Valuation Related Tax Court Cases
Keep the IRS Honest


Before we delve into tax court cases to keep in your hip pocket prior to or after an IRS challenge or Notice of Deficiency arrives, here are some things to think about when discussing a valuation report with a client: How much is the interest holder impaired? Compared to whom? For how long? What is the basis for these conclusions?

Beginning with the fundamentals, investors acquire or sell based upon total return. Total return is how much an investment will increase in value (growth or capital appreciation/gain) and/or how much income it pays (dividend yield/distribution). We’ll discuss just how relevant this basic concept is to tax court cases involving valuation shortly.

We all understand that ownership of public stock index funds attempts to smooth the volatility (risk) of any one company and if held for a sufficient period of time can often beat most non-index investment managers’ return performance. So, in a manner of speaking, the index is the market’s or industry’s central tendency as of a given point in time. Does this mean all companies are directly on the hypothetical axis (line)? Of course not, because we understand that the further a company is away from this “line” there must be unique factors influencing its value and volatility. A “reasonable range” (+/-) represents owners who may wish to buy or sell the same share based upon their unique investment perceptions and expectations. Again, as of a given period of time.

Take Ford Motor Company (Symbol “F”), which traded during a single day (September 4, 2009) from $7.27 (low) to $7.55 (high). The price per share opened at $7.49 and closed at $7.43. During the day, the price was as low as -3% below the opening price and as high as +0.8% above the opening price. Who decided? The investors who bought and sold 42,539,791 shares on that given day. The point is that there was an absolute spread of (-3%) to (+0.8%) or 4% for that given day. Value is not static and isn’t a single point.

These arm’s length transactions capture the concept of the hypothetical buyers and sellers under the fair market value standard. They reflect investor return expectations on that given day. Since Ford shares traded down -$0.06 per share, those (sellers) who thought it was a less attractive investment than alternatives held a small sway on a single day result. The reduction reflects a capital loss (if the share was bought at $7.49 and sold at $7.43). If a share had been purchased at $7.27 and sold at $7.43, the per share appreciation or gain would have been +$0.16.

As there was no income received on that day, a $0.16 gain would have equated to the total return less consideration for taxes. During the past 52 weeks, the price of a share of Ford has ranged from $1.01 to $8.86. Clearly, a considerable degree of volatility. This raises the issue of whether a single year is indicative of typical performance. An optimistic investor who purchased at the bottom and sold at or near the top during this period could have realized over a seven fold return (capital appreciation). This does not mean the company grew its revenues by seven fold, but it does mean the market had perceived its risk was less than what $1.01 per share reflects.

What is the instructive “take away” from the perspective of a legal practitioner?: (1) There is great risk in non-diversification, (2) Values can change considerably in both short and long periods and (3) The responsibility of the advisor is to adequately capture the most likely risk of an investment based upon knowledge of the proxy of return expectation. This is where the appropriate level of impairment adjustments is more than a gross downward adjustment (or discount). Based upon what proxy measures?

So, we look at three companies in the same industry or asset class. Each has reported a 12% annual return. Compared to what? If we look at the industry, we find that annual returns averaged a hypothetical 15% annually over the past five years and that six years is a “typical” period investors hold such investments. All things being equal, it would be reasonable to assume next year a 15% return would occur.

Q: What is the first assumption an investor in the three companies can make? A: Since my investment has been providing a 12% return, the industry is performing better than my investment by 3% (300 basis points) or [1- (.15/.12)] or +25% greater. Therefore, to achieve a similar level of return in the industry, my investment would have to be discounted by 20% [.15 - (.15 x -.20)] to obtain the same level of performance.


Asset value is $100 and provides 12% annual return. At year-end, it would receive, if sold, $112 or a $12 increase. If asset was sold at a 20% discount or $80, but received the $12 ($12/$80 = 15%), then it would be comparable to the industry’s historic return.

The next question asked is what comprises the 12% annual return? Let’s say in Company #1 it was 9% yield and 3% growth; Company #2 it was 6% yield and 6% growth; and Company #3 it was 3% yield and 9% growth. It should be clear that until Company #1 is sold, the 3% annual growth is a paper gain; however, the investor enjoys the quarterly benefit of income of 9% of the asset’s value on an annual basis. Conversely, Company #3’s investor only receives a third of the yield Company #1 enjoys, but will likely receive a higher gain when the holdings are sold.

Q: Would holding period have an impact on the investor total return decisions? A: Certainly, as the investor who is receiving 9%/12% or 75% of the return on an annual basis could mitigate lower performance by investing the yield in assets that may provide a greater return until the asset itself is sold. This would not be the case in Company #3.

The point is that in the above discussion, we have attempted to address the influence of return components, investor expectations and how holding period influences decisions. What is VERY important is that in all these scenarios, the investor is presumed to have control to effectuate a better return. What if the investor could not, because s/he did not have the authority to buy or sell to optimize return on investment as is assumed under the fair market value standard?

The Service has classically taken the position that should better performance be available, the investor will gravitate to it. The recent market decline in October 2008 is instructive. The Service assumes an almost instantaneous cash equivalency position when arguing for little or no discounts for lack of control or marketability. Succeeding in this argument means tax revenue to the Treasury. However, how then could institutional investors with billions of dollars from the Harvard Endowment to CALPERS (retirement fund) to numerous professionally managed mutual funds and numerous public companies suffer -25%, -35% and -50%+ losses in value in the space of a few months, when they had control to mitigate their losses based on the Service’s logic? Just because they could rapidly move to cash positions, does not mean that did or would.

