
it acted with reasonable cause and in good faith. One way to prove you qualify for this exception is to
hire a “qualified appraiser” to perform a “qualified appraisal.”
A qualified appraiser has earned an appraisal designation from a recognized professional
organization. It’s also important for the expert to have appropriate education and experience in
valuing the specific type of property.
A qualified appraisal report must:
Be prepared, signed and dated by an independent qualified appraiser,
Provide certain relevant information, such as a description of the property and its physical
condition, the terms of any agreements that affect the property’s value, the appraiser’s identity and
qualifications, the valuation date, and the methods and basis of valuation, and
Not involve a “prohibited appraisal fee.”
An example of a prohibited appraisal fee is one that’s based on a percentage of the property’s
appraised value — or contingent on the outcome of an IRS investigation.
Choosing between
lost profits and lost value
ow do valuators quantify losses when breach
Most courts agree that, when a defendant’s conduct
of contract, patent infringement or other
destroys a business, the proper measure of damages
illegal acts damage a business? Three options
is the business’s fair market value on the date of loss.
exist: Calculate lost profits over a finite period, com-
But in “slow death” cases, in which a defendant’s
pute the decrease in business value or use a combina-
conduct injures, and eventually kills, the plaintiff’s
tion of both. What’s appropriate depends on various
business, both damages measures may come into play.
factors, including relevant laws and the nature of the
alleged wrongdoing.
Calculating lost profits
Different situations
require different solutions
and lost business value
The decision to quantify lost profits or lost business
often involves different sets
value (or both) depends on applicable federal or state
law. For example, courts customarily limit damages
of assumptions, leading to
in breach-of-contract cases to a plaintiff’s lost profits
different results.
during the contract term — even if the breach causes
the plaintiff to go out of business.
The rationale is that, if the defendant hadn’t breached
Double dipping is
the contract, it could have terminated the relationship
a potential hazard
at the end of the term, and the plaintiff would have
Double dipping may occur when lost profits and
lost the defendant’s business anyway. A plaintiff might
lost business value damages relate to the same time
counter, however, that if the defendant hadn’t ended
period. The value of a business for a going concern
the contract prematurely it would have had time to
is generally based on the future profits a hypothetical
develop new business to replace the loss.
buyer can expect to earn. This is true regardless of
the valuation method.
When the income approach is used, the relation-
ship between profits and value is obvious. Under
this approach, a valuator uses discounted cash flow
or some other method to convert anticipated future
earnings into a present value. Damages measure-
ments for both lost profits and lost value focus on
cash flow estimation and timing. They also take into
account the risk associated with the probability of
achieving a projected cash flow stream.
A company’s anticipated future earnings are also
considered when it’s appraised using the market or
cost approaches. For example, the market approach
may derive value from a price-to-earnings or price-
to-cash-flow multiple. Conversely, when the cost
approach is used to value a holding company, asset
or other factors that cause it to earn more (or less)
values may inherently take into account each asset’s
than a hypothetical investor. In addition, the valuator
projected income, thus reflecting the company’s
may reduce the business value for lack of market-
anticipated future earnings.
ability or liquidity — reductions that aren’t generally
applied in lost profits cases.
Methods may generate
The role of hindsight is another potential differ-
conflicting results
ence between lost profits and lost value. Business
Even when damages based on lost profits and lost
value generally is based on facts known or reasonably
business value overlap, the results of these two
knowable on the valuation date, regardless of what
approaches won’t necessarily be identical. In theory,
has transpired between that time and the trial date.
when a defendant’s conduct diminishes the value of a
But valuators sometimes consider subsequent events
plaintiff’s business, the difference between the “before”
in determining the amount of lost profits.
and “after” values may equal the present value of the
plaintiff’s lost profits on the valuation date.
