17 6 2017 Federal Tax Case Update
CUV 2017 State and Federal Case Law Update
Consultants’ Training Institute
Trending Matters in Business Valuation
2017 National Association of Certified Valuators ®). All rights © 2016 National Association of©Certified Valuators and Analysts™ (NACVA reserved.and
Analysts™ (NACVA®). All rights reserved. 1
Federal Case Law Update
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved. 2
Summary of Federal Cases CASES
CITATION/DATE
ISSUES
Estate of Dieringer v. Commissioner
146 T.C. No. 8, Mar. 30, 2016
Estate of Giustina v. Commissioner (Giustina III)
Family limited partnership valuation, income 586 Fed. Appx. 471, Jun. 13, approach, asset approach, 2016 weighting of approaches
H.W. Johnson v. Commissioner
MSKP Oak Grove, LLC v. Venuto
Charitable contribution claim, value differentiation
T.C. Memo. 2016-95, May 11, 2016
Reasonable compensation claim, return on equity analysis, reasonable comparative analysis
2016 U.S. Dist. LEXIS 84950, Jun. 29, 2016
Daubert action, expert report, adherence to valuation standards
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
3 3
Estate of Dieringer v. Commissioner
Action brought by IRS, after Service discovers “significant” gap in value of company claimed in Charitable Contribution vs. value of company in context of a Redemption Transaction. Redemption Transaction was only seven (7) months after Charitable Contribution. IRS claimed estate was negligent complying with U.S. Tax Law, and levied an accuracyrelated penalty.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
4 4
Estate of Dieringer (Continued)
Company Ownership: Shareholder
% Ownership
Type
Decedent
81%
Voting
Son 1
19%
Voting
Decedent
84%
Non-Voting
Son 1 & Son 2
16%
Non-Voting
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
5 5
Estate of Dieringer (Continued)
Company was a property management company. Organized as a C Corporation. Decedent’s estate planning set forth the following: • Will left entire estate to the trust. • Trust agreement specified that $600K of estate would go to various charities. • Remainder (amount in excess of $600K), consisting primarily of company stock and promissory notes, would be transferred to a family foundation. Son 1 was sole trustee of the trust and foundation.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
6 6
Estate of Dieringer (Continued)
In November 2009, seven months after decedent’s death, the estate retained a valuation firm to determine FMV of decedent’s stock for Estate Tax Reporting purposes. Voting shares were valued at $1,824 per share (no discounts since shares represented voting shares and a controlling interest). Non-Voting shares were valued at $1,733 per share, applying a 5% discount for lack of voting power.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
7 7
Estate of Dieringer (Continued)
Post-Decedent Death Developments: • Son 1 took lead role in company (was previously president). • Company elected “S” status to avoid built-in capital gains. • Son 1 was concerned that the foundation would have to make an annual distribution of 5% of the value of its assets, and would be subject to tax on the value of any excess holdings the entity had in the company after five years. • Company’s board voted to effect a redemption of shares to freeze the value of the shares into a promissory note.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
8 8
Estate of Dieringer (Continued)
Final company redemption agreement stated that the company would redeem all voting shares and just over 2/3 of the non-voting shares. Company retained the same appraiser to determine FMV of shares for redemption purposes. Appraiser was unaware that the company had converted to an S Corporation. Valued company as a C Corporation.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
9 9
Estate of Dieringer (Continued)
Appraiser testified that he received instructions, from Son 1, to value the bequeathed shares as a minority interest. • Redemption valuation included the following discounts: Discount for lack of control – 15% Discount for lack of marketability – 35%
Voting share value was $916 (from $1,824). Appraiser applied additional 5% discount for lack of voting power to non-voting shares. Non-voting share value was $870 (from $1,733).
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
10 10
Estate of Dieringer (Continued)
Company (Son 1) signed short-term promissory note for $3 million. Around time of redemption agreement decedent’s 3 sons bought shares (to inject cash to company to pay off promissory note). After share purchases, trust was left with no voting shares and 2,163 non-voting shares. Trust then transferred non-voting shares and promissory note to foundation.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
11 11
Estate of Dieringer (Continued) Pursuant to three subscription agreements, decedent's sons obtained 290 out of 425 voting shares and 3,868 of the 7,736.5 nonvoting shares – all including DLOC and DLOM. Son 1 ended up with a majority of both voting and non-voting shares.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
12 12
Estate of Dieringer (Continued)
IRS discovers disconnect in value between value claimed on the decedent’s Form 706 and the charitable contribution. IRS noted value of company was affected by postdeath changes to the company. IRS took position that the charitable deduction could only reflect the value of the promissory notes and a fraction of the non-voting shares that were transferred to the foundation. IRS issued a tax deficiency in the amount of $4.1 million, and an accuracy-related penalty of nearly $825K.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
13 13
Estate of Dieringer (Continued)
Estate challenged the IRS, arguing the following: • There was no justification for calculating charitable contribution based on value foundation received. • Argued that under regulations the date for determining the value of contribution was date of death. • Argued that at death the bequest was not subject to redemption agreement or other contingencies. • Argued that considering post-death events did not “truly reflect” FMV. • Argued that changes in company occurred for valid business reasons.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
14 14
Estate of Dieringer (Continued)
IRS argued that post-death events should be considered because decedent’s sons “thwarted decedent’s intent to bequeath all of her majority interest in the company or the equivalent value of the stock to the foundation.” IRS argued that the manner in which Son 1 orchestrated the appraisals (instructing that the second appraisal be valued at minority interest), was evidence that they never intended to carry out decedent’s will.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
15 15
Estate of Dieringer (Continued)
Tax Court sided with the IRS. Tax Court ruled that the post-valuation date events that occurred after decedent’s death and before the transfer to the foundation “changed the nature and reduced the value of decedent’s charitable contribution.” Tax Court noted that the change in corporate structure, redemption transaction, signing of subscription agreements (to reflect share purchases) all occurred on the same day, seven months after decedent’s death.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
16 16
Estate of Dieringer (Continued)
Court noted that the estate provided business reasons for each of the aforementioned; however, the court noted that there was insufficient evidence to support the substantial decline in the company’s per-share value. Son 1 pointed to “poor business climate” at date of Valuation 2. Tax Court dismissed this argument and pointed to the sole fact affecting the value of the stock was Son 1’s instruction to the appraiser to value the stock as a minority position.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
17 17
Estate of Dieringer (Continued)
Tax Court also found that the facts of the case supported an accuracy-related penalty, since the IRS showed that the estate failed to inform the appraiser that the redemption was for a majority interest and, instead, specifically instructed him to value the stock as a minority block. IRS noted that this represented negligence, the “failure to make a reasonable attempt to comply with the provisions of the IRS laws, to exercise due care, or to do what a reasonable and prudent person would do under the circumstances.”
