Magazine article The CPA Journal

Fifth Circuit, Reversing Tax Court, Clarifies Valuation of Privately Held Corporations

Magazine article The CPA Journal

Fifth Circuit, Reversing Tax Court, Clarifies Valuation of Privately Held Corporations

Article excerpt

In Estate of Dunn [301 F.3d 339 (2002), rev. 79 TCM 1337 (2000)], the Fifth Circuit ruled that the full amount of the corporate income tax on the sale of assets can be subtracted when using the asset-based method to value a privately held corporation, because the asset-based method assumes the assets are sold. The Fifth Circuit also ruled that the likelihood that a corporation will be liquidated or sold is relevant only in determining the weights to be assigned to the earningsbased value and the asset-based value. Finally, the Fifth Circuit's assignment of these weights in Estate of Dunn significantly reduced the valuation for estate tax purposes.

Prior Law

Case law has long established that fair market value is the price a willing buyer would pay a willing seller, both having reasonable knowledge of the facts, and neither under compulsion. In general, when no recent transactions in the stock have occurred, there are two approaches to valuing a privately held corporation: the earnings-based method (calculated using income or cash flow) and the assetbased method. Revenue Ruling 59-60, 1959-1 CB 237, specifies the following factors in determining the fair market value of a privately held corporation's stock: earnings; financial position and book value; economic and industry outlook; management skills; dividend-paying capacity; goodwill; the size of the block of stock; and the value of similar businesses. Revenue Ruling 59-60 also states that, in general, earnings may be the most important criterion when valuing a business selling products or services, whereas the value of the assets may be most important in valuing an investment or holding company.

Facts of Dunn

Beatrice Dunn, owner of 63% of Dunn Equipment common stock, died in 1991. Dunn Equipment rents heavy equipment, with or without trained operators. From 1987 to 1991, Dunn Equipment paid no dividends, its officers were paid relatively low compensation, and it had an average annual cash flow of $286,421. In 1991, with assets of approximately $8.27 million and liabilities of $7.3 million, Dunn Equipment was a viable operating company with 134 employees and strong community ties. To sell, liquidate, or merge Dunn Equipment required a super majority (two-thirds vote of the outstanding shares) under state law.

On the estate tax return, decedent's Dunn Equipment stock was valued at $1,635,465. The IRS valued the stock at $2,229,043 in the deficiency notice. Subsequently, in Tax Court filings, the IRS valued the stock at $4,430,238. The estate's expert argued for assigning equal weight to the earnings-based value and the asset-based value, and for a 34% reduction to the asset-based value for the corporate income tax on liquidation of Dunn Equipment. This income tax flows from the accrued taxable gains on the disposal of equipment. The IRS based its value solely on the asset-based method, arguing that the lower value from the earnings-based method should be ignored because of the large difference between the two methods' results. The IRS also allowed no reduction for income tax. Both parties subtracted discounts for lack of super-majority control and lack of marketability.

Tax Court Ruling

In its ruling, the Tax Court assigned a 35% weight to the earnings-based value and a 65% weight to the asset-based value, and then allowed a 5% reduction for income taxes from the asset-based value. The Tax Court ruled that the full assetbased value of Dunn Equipment was $7,922,892, and the full earnings-based value, using cash flow, was $1,321,740. Furthermore, the Tax Court allowed the two discounts, resulting in a value for the decedent's 63% ownership interest of $2,738,558, which exceeded the value reported on the estate tax return by more than $1 million. …

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