Valuators bring clarity and support
There’s more than one way to quantify economic
But this seldom happens in practice. Calculating lost
damages in tort claims. Valuators bring clarity
profits and lost business value often involves different
by helping attorneys decide on the appropriate mea-
sets of assumptions, leading to different results.
sure of damages, calculating losses and reconciling
differences between lost profits and lost business
For example, a lost profits calculation may involve
consideration of the plaintiff’s specific tax situation
value claims. l
Are shareholder advances
bona fide debt or equity?
losely held business owners sometimes need
To illustrate, suppose a company has a shareholder
to advance their companies money to bridge
“loan” on the books for $200,000 and no other
a temporary downturn or provide extra cash
long-term debt. Also assume the fair market value of
flow for other purposes. How should valuators cat-
invested capital — long-term debt plus equity — is
egorize those advances — as bona fide debt, addi-
$1 million.
tional paid-in capital or somewhere in between? The
answer depends on the facts and circumstances of
If the advance is treated as equity, the value of the
each assignment.
business is simply $1 million, before discounts for
lack of control and marketability. If the advance is
treated as bona fide debt, the undiscounted value of
How advances affect value
the business is $800,000 ($1 million – $200,000).
How an appraiser classifies advances from sharehold-
ers has a direct impact on the value of equity. If an
advance is classified as bona fide debt that must be
When shareholder advances matter
repaid before debt owed to the bank or other credi-
The proper classification of shareholder advances
tors, the value of equity is lower than if it’s classified
comes into play in divorce, bankruptcy, minority
as additional paid-in capital and treated as equity.
shareholder disputes and tax situations. Continuing
Loan terms. An advance is more likely
to be treated as bona fide debt if the
parties have signed a written promissory
note that bears reasonable interest, has
a fixed maturity date and a history of
periodic loan repayments, and includes
some form of collateral. If an advance
is subordinate to bank debt and other
creditors, it’s more likely to qualify as
equity, however.
Third party reporting. Consistently
treating an advance as debt (or equity)
on tax returns and CPA-prepared finan-
cial statements can provide additional
insight into its proper classification.
Ability to repay. Other factors to
consider when evaluating the nature
with the previous example, let’s suppose the company
of shareholder advances include the company’s his-
is owned by one shareholder who is currently dissolv-
toric and future debt service capacity, as well as its
ing her marriage.
credit standing and ability to secure other forms
of financing.
If the $200,000 advance is treated as bona fide debt,
her marital estate includes privately held stock and
a receivable from the company. If not, the marital
estate includes her stock, but no receivable. Initially,
the classification of advances seems to have no net
The proper classification
effect on the value of the marital estate. But this isn’t
of shareholder advances
necessarily true.
comes into play in divorce,
It’s only a “wash” if all of the business interest is
bankruptcy, minority
includable in the marital estate and no discounts are
applied to the value of the business interest. The
shareholder disputes and
waters become even muddier when the subject com-
pany is owned by more than one shareholder or when
tax situations.
advances are made by other related parties, such as a
parent company or subsidiary.
How to classify advances
When in doubt, some clients hedge their bets by
requesting two valuation scenarios: one that treats
When deciding how to classify shareholder advances,
shareholder advances as bona fide debt; the other as
valuators look to the economic substance of the
additional paid-in capital.
transaction over its form. Some factors to consider
when classifying these transactions include:
Who can help
Intent to repay. Open-ended understandings between
Shareholder advances create appraisal challenges
related parties about repayment imply that an advance
that can’t be fixed with a one-size-fits-all solution.
is a form of equity. For example, an advance may be
Valuation professionals evaluate many factors
classified as a capital contribution if it was extended
when deciding on the nature of these transactions.
to save the business from imminent failure and no
The “right” answer must be decided on a case-by-
attempts at repayment have ever been made.
case basis. l
The cost approach: An integral
piece of the valuation puzzle
umerous articles have been written about
the nuances of the income and market
approaches. But the cost approach can also
be a viable valuation technique. The concept under-
lying the cost (or asset-based) approach is that the
value of a business equals the difference between
the values of its assets and liabilities. Here’s a closer
look at how it works.
Create a value-based balance sheet
Under the cost approach, appraisers identify all of the
subject company’s assets and liabilities. Next, they
Let common sense guide you
assign a value to each item, based on the appropri-
Courts often prefer the perceived simplicity of the
ate standard of value. The book value of equity may
cost approach, especially for asset holding companies
not be a reasonable proxy of its fair market value for
and small manufacturers that rely heavily on their
many reasons, however.