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
18 18
Estate of Giustina v. Commissioner (Giustina III) Case was remanded to the U.S. Tax Court from the U.S. Court of Appeals for the 9th Circuit. 9th Circuit ruled the Tax Court (in original opinion) made unjustifiable assumptions. Court’s re-valuation served as a boon to the taxpayer.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
19 19
Guistina III (Continued)
First valuation facts: • Decedent owned a 41% LP interest in a timber • • • •
partnership. Partnership owned 48K acres of timberland. Partnership had operated for fifteen years at date of decedents' death. Partnership had 2-GPs and 8-LPs at date of death. All partners were family members or trust acting on behalf of a family member.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
20 20
Guistina III (Continued) IRS assed a deficiency of $12.66 million. Tax Court originally valued LP interest based on weighting of both Income Approach (DCF Method), and Asset Approach (Adjusted-Net Asset Value Method). Tax Court gave 75 percent weight to the Income Approach and 25 percent weight to the Asset Approach.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
21 21
Guistina III (Continued) Tax Court credited the estate expert’s DCF method, but applied adjustments. Most significant adjustment was the court’s cutting in half of the 3.5 percent company specific risk premium. Court contended that a hypothetical buyer could minimize this risk by diversifying the portfolio of assets.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
22 22
Guistina III (Continued)
Important to note the CSRP is synonymous with “unsystematic risk,” which, by definition is “non-diversifiable risk.” The estate appealed the Tax Court’s original ruling and the 9th Circuit agreed with the estate on the following: • That the Tax Court had not sufficiently explained
its decision to reduce the CSRP by 50%. • Appeals court noted that the 25% weight to the asset approach was unsupported by evidence, as the LP interest could not unilaterally effect liquidation of the long-term partnership. Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
23 23
Guistina III (Continued)
9th Circuit instructed Tax Court to re-determine FMV. Tax Court assigned 100 percent weight to the value derived under Income Approach. Tax Court explained that the one and only reason for reducing the CSRP was the possibility that a hypothetical buyer could diversify risk. The Tax Court concluded that this assumption was no longer tenable in light of the 9th Circuit’s ruling. The 9th Circuit noted that a hypothetical buyer had to be someone who could be an owner under the partnership agreement.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
24 24
Guistina III (Continued)
Tax Court noted that since all limited partners were either individuals or trusts for the benefit of individual family members, there was no basis for assuming a multiowner entity (hedge fund, VC fund, etc.) could be a buyer. Court also noted that the transfer of an LP interest required the approval of the company’s two GPs. Court noted they had run the partnership since inception (15+ years); as such, it was unlikely they would sell to a party, such as an investment company, whose sole objective was to increase its rate of return on the investment by dissolving the business.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
25 25
Guistina III (Continued) Based on the aforementioned, the Tax Court ruled there was no rationale for reducing the CSRP. Tax Court then adopted the estate expert’s original 3.5% CSRP. Adjustment caused a decrease in the decedent’s interest from $27.5 million to $`14.0 million.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
26 26
H.W. Johnson v. Commissioner
Case represents a dispute over executive compensation for purposes of a tax deduction. Dispute boiled down to whether the taxpayer, after paying the compensation, achieved enough of a return on equity to satisfy an independent investor (“Independent Investor Test”). If the return on equity did not provide adequate return, the executive compensation would be excessive.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
27 27
H.W. Johnson (Continued) The taxpayer met the burden by offering testimony from an expert whose ROE analysis the Tax Court found more persuasive than the IRS’ expert. This opinion serves as an important reminder to valuation analysts of the importance of ensuring that comparables are truly comparable, and moored in specific analysis, not a cursory review.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
28 28
H.W. Johnson (Continued)
Case background: • Subject company was a large concrete contracting business located in Arizona. • The business performed curb, gutter and sidewalk work. • Company had a stellar reputation in the local market. • Reputation allowed the business to secure contracts even when it was not the lowest bidder. • In 2003 & 2004 (years at issue), the company had over 200 employees, and contract revenues of $23.7 MM and $38.0 MM, respectively.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
29 29
H.W. Johnson (Continued)
Case background (continued): • • • •
Husband & wife founded the business in 1974. Sons (two) assumed complete control in 1993. Company had contract revenues, in 1993, of only $4.0 MM. When the sons took over the business their mother held a 51% controlling interest, and each son held a 24.5% minority position. • During the years at issue, the sons were co-vice presidents, and their mother was the president and chair of the board. • The board was made up of the two sons and their mother.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
30 30
H.W. Johnson (Continued)
Case background (continued): • In terms of operations, each son managed a geographical • • • •
•
area. Each son oversaw 100 employees. Each son reported working 10 to 12 hours a day, five of six days a week. Success of the business hinged on a steady supply of concrete. The AZ housing boom resulted in several concrete shortages. The sons proposed, in 2002, that the company invest in a concrete supply company. Their mother refused.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
31 31
H.W. Johnson (Continued)