Issues such as date(s) of value, investor expectations, elements of total return and holding period cannot be simply expressed as aggregate discounts, but must be integrated in order to reflect an informed transaction from the part of the buyer and seller where a discount of -15% may be too high and -85% may be too low, not because of some feeling, but based on factual data available to both the Service as well as the taxpayer.

While certainly not all inclusive and tending to lean towards asset holding companies, the following cases are instructive:

Use of both NAV & Income Approaches

Many business valuations fail to recognize how important total return is to the investors reflected under the fair market value standard. The Income Approach is often the best means to capture just how significant this issue may be. If an entity is unable or unwilling to pay sufficient distributions, then under this approach the value will be considerably lower. The tax court has recognized that appropriate weight should be afforded to this approach with often a significant impact on the aggregate discount. Arguably, Z. Chris Mercer, ASA, recognized this in developing his Quantifying Marketability Discount Model (“QMDM”) in substantiating discounts for lack of marketability.

Estate of Smith TCM 1999-368; Estate of Ford v. Comm’r, 66 T.C.M. (CCH) 1507(1993), aff’d, 53 F.3d 924 (8th Cir. 1995), Estate of Andrews v. Comm’r, 79 T.C. 938 (1982), Estate of Katz v. Commissioner 27 TCM 825-1968; Estate of Watts v. Commissioner 823 F 2d 483 (11 Cir. 1987) and Estate of Ward (87 TC 78 – 1986).

Embedded Gain Liability

Neither the Service nor the taxpayer can have their cake and eat it, too. If the Service argues that a taxable gain liability can be deferred, they are also arguing for an extended holding period. The longer the holding period, the greater the perceived investment risk. The greater the risk, the greater the desired discount to compensate for the risk. This is reflected in a higher discount for lack of marketability. The only question remaining to be answered is how long a holding period, which should reflect both investor expectations and provisions unique to the company and interest(s) held. In Jelke, the taxpayer successfully argued for every dollar of expected tax, a dollar discount should be applied.

Estate of Jelke TCM 2005-131

Interests in Company Holding Underlying Assets is What is Germane

It seems that after Strangi I & II, Holman (entity holding solely Dell stock) scared many practitioners from recognizing legitimate impairments associated with noncontrolling equity ownership. In fact, Judge Halpern, who decided Holman, also decided Gross (below) a few months later which allowed discounts despite the entity holding primarily marketable securities. Also, size of block, if non-controlling even when above 90% is constrained if there are no “put” and “call” options, which was clearly found in Kelley.

Estate of Gross TCM 2008-221                                             DLOM                 35% aggregate

(Judge HalpernSame Judge as Holman LP w/securities)

Estate of Kelley TCM 2005-235                                            DLOM                 23% Only held Cash & CD’s!!!!!

(94.83% Interest)

Estate of Schutt TCM 2005 – 126                                       DLOM                 32.5% IRS Stip. To 32.5% discountif no 2036 issues

(Held Dupont & Exxon Stock)

IRS Penalties May Result If Business Valuation Expert’s Report Is Unsupported

The 20-percent penalty for an underpayment of tax resulting from a "substantial estate or gift valuation understatement" under IRC §6662(g) (and the 40-percent penalty for a "gross valuation misstatement" under IRC §6662(h)) does not apply when reasonable cause exists for the underpayment and the taxpayer acted in good faith. IRC §6664(c)(1).

For charitable contributions, the similar penalty for a substantial valuation overstatement (but not a gross valuation misstatement) does not apply if the taxpayer obtains a "qualified appraisal" from a "qualified appraiser" (see IRC §170(f)(11)(E)) and the taxpayer made a good faith investigation of the value of the contributed property. IRC §6664(c)(2). A "qualified appraisal" must be conducted by a "qualified appraiser" in accordance with generally accepted appraisal standards and any regulations or other guidance prescribed by the IRS. IRC §6664(c)(3)(B); see IRC §170(f)(11)(E)(i).

A "qualified appraiser" is someone who has earned an appraisal designation from a recognized professional appraiser organization "or has otherwise met minimum education and experience requirements" set forth in applicable regulations and who regularly performs appraisals for compensation. IRC §6664(c)(3)(C); see IRC §170(f)(11)(E)(ii).

The appraiser also must meet other requirements prescribed by the IRS. An individual will not be treated as a qualified appraiser with respect to any specific appraisal unless he or she shows verifiable education and experience in valuing the type of property subject to the appraisal, and the individual has not been prohibited from practicing before the IRS (see 31 USC §330(c)) at any time during the 3-year period ending on the date of the appraisal. See IRC §170(f)(11)(E)(iii).

At a minimum, Section 6664(c) implies that reliance on a qualified appraisal or business valuation report will likely be considered a reasonable cause for a substantial estate or gift tax valuation understatement involving business interests. However, as noted by the court of appeals in Estate of Thompson, TC Memo 2004-174, reliance on a business valuation expert does not necessarily establish reasonable cause and good faith for purposes of the reasonable cause exception to the taxpayer penalty for the undervaluation. See IRC §6664(c).

This article examined the conditions believed to exist under the fair market value and provided illustrations for practitioners to better understand how to consider and support appropriate levels of discounts. Tax court cases have illustrated the importance of a qualified appraiser performing such work product with the inherent risks of failing to do so borne by the taxpayer as well as those advisors s/he relied upon.