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Richard L. Lies III

CFA, ASA

E-mail:

rlies@BlackmanKallick.com

Phone:

312-980-2922

• Gallagher, who passed away on July 5, 2004, was a minority shareholder (15 percent) of the Paxton Media Group LLC (PMG), a privately held and family-owned newspaper publishing company. The only issue at trial was the value of the interest.
• The tax court decided on several issues critical to the valuation of an interest in a closely held business, including: (1) the relevant date of financial information  to be used in a date-of-death valuation, (2) appropriate adjustments to historical financial statements and enterprise value, (3) reliance on the guideline public company method, (4) the use of the weighted average cost of capital (WACC) as an appropriate rate of return in the income approach, (5) whether to tax-affect earnings in a tax-pass-through entity in the income approach, and (6) the proper type and size of applicable discounts.
• The court concluded that the June 30, 2004 financial statements for PMG and public companies could be utilized, despite not being readily available on the July 5, 2004 date of death. It reasoned that hypothetical actors could make inquiries of PMG or the public companies, which would have elicited the information that wasn’t readily available.
• Judge Halpern disregarded many of the historical and enterprise value adjustments made by the estate’s expert because the expert’s support for the adjustments was either not “persuasive” or did not provide enough explanation.
• Both of the experts utilized the guideline public company method, but only the IRS’s expert gave it any weight. The tax court found that the IRS’s expert improperly relied upon the method as the companies selected were not similar enough to PMG to “warrant its application.”
• Both parties’ experts relied upon PMG’s WACC as the appropriate rate of return with which to discount future cash flows under the income approach. Judge Halpern does not believe that utilizing the WACC is an appropriate analytical tool to value a “small, closely held corporation with little possibility of going public.” However, since both experts relied upon the WACC, Judge Halpern utilized it in his analysis (although the decision stated that he did not “set a general rule in doing so”).
• PMG was an S-corporation and thus did not pay corporate-level taxes. The estate’s expert tax-affected PMG’s earning, assuming an approximate C-corporation rate. The tax court stated “the principal benefit enjoyed by S corporation shareholders is the reduction in their total tax burden, a benefit that should be considered when valuing an S corporation. [The estate’s expert] has advanced no reason for ignoring such a benefit, and we will not impose an unjustified fictitious corporate tax rate burden on PMG’s future earnings.”
• The tax court concluded that a minority interest discount of 23 percent, higher than those of both experts, was appropriate. It also concluded a discount for lack of marketability of 31 percent was appropriate, based on the experts’ reliance on the restricted stock studies. However, the court noted that it had disregarded conclusions as to marketability discounts based upon those studies in the past.

While the results of the case seem to be a win for the taxpayer, some of the decisions made by the tax court likely left many business valuation professionals scratching their heads. The tax court's stance on the WACC and simply not tax-affecting an entity’s earnings in the income approach is in contrast with the majority in the valuation community. It is worth noting, however, that the tax court generally sided with the expert that did the better job of explaining and supporting his arguments. This demonstrates that when selecting a business valuation professional it pays to make sure they are able to not only provide sound valuation analyses, but also have the ability to break down the complex and explain it so the layman can understand. 

For further information or questions, please contact Rich Lies  at rlies@BlackmanKallick.com or 312-980-2922 or your Blackman Kallick representative.