Case background (continued): • Sons, along with other investors formed a separate concrete supply company. • The new business was able to provide a steady supply of concrete at a discounted price, when other contractors had to suspend operations because they could not procure concrete. • In 1991 the company adopted a formal bonus plan, which was amended in1999. • At year-end, based on advice from the company’s accountant, the board issued bonuses out of a “bonus pool” based on officer performance and the company’s ability to pay.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
32 32
H.W. Johnson (Continued)
Case background (continued): • Similarly, the company had a dividend plan that envisioned
paying out dividends when the company’s retained earnings were over $2.0 million. • In 2003 and 2004, the company paid the sons roughly $4 million and $7.3 million as compensation, claiming these amounts on their federal income tax returns. • The IRS issued a notice of deficiency, in which it disallowed over $2.6 million (2003) and $5.6 million (2004) of the claimed deductions. • The IRS subsequently conceded that deduction sin the amount of $3.2 million (2003) and $6.5 million (2004) were reasonable.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
33 33
H.W. Johnson (Continued)
Under Internal Revenue Code, Section 162(a)(1), a taxpayer may deduct “a reasonable allowance for salaries and other compensation for personal services actually rendered” as an ordinary and necessary business expense. The issue is whether the executive compensation is “reasonable.” The 9th Circuit Court of Appeals (which would handle any appeal) uses the five-factor test to determine reasonableness. • The five-factor test was originally discussed in Elliotts v. Commissioner, 716 F.2d 1241 (9th Cir. 1983).
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
34 34
H.W. Johnson (Continued)
The five factors include: 1. The employee’s role in the company. 2. A comparison of compensation paid by
similar companies for similar services. 3. The character and condition of the company. 4. Potential conflicts of interest. 5. The internal consistency of compensation arrangements. Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
35 35
H.W. Johnson (Continued) In the case at hand, the IRS conceded that four out of the five factors weighed in favor of the petitioner, or at lease were neutral. The only factor on which the IRS focused was the fourth – potential conflicts of interest, which required a determination of whether a hypothetical independent investor would receive an adequate return on equity after paying the sons’ compensation.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
36 36
H.W. Johnson (Continued)
Both experts agreed that the company had pre-tax returns on equity of 10.2% and 9.0% in 2003 and 2004, respectively. The experts disagreed over what the expected return on equity should have been. The IRS expert derived return on equity figures from four data sources, achieving a range from 13.8 percent to 18.3 percent. The Tax Court found the data sources( and the IRS expert’s resulting return on equity figures) unreliable when compared with the source used by the taxpayer’s expert.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
37 37
H.W. Johnson (Continued)
The IRS expert’s first figure was derived from seven guideline companies. The court rejected this analysis, ruling that the companies were not comparable. The court noted that the comparables were publicly traded and were active in an industry that was different from the subject company’s, and had sales that were considerably larger than the subject company’s.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
38 38
H.W. Johnson (Continued)
The IRS expert’s second figure relied on company data from RMA’s Annual Statement Studies. The court observed that the publication expressly states that the data should serve “only as general guidelines and not as absolute industry norms.” Data “may not be fully representative of a given industry,” the publisher adds. The IRS expert’s third figure relied on data published by the Construction Financial Management Association.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
39 39
H.W. Johnson (Continued)
The expert’s fourth figure was based on data from Ibbotson Associates. The court observed that the data concerned companies operating in the construction industry, in general, but not the concrete contracting sector in which the subject company operated. The Tax Court ruled that none of the data sources on which the IRS expert based his return on equity analysis provided meaningful information.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
40 40
H.W. Johnson (Continued)
The Tax Court accepted the analyses proffered by the taxpayer’s expert. The taxpayers expert relied on data from Integra Information. Specifically, the expert used Integra data from 33 companies that fell under SIC code 1771 (Construction Special Trade Contractors, Concrete Work), sales ranged from $25 MM to just under $50 MM. He determined average pre-tax return on equity ranging from 0.3% to 1.9%.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
41 41
H.W. Johnson (Continued)
The Tax Court noted “On balance, we are persuaded that companies which are closest to petitioner with respect to the nature of the business activity and the size of annual sales provide the best index of a reasonable return on equity,” the court said. The court noted that the IRS failed to cite support for its claim that, under the independent investor test, the rate of return on equity must significantly exceed the industry average when the subject company is particularly successful.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
42 42
H.W. Johnson (Continued)
The Tax Court noted that case law suggests that a 10% return on equity would satisfy an independent investor, which means that compensation that leaves that level rate of return is reasonable. The court also noted the ruling in Multi-Pak Corp. v. Commissioner, T.C. Memo 2010-139, which found that a return on equity of 2.9 percent was reasonable. The court observed that under case law compensation is deemed unreasonable when the resulting return on equity is zero or less than zero. Hence, the company’s rates of 10.2% and 9% for 2003 and 2004 met the independent investor test and “tend to show” that the compensation payments to the sons were reasonable. As such, the court ruled that factor four weighed in favor of the company.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
