Taxpayer Wins Major Gift Tax Valuation Case
Mr. Jones established three trusts for his daughters in May 2009. He gifted voting and non-voting stock of Seneca Sawmill Co. (“SSC”) and limited partnership interest of Seneca Jones Timber Co. (“SJTC”) to the trusts. Together these entities operated a lumber and timber business. Mr. Jones filed a gift tax return and reported the total value of the gifts at approximately $21,000,000. The return was audited by the IRS and the IRS determined the value should be approximately $121,000,000 and assessed a gift tax efficiency of about $45,000,000. In a tax court memorandum decision (T.C. Memo. 2019-101), Judge Pew agreed with Mr. Jones’ appraiser that the value of the gifts was approximately $24,000,000, resulting in an additional gift tax liability of about $1,200,000 ($3,000,000 x 40%).
SSC was the manufacturer of lumber. The business was started in 1954. In 1986 it elected S status. In 1989 SSC began to purchase its own land to reduce its reliance on timber grown on federal lands. In 1992 Mr. Jones formed Seneca Jones Timber Co. (“SJTC”) to acquire and hold timber lands to provide SSC with inventory and also to make it easier to obtain loans since they could be secured by the timber lands. SSC became the general partner of SJTC and received a 10% interest for the lands it recently purchased, which it contributed to SJTC.
The same management personnel ran SSC and SJTC and they shared a common headquarters.
The SSC shares are restricted by a Buy/Sell Agreement. Any attempt at sale of SSC shares by a shareholder triggers a right of first refusal to SSC. If SSC did not purchase the shares the other shareholders have the option to purchase them. The purchase price is the fair market value mutually agreed upon or if such agreement was not reached, then by appraisal. When an appraisal is used, consideration had to be given to discounts of lack of marketability, lack of control and anticipated cash distributions.
Under the SJTC Buy/Sell provisions, any attempted transfer of a SJTC partnership interest produced a right of first refusal. SJTC had the first option and if it did not exercise such right, then the limited partners had the option to purchase the Units. In addition, any purchaser would be an unadmitted Assignee. The same discounts applicable to SSC applied to SJTC.
There were two main areas of dispute between Mr. Jones and the IRS in valuing the gifts. The first issue was that in determining the value of SJTC, the IRS’ position was that the value of the underlying timber should be the primary factor not cash flow. Mr. Jones argued that the units of SJTC should be valued under the income method. The second issue was whether the earnings of SSJ and SJTC should be “tax effected” by deducting a hypothetical income tax on their earnings or whether no income tax should be deducted since S corporations and limited partnerships pay no income taxes.
Mr. Jones died before trial and he was replaced by his estate. The estate’s appraiser, Richard Reilly, employed the discounted cash flow method in valuing the stock of SSC and the limited partnership interests of SJTC. He appraised each limited partnership unit of SJTC to be worth $380. The IRS appraiser using that net asset value approach (NAV) determined the value of each limited partnership unit to be $2,530. The IRS did not submit a valuation of SSC and largely accepted a valuation used by Mr. Reilly except for the “tax effecting” issue.
From a dollar standpoint, the biggest issue concerned the value of limited partnership interests of SJTC. A court determined that SJTC is a going concern but had aspects of an operating company and an investment company. It plants, sells, grows and harvests trees and sells the logs but holds large amounts of timber lands it will retain and which will increase in value, even if SJTC is not profitable year-to-year . The court further noted that SJTC and SSC shared common management. SSC purchased large amounts of product from SJTC and Judge Pew held that overall the income method approach was the best approach to use in valuing SJTC. The court also noted that a holder of limited partnership interest would have no way to force a sale of the timber lands. This was a factor for using the discounted cash flow method.
In determining the earnings of SJTC and SSC, Mr. Reilly “tax-effected” the earning of SJTC and SSC by using the combined federal and income tax rates that would be paid if both entities were C corporations but taxed at individual tax rates. The IRS argued that earnings should not be tax effected because there is no evidence that either SJTC or SSC would lose its pass-through status and cited various court cases that supported the IRS position.
Judge Pew held that all cited cases did not hold that the earnings of pass-through entities could never be tax effected but that tax-effecting is a facts-based issue. Judge Pew said that the facts here supported tax-effecting. The Judge found that under these facts, the buyer would consider what the tax on the income would be since the buyer would have to pay the tax either individually or at the entity level if the purchaser was a C corporation.
After tax-effecting earnings, Mr. Reilly applied a 20% premium to the business enterprise value to reflect a benefit of not having to pay double taxes as would a C corporation. The court noted that the IRS appraiser offered no defense of the IRS’ proposed tax rate.
The court concluded that valuing closely held companies is not an exact science and that the court might find the valuation by one party to be more convincing than the other, which would produce a significant financial defeat for one. However, the court declined to apply the “middle of the road approach” that it thought each party expected it to do. The court found that overall tax-effecting wasn’t exact, but it was more complete and more convincing than the IRS’ zero tax rate.