“hard” assets. It may also be used when the parties
present conflicting appraisal evidence.
For example, assets are recorded at historic cost
under Generally Accepted Accounting Principles
For example, in Starling v. Starling, the Virginia
(GAAP). Over time, historic cost may understate
Court of Appeals opted for the cost approach when
market value for appreciable assets, such as market-
valuing a family-owned electrical contracting busi-
able securities and real estate.
ness. The court rejected the wife’s appraisal, which
derived value from future earnings and failed to
In addition, some intangible assets — such as cus-
adequately factor in business risks. Similarly, it dis-
tomer lists, brands and goodwill — are excluded from
regarded the husband’s appraisal, because it was far
balance sheets prepared in accordance with GAAP,
below the interest’s liquidation value
unless they were acquired from other companies.
Balance sheets also might not include contingent
As Starling illustrates, the cost approach provides a
liabilities, such as pending litigation or an IRS audit.
useful “floor” for a company’s value that serves as
a sanity check for the other valuation approaches.
Companies that use cash- or tax-basis accounting
After all, reasonable sellers typically won’t accept less
methods present additional valuation challenges.
than net asset value in mergers or acquisitions, unless
Their balance sheets may exclude accruals (such as
they’re under duress to sell.
accounts receivable and payable) and rely on acceler-
ated depreciation methods that understate the value
of fixed assets.
Remember the cost approach
Don’t automatically overlook the cost approach in
This process results in the creation of a market-based
favor of more sophisticated market- and income-
balance sheet. Revaluing certain assets — such as
based techniques. It can provide straightforward —
machinery, equipment and real estate — may require
but valuable — insight into the value of a private
separate appraisals.
business. l
This publication is distributed with the understanding that the author, publisher and distributor are not rendering legal, accounting or other
professional advice or opinions on specific facts or matters, and, accordingly, assume no liability whatsoever in connection with its use. In
addition, any discounts are used for illustrative purposes and do not purport to be specific recommendations. ©2014 VVja14
John M. Leask II CPA, LLC.
Business Valuation Services
765 Post Road, Fairfield, Connecticut 06824
John M. Leask II (Mac), CPA/ABV, CVA, values 25 to 50 businesses annually. Often, Mac’s valuations,
oral or written, are compiled in conjunction with the purchase or sale of a business, to assist shareholders
prepare buy/sell agreements, or to set values when shareholders purchase the interest of a retiring share-
holder. Here are examples:
Due Diligence & Assist with Purchase of a Business. Mac has assisted purchasers of businesses
by determining or reviewing the offer. He helps negotiate the price, perform due diligence prior to
closing and/or helps structure and secure financing. Services have included, but are not limited to,
verifying liabilities and assets, reviewing sales and expense records, and identifying critical issues
relating to future success, and helping management plan future operations.
Family Limited Liability Partnerships, Companies & Closely Held Businesses. Mac regularly values
various sized business interests for estate and gift tax purposes. He provides assistance to estate and trust
experts during audits of reports prepared by other valuators.
Mac also helps business owners and their CPAs and/or lawyers in the following ways:
• Planning — prior to buying or selling the business
• Prepare valuation reports in conjunction with filing estate and gift tax returns
• Plan buy/sell agreements and suggest financing arrangements
• Expert witness in divorce & shareholder disputes
John M. Leask II CPA, LLC.
• Support charitable contributions
Business Valuation Services
• Document value prior to sale of charitable entities
• Assist during IRS audits involving other valuators’ reports
• Succession planning
• Prepare valuation reports in conjunction with pre-nuptial agreements
• Understanding firm operations & improving firm profitability
More information about the firm’s valuation services (including case studies) may be found at www.LeaskBV.com.
To schedule an individual consultation or to discuss any other points of interest, Mac may be reached at 203 – 255 – 3805.
The fax is 203 – 380 – 1289, and e-mail is Mac@LeaskBV.Com.
If you have a business valuation problem, Mac is always available to discuss your options — at no charge.
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