43 43
H.W. Johnson (Continued)
Based on the five-factor Ellliotts analysis, the Tax Court concluded officer compensation for both years was reasonable and, therefore, deductible.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
44 44
MSKP Oak Grove, LLC v. Venuto
This case was a Daubert action. Plaintiff retained an expert to show that defendants committed fraud, but the expert received incomplete documents. The plaintiff’s expert, a NACVA Member, illustrated that a thorough expert report, and adherence to professional standards can help a valuator in a litigation context. The court found that the expert sufficiently documented how the many assumptions, estimates, and adjustments that went into her re-creating of missing information aligned with valuation standards and the authoritative literature.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
45 45
MSKP Oak Grove (Continued) Four defendants owned a company, Hollywood Tanning Systems (“HTS”), which operated tanning salons and sold franchises and tanning equipment to other salons. HTS had a lease agreement with the plaintiff’s predecessor in interest that allowed HTS to sublease the space to a franchise. The franchisee sublettor defaulted on the lease.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
46 46
MSKP Oak Grove (Continued)
In Spring of 2007, HTS signed an asset purchase agreement with a buyer that agreed to purchase the assets of HTS and assume most of its liabilities for total consideration of $40 million. Defendants were to receive a 25% interest in the buyer and contingency payments based on the buyer’s future earnings. The day after the transaction closed the defendants each received $5.8 million. The buyer subsequently filed for bankruptcy in June 2007.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
47 47
MSKP Oak Grove (Continued)
Approximately one year after the asset sale, the plaintiff sued the defendants over the sublettor’s default on the lease and won a judgment for over $411,000, which remained unpaid. The plaintiff then sued the defendants claiming HTS fraudulently distributed over $23.8 million to its shareholders, leaving the company unable to pay its creditors, including the plaintiff. After five years of litigation, the issue boiled down to whether the $23.8 million payment to the shareholders was a proper shareholder distribution or an illegal diversion of the buyer’s assets.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
48 48
MSKP Oak Grove (Continued)
The plaintiff hired an expert. The expert prepared two reports. The first report was a “fraudulent conveyance report.” The second report was a “valuation report.” In the reports the expert opined that she had not been provided with many of the documents “normally maintained by companies of this size for tax and management purposes.”
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
49 49
MSKP Oak Grove (Continued)
The expert found that, at the valuation date, (the date of the distributions to the defendants), HTS’ general ledger showed only deposits of about $4.3 million as proceeds from the transaction and about $128,000 from the transfer of “other accounts” but did not show the $23.8 million disbursed to the defendant shareholders. The expert had to reverse engineer the company’s financial position at the date of valuation, due to the fact that she was provided with incomplete records.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
50 50
MSKP Oak Grove (Continued)
The expert’s reverse engineering process encompassed making “normalization adjustments” pursuant to the AICPA’s Statement on Standards for Valuation Services Section 100 (“VS-100”), treatises by intellectual leaders in valuation (Pratt & Hitchner), and generally accepted accounting principles. The expert explained that VS-100.41f advised using discounts to account for non-operating assets and excess operating assets in a business valuation.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
51 51
MSKP Oak Grove (Continued)
The expert deduced, after a review of certain losses the company booked on its tax filings that certain stores should not have been considered functioning stores. As such, she concluded the company overstated its accounts receivable by $3 MM. Similarly, based on a Pratt treatise, she adjusted projections as to the buyer’s ability to generate income in the future. She attached copies of the sources guiding her analysis, to her reports.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
52 52
MSKP Oak Grove (Continued)
In terms of the company’s FMV, she concluded that HTS did not receive reasonably equivalent value from the defendants for the distributions. The assets left to the company after the distributions and diversion of cash to the defendants were unreasonably small in relation to the distributions. The expert surmised that, at the date of the distributions, the company knew, or should have known, that it would incur debt beyond its ability to pay as the debt became due. The distributions left the company insolvent. There was evidence of post-transaction insolvency in the company’s 2007 year-end financial statements.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
53 53
MSKP Oak Grove (Continued)
The defendants moved to exclude the expert’s testimony under Daubert. The defendant’s claimed the reports were stand-alones, and since the expert did not attach a summary of methodology to the “fraudulent conveyance” report, it was per se inadmissible. They said the reconstruction of the company’s financial health was based on an unreliable methodology (hindsight) and the valuation report was not helpful to the trier of fact.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
54 54
MSKP Oak Grove (Continued)
The expert opined that the two reports formed part of one expert opinion and the discussion of principles and methodologies that appeared in the valuation report covered the fraudulent conveyance report as well. The court agreed with the plaintiff. In discussing Federal Rules of Evidence (“FRE”) 702 and Daubert, the court referred to “a trilogy of restrictions on expert testimony: qualification, reliability, and fit.”
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
55 55
MSKP Oak Grove (Continued)
The court noted that there was no dispute that the expert’s testimony met the first two requirements. The “fit requirement,” the court noted “goes primarily to relevance,” that is, the testimony must be relevant to the legal issues in the case and assist the trier of fact in resolving the legal questions. In this case, the expert reports were “certainly relevant” to the resolution of the plaintiff’s fraud and concealment claims, the court found.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
56 56
MSKP Oak Grove (Continued)
The final discussion centered on reliability of the methodology. The court rejected the defendants’ proposition that the reports were separate and that one was missing a section on methodology. At the Daubert hearing, the expert convincingly explained that she prepared a two-part report to facilitate and expedite discovery in the case. She also explained that she intended the methodologies and approaches sections appearing in the valuation report, as well as the attached copies of the AICPA Standards and treatise pages, to apply to both parts of the report.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
57 57
MSKP Oak Grove (Continued)
In terms of substance, the court found the methodology the expert used to re-create HTS’ financial situation and value the business comported with accepted business valuation principles, stating, “in short, she described her application of reliable, recognized principles of accounting and valuation analysis.” As for the expert’s performance during the Daubert hearing, the court said, while it “may have detected some confusion or non-responsiveness to several crossexamination questions, those hesitations are relevant to the witness’ demeanor on the witness stand,” and therefore, go toward the weight of the testimony, not its admissibility.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
58 58
Consultants’ Training Institute
Trending Matters in Business Valuation
2017 National Association of Certified Valuators ®). All rights © 2016 National Association of©Certified Valuators and Analysts™ (NACVA reserved.and
Analysts™ (NACVA®). All rights reserved. 1
Federal Case Law Update
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved. 2
Summary of Federal Cases CASES
CITATION/DATE
ISSUES
Estate of Dieringer v. Commissioner
146 T.C. No. 8, Mar. 30, 2016
Estate of Giustina v. Commissioner (Giustina III)
Family limited partnership valuation, income 586 Fed. Appx. 471, Jun. 13, approach, asset approach, 2016 weighting of approaches
H.W. Johnson v. Commissioner
MSKP Oak Grove, LLC v. Venuto
Charitable contribution claim, value differentiation
T.C. Memo. 2016-95, May 11, 2016
Reasonable compensation claim, return on equity analysis, reasonable comparative analysis
2016 U.S. Dist. LEXIS 84950, Jun. 29, 2016
Daubert action, expert report, adherence to valuation standards
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
3 3
Estate of Dieringer v. Commissioner
Action brought by IRS, after Service discovers “significant” gap in value of company claimed in Charitable Contribution vs. value of company in context of a Redemption Transaction. Redemption Transaction was only seven (7) months after Charitable Contribution. IRS claimed estate was negligent complying with U.S. Tax Law, and levied an accuracyrelated penalty.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
4 4
Estate of Dieringer (Continued)
Company Ownership: Shareholder
% Ownership
Type
Decedent
81%
Voting
Son 1
19%
Voting
Decedent
84%
Non-Voting
Son 1 & Son 2
16%
Non-Voting
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
5 5
Estate of Dieringer (Continued)
Company was a property management company. Organized as a C Corporation. Decedent’s estate planning set forth the following: • Will left entire estate to the trust. • Trust agreement specified that $600K of estate would go to various charities. • Remainder (amount in excess of $600K), consisting primarily of company stock and promissory notes, would be transferred to a family foundation. Son 1 was sole trustee of the trust and foundation.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
6 6
Estate of Dieringer (Continued)
In November 2009, seven months after decedent’s death, the estate retained a valuation firm to determine FMV of decedent’s stock for Estate Tax Reporting purposes. Voting shares were valued at $1,824 per share (no discounts since shares represented voting shares and a controlling interest). Non-Voting shares were valued at $1,733 per share, applying a 5% discount for lack of voting power.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
7 7
Estate of Dieringer (Continued)
Post-Decedent Death Developments: • Son 1 took lead role in company (was previously president). • Company elected “S” status to avoid built-in capital gains. • Son 1 was concerned that the foundation would have to make an annual distribution of 5% of the value of its assets, and would be subject to tax on the value of any excess holdings the entity had in the company after five years. • Company’s board voted to effect a redemption of shares to freeze the value of the shares into a promissory note.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
8 8
Estate of Dieringer (Continued)
Final company redemption agreement stated that the company would redeem all voting shares and just over 2/3 of the non-voting shares. Company retained the same appraiser to determine FMV of shares for redemption purposes. Appraiser was unaware that the company had converted to an S Corporation. Valued company as a C Corporation.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
9 9
Estate of Dieringer (Continued)
Appraiser testified that he received instructions, from Son 1, to value the bequeathed shares as a minority interest. • Redemption valuation included the following discounts: Discount for lack of control – 15% Discount for lack of marketability – 35%
Voting share value was $916 (from $1,824). Appraiser applied additional 5% discount for lack of voting power to non-voting shares. Non-voting share value was $870 (from $1,733).
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
10 10
Estate of Dieringer (Continued)
Company (Son 1) signed short-term promissory note for $3 million. Around time of redemption agreement decedent’s 3 sons bought shares (to inject cash to company to pay off promissory note). After share purchases, trust was left with no voting shares and 2,163 non-voting shares. Trust then transferred non-voting shares and promissory note to foundation.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
11 11
Estate of Dieringer (Continued) Pursuant to three subscription agreements, decedent's sons obtained 290 out of 425 voting shares and 3,868 of the 7,736.5 nonvoting shares – all including DLOC and DLOM. Son 1 ended up with a majority of both voting and non-voting shares.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
12 12
Estate of Dieringer (Continued)
IRS discovers disconnect in value between value claimed on the decedent’s Form 706 and the charitable contribution. IRS noted value of company was affected by postdeath changes to the company. IRS took position that the charitable deduction could only reflect the value of the promissory notes and a fraction of the non-voting shares that were transferred to the foundation. IRS issued a tax deficiency in the amount of $4.1 million, and an accuracy-related penalty of nearly $825K.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
13 13
Estate of Dieringer (Continued)
Estate challenged the IRS, arguing the following: • There was no justification for calculating charitable contribution based on value foundation received. • Argued that under regulations the date for determining the value of contribution was date of death. • Argued that at death the bequest was not subject to redemption agreement or other contingencies. • Argued that considering post-death events did not “truly reflect” FMV. • Argued that changes in company occurred for valid business reasons.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
14 14
Estate of Dieringer (Continued)
IRS argued that post-death events should be considered because decedent’s sons “thwarted decedent’s intent to bequeath all of her majority interest in the company or the equivalent value of the stock to the foundation.” IRS argued that the manner in which Son 1 orchestrated the appraisals (instructing that the second appraisal be valued at minority interest), was evidence that they never intended to carry out decedent’s will.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
15 15
Estate of Dieringer (Continued)
Tax Court sided with the IRS. Tax Court ruled that the post-valuation date events that occurred after decedent’s death and before the transfer to the foundation “changed the nature and reduced the value of decedent’s charitable contribution.” Tax Court noted that the change in corporate structure, redemption transaction, signing of subscription agreements (to reflect share purchases) all occurred on the same day, seven months after decedent’s death.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
16 16
Estate of Dieringer (Continued)
Court noted that the estate provided business reasons for each of the aforementioned; however, the court noted that there was insufficient evidence to support the substantial decline in the company’s per-share value. Son 1 pointed to “poor business climate” at date of Valuation 2. Tax Court dismissed this argument and pointed to the sole fact affecting the value of the stock was Son 1’s instruction to the appraiser to value the stock as a minority position.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
17 17
Estate of Dieringer (Continued)
Tax Court also found that the facts of the case supported an accuracy-related penalty, since the IRS showed that the estate failed to inform the appraiser that the redemption was for a majority interest and, instead, specifically instructed him to value the stock as a minority block. IRS noted that this represented negligence, the “failure to make a reasonable attempt to comply with the provisions of the IRS laws, to exercise due care, or to do what a reasonable and prudent person would do under the circumstances.”
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
18 18
Estate of Giustina v. Commissioner (Giustina III) Case was remanded to the U.S. Tax Court from the U.S. Court of Appeals for the 9th Circuit. 9th Circuit ruled the Tax Court (in original opinion) made unjustifiable assumptions. Court’s re-valuation served as a boon to the taxpayer.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
19 19
Guistina III (Continued)
First valuation facts: • Decedent owned a 41% LP interest in a timber • • • •
partnership. Partnership owned 48K acres of timberland. Partnership had operated for fifteen years at date of decedents' death. Partnership had 2-GPs and 8-LPs at date of death. All partners were family members or trust acting on behalf of a family member.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
20 20
Guistina III (Continued) IRS assed a deficiency of $12.66 million. Tax Court originally valued LP interest based on weighting of both Income Approach (DCF Method), and Asset Approach (Adjusted-Net Asset Value Method). Tax Court gave 75 percent weight to the Income Approach and 25 percent weight to the Asset Approach.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
21 21
Guistina III (Continued) Tax Court credited the estate expert’s DCF method, but applied adjustments. Most significant adjustment was the court’s cutting in half of the 3.5 percent company specific risk premium. Court contended that a hypothetical buyer could minimize this risk by diversifying the portfolio of assets.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
22 22
Guistina III (Continued)
Important to note the CSRP is synonymous with “unsystematic risk,” which, by definition is “non-diversifiable risk.” The estate appealed the Tax Court’s original ruling and the 9th Circuit agreed with the estate on the following: • That the Tax Court had not sufficiently explained
its decision to reduce the CSRP by 50%. • Appeals court noted that the 25% weight to the asset approach was unsupported by evidence, as the LP interest could not unilaterally effect liquidation of the long-term partnership. Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
23 23
Guistina III (Continued)
9th Circuit instructed Tax Court to re-determine FMV. Tax Court assigned 100 percent weight to the value derived under Income Approach. Tax Court explained that the one and only reason for reducing the CSRP was the possibility that a hypothetical buyer could diversify risk. The Tax Court concluded that this assumption was no longer tenable in light of the 9th Circuit’s ruling. The 9th Circuit noted that a hypothetical buyer had to be someone who could be an owner under the partnership agreement.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
24 24
Guistina III (Continued)
Tax Court noted that since all limited partners were either individuals or trusts for the benefit of individual family members, there was no basis for assuming a multiowner entity (hedge fund, VC fund, etc.) could be a buyer. Court also noted that the transfer of an LP interest required the approval of the company’s two GPs. Court noted they had run the partnership since inception (15+ years); as such, it was unlikely they would sell to a party, such as an investment company, whose sole objective was to increase its rate of return on the investment by dissolving the business.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
25 25
Guistina III (Continued) Based on the aforementioned, the Tax Court ruled there was no rationale for reducing the CSRP. Tax Court then adopted the estate expert’s original 3.5% CSRP. Adjustment caused a decrease in the decedent’s interest from $27.5 million to $`14.0 million.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
26 26
H.W. Johnson v. Commissioner
Case represents a dispute over executive compensation for purposes of a tax deduction. Dispute boiled down to whether the taxpayer, after paying the compensation, achieved enough of a return on equity to satisfy an independent investor (“Independent Investor Test”). If the return on equity did not provide adequate return, the executive compensation would be excessive.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
27 27
H.W. Johnson (Continued) The taxpayer met the burden by offering testimony from an expert whose ROE analysis the Tax Court found more persuasive than the IRS’ expert. This opinion serves as an important reminder to valuation analysts of the importance of ensuring that comparables are truly comparable, and moored in specific analysis, not a cursory review.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
28 28
H.W. Johnson (Continued)
Case background: • Subject company was a large concrete contracting business located in Arizona. • The business performed curb, gutter and sidewalk work. • Company had a stellar reputation in the local market. • Reputation allowed the business to secure contracts even when it was not the lowest bidder. • In 2003 & 2004 (years at issue), the company had over 200 employees, and contract revenues of $23.7 MM and $38.0 MM, respectively.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
29 29
H.W. Johnson (Continued)
Case background (continued): • • • •
Husband & wife founded the business in 1974. Sons (two) assumed complete control in 1993. Company had contract revenues, in 1993, of only $4.0 MM. When the sons took over the business their mother held a 51% controlling interest, and each son held a 24.5% minority position. • During the years at issue, the sons were co-vice presidents, and their mother was the president and chair of the board. • The board was made up of the two sons and their mother.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
30 30
H.W. Johnson (Continued)
Case background (continued): • In terms of operations, each son managed a geographical • • • •
•
area. Each son oversaw 100 employees. Each son reported working 10 to 12 hours a day, five of six days a week. Success of the business hinged on a steady supply of concrete. The AZ housing boom resulted in several concrete shortages. The sons proposed, in 2002, that the company invest in a concrete supply company. Their mother refused.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
31 31
H.W. Johnson (Continued)
Case background (continued): • Sons, along with other investors formed a separate concrete supply company. • The new business was able to provide a steady supply of concrete at a discounted price, when other contractors had to suspend operations because they could not procure concrete. • In 1991 the company adopted a formal bonus plan, which was amended in1999. • At year-end, based on advice from the company’s accountant, the board issued bonuses out of a “bonus pool” based on officer performance and the company’s ability to pay.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
32 32
H.W. Johnson (Continued)
Case background (continued): • Similarly, the company had a dividend plan that envisioned
paying out dividends when the company’s retained earnings were over $2.0 million. • In 2003 and 2004, the company paid the sons roughly $4 million and $7.3 million as compensation, claiming these amounts on their federal income tax returns. • The IRS issued a notice of deficiency, in which it disallowed over $2.6 million (2003) and $5.6 million (2004) of the claimed deductions. • The IRS subsequently conceded that deduction sin the amount of $3.2 million (2003) and $6.5 million (2004) were reasonable.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
33 33
H.W. Johnson (Continued)
Under Internal Revenue Code, Section 162(a)(1), a taxpayer may deduct “a reasonable allowance for salaries and other compensation for personal services actually rendered” as an ordinary and necessary business expense. The issue is whether the executive compensation is “reasonable.” The 9th Circuit Court of Appeals (which would handle any appeal) uses the five-factor test to determine reasonableness. • The five-factor test was originally discussed in Elliotts v. Commissioner, 716 F.2d 1241 (9th Cir. 1983).
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
34 34
H.W. Johnson (Continued)
The five factors include: 1. The employee’s role in the company. 2. A comparison of compensation paid by
similar companies for similar services. 3. The character and condition of the company. 4. Potential conflicts of interest. 5. The internal consistency of compensation arrangements. Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
35 35
H.W. Johnson (Continued) In the case at hand, the IRS conceded that four out of the five factors weighed in favor of the petitioner, or at lease were neutral. The only factor on which the IRS focused was the fourth – potential conflicts of interest, which required a determination of whether a hypothetical independent investor would receive an adequate return on equity after paying the sons’ compensation.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
36 36
H.W. Johnson (Continued)
Both experts agreed that the company had pre-tax returns on equity of 10.2% and 9.0% in 2003 and 2004, respectively. The experts disagreed over what the expected return on equity should have been. The IRS expert derived return on equity figures from four data sources, achieving a range from 13.8 percent to 18.3 percent. The Tax Court found the data sources( and the IRS expert’s resulting return on equity figures) unreliable when compared with the source used by the taxpayer’s expert.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
37 37
H.W. Johnson (Continued)
The IRS expert’s first figure was derived from seven guideline companies. The court rejected this analysis, ruling that the companies were not comparable. The court noted that the comparables were publicly traded and were active in an industry that was different from the subject company’s, and had sales that were considerably larger than the subject company’s.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
38 38
H.W. Johnson (Continued)
The IRS expert’s second figure relied on company data from RMA’s Annual Statement Studies. The court observed that the publication expressly states that the data should serve “only as general guidelines and not as absolute industry norms.” Data “may not be fully representative of a given industry,” the publisher adds. The IRS expert’s third figure relied on data published by the Construction Financial Management Association.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
39 39
H.W. Johnson (Continued)
The expert’s fourth figure was based on data from Ibbotson Associates. The court observed that the data concerned companies operating in the construction industry, in general, but not the concrete contracting sector in which the subject company operated. The Tax Court ruled that none of the data sources on which the IRS expert based his return on equity analysis provided meaningful information.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
40 40
H.W. Johnson (Continued)
The Tax Court accepted the analyses proffered by the taxpayer’s expert. The taxpayers expert relied on data from Integra Information. Specifically, the expert used Integra data from 33 companies that fell under SIC code 1771 (Construction Special Trade Contractors, Concrete Work), sales ranged from $25 MM to just under $50 MM. He determined average pre-tax return on equity ranging from 0.3% to 1.9%.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
41 41
H.W. Johnson (Continued)
The Tax Court noted “On balance, we are persuaded that companies which are closest to petitioner with respect to the nature of the business activity and the size of annual sales provide the best index of a reasonable return on equity,” the court said. The court noted that the IRS failed to cite support for its claim that, under the independent investor test, the rate of return on equity must significantly exceed the industry average when the subject company is particularly successful.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
42 42
H.W. Johnson (Continued)
The Tax Court noted that case law suggests that a 10% return on equity would satisfy an independent investor, which means that compensation that leaves that level rate of return is reasonable. The court also noted the ruling in Multi-Pak Corp. v. Commissioner, T.C. Memo 2010-139, which found that a return on equity of 2.9 percent was reasonable. The court observed that under case law compensation is deemed unreasonable when the resulting return on equity is zero or less than zero. Hence, the company’s rates of 10.2% and 9% for 2003 and 2004 met the independent investor test and “tend to show” that the compensation payments to the sons were reasonable. As such, the court ruled that factor four weighed in favor of the company.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
43 43
H.W. Johnson (Continued)
Based on the five-factor Ellliotts analysis, the Tax Court concluded officer compensation for both years was reasonable and, therefore, deductible.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
44 44
MSKP Oak Grove, LLC v. Venuto
This case was a Daubert action. Plaintiff retained an expert to show that defendants committed fraud, but the expert received incomplete documents. The plaintiff’s expert, a NACVA Member, illustrated that a thorough expert report, and adherence to professional standards can help a valuator in a litigation context. The court found that the expert sufficiently documented how the many assumptions, estimates, and adjustments that went into her re-creating of missing information aligned with valuation standards and the authoritative literature.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
45 45
MSKP Oak Grove (Continued) Four defendants owned a company, Hollywood Tanning Systems (“HTS”), which operated tanning salons and sold franchises and tanning equipment to other salons. HTS had a lease agreement with the plaintiff’s predecessor in interest that allowed HTS to sublease the space to a franchise. The franchisee sublettor defaulted on the lease.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
46 46
MSKP Oak Grove (Continued)
In Spring of 2007, HTS signed an asset purchase agreement with a buyer that agreed to purchase the assets of HTS and assume most of its liabilities for total consideration of $40 million. Defendants were to receive a 25% interest in the buyer and contingency payments based on the buyer’s future earnings. The day after the transaction closed the defendants each received $5.8 million. The buyer subsequently filed for bankruptcy in June 2007.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
47 47
MSKP Oak Grove (Continued)
Approximately one year after the asset sale, the plaintiff sued the defendants over the sublettor’s default on the lease and won a judgment for over $411,000, which remained unpaid. The plaintiff then sued the defendants claiming HTS fraudulently distributed over $23.8 million to its shareholders, leaving the company unable to pay its creditors, including the plaintiff. After five years of litigation, the issue boiled down to whether the $23.8 million payment to the shareholders was a proper shareholder distribution or an illegal diversion of the buyer’s assets.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
48 48
MSKP Oak Grove (Continued)
The plaintiff hired an expert. The expert prepared two reports. The first report was a “fraudulent conveyance report.” The second report was a “valuation report.” In the reports the expert opined that she had not been provided with many of the documents “normally maintained by companies of this size for tax and management purposes.”
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
49 49
MSKP Oak Grove (Continued)
The expert found that, at the valuation date, (the date of the distributions to the defendants), HTS’ general ledger showed only deposits of about $4.3 million as proceeds from the transaction and about $128,000 from the transfer of “other accounts” but did not show the $23.8 million disbursed to the defendant shareholders. The expert had to reverse engineer the company’s financial position at the date of valuation, due to the fact that she was provided with incomplete records.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
50 50
MSKP Oak Grove (Continued)
The expert’s reverse engineering process encompassed making “normalization adjustments” pursuant to the AICPA’s Statement on Standards for Valuation Services Section 100 (“VS-100”), treatises by intellectual leaders in valuation (Pratt & Hitchner), and generally accepted accounting principles. The expert explained that VS-100.41f advised using discounts to account for non-operating assets and excess operating assets in a business valuation.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
51 51
MSKP Oak Grove (Continued)
The expert deduced, after a review of certain losses the company booked on its tax filings that certain stores should not have been considered functioning stores. As such, she concluded the company overstated its accounts receivable by $3 MM. Similarly, based on a Pratt treatise, she adjusted projections as to the buyer’s ability to generate income in the future. She attached copies of the sources guiding her analysis, to her reports.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
52 52
MSKP Oak Grove (Continued)
In terms of the company’s FMV, she concluded that HTS did not receive reasonably equivalent value from the defendants for the distributions. The assets left to the company after the distributions and diversion of cash to the defendants were unreasonably small in relation to the distributions. The expert surmised that, at the date of the distributions, the company knew, or should have known, that it would incur debt beyond its ability to pay as the debt became due. The distributions left the company insolvent. There was evidence of post-transaction insolvency in the company’s 2007 year-end financial statements.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
53 53
MSKP Oak Grove (Continued)
The defendants moved to exclude the expert’s testimony under Daubert. The defendant’s claimed the reports were stand-alones, and since the expert did not attach a summary of methodology to the “fraudulent conveyance” report, it was per se inadmissible. They said the reconstruction of the company’s financial health was based on an unreliable methodology (hindsight) and the valuation report was not helpful to the trier of fact.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
54 54
MSKP Oak Grove (Continued)
The expert opined that the two reports formed part of one expert opinion and the discussion of principles and methodologies that appeared in the valuation report covered the fraudulent conveyance report as well. The court agreed with the plaintiff. In discussing Federal Rules of Evidence (“FRE”) 702 and Daubert, the court referred to “a trilogy of restrictions on expert testimony: qualification, reliability, and fit.”
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
55 55
MSKP Oak Grove (Continued)
The court noted that there was no dispute that the expert’s testimony met the first two requirements. The “fit requirement,” the court noted “goes primarily to relevance,” that is, the testimony must be relevant to the legal issues in the case and assist the trier of fact in resolving the legal questions. In this case, the expert reports were “certainly relevant” to the resolution of the plaintiff’s fraud and concealment claims, the court found.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
56 56
MSKP Oak Grove (Continued)
The final discussion centered on reliability of the methodology. The court rejected the defendants’ proposition that the reports were separate and that one was missing a section on methodology. At the Daubert hearing, the expert convincingly explained that she prepared a two-part report to facilitate and expedite discovery in the case. She also explained that she intended the methodologies and approaches sections appearing in the valuation report, as well as the attached copies of the AICPA Standards and treatise pages, to apply to both parts of the report.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
57 57
MSKP Oak Grove (Continued)
In terms of substance, the court found the methodology the expert used to re-create HTS’ financial situation and value the business comported with accepted business valuation principles, stating, “in short, she described her application of reliable, recognized principles of accounting and valuation analysis.” As for the expert’s performance during the Daubert hearing, the court said, while it “may have detected some confusion or non-responsiveness to several crossexamination questions, those hesitations are relevant to the witness’ demeanor on the witness stand,” and therefore, go toward the weight of the testimony, not its admissibility.
Trending Matters in Business Valuation © 2016 National Association of Certified Valuators and Analysts™ (NACVA ®). All rights reserved.
58 58
