A recent gift tax case, decided in a U.S. Federal District Court in Wisconsin in March, might have sweeping impact on the valuation of S corporations nationwide.

The case, Kress v. United States, involved Green Bay Packaging (GBP), a family-owned paper and packaging manufacturer founded by George Kress in 1933. The company has enjoyed steady and substantial growth over its history, and its balance sheet is strong.

GBP has more than 3,400 employees in 32 manufacturing locations in 15 states. Nearly 90 percent of its shares are owned by Kress family members, with the remaining shares owned by employees and directors.

Among many valuation issues addressed in the court case, the legitimacy of tax-affecting S corps has piqued the interest of valuation professionals the most.

Cost of Capital

The ongoing debate about tax-affecting centers on how to derive the cost of capital for S corps. To do so, valuation analysts rely on a variety of inputs, many of which are based on C corp data. But because C corps are subject to double taxation, valuation analysts often “tax-affect” S corps to create a C corp equivalent and then add a premium for S corp status when estimating fair market value.

While this sounds completely logical to most valuation analysts, until now, the IRS has not acknowledged that S corps should be tax-affected. Before the recent Kress decision, the landmark tax court case on tax-affecting, Gross v. Commissioner, resulted in a ruling that tax-affecting earnings should not be standard practice.

Kress might have changed that—or at least opened the door for further discussion.

Gift Taxes in Question

The Kress case centers on James and Julie Ann Kress’s gift of minority shares of GBP to their children and grandchildren in 2006, 2007 and 2008. Their gift tax returns based the fair market value on annual valuation reports that were prepared for the company in the ordinary course of business. They each paid $1.2 million in taxes on the shares, for a total tax of $2.4 million.

In 2010, the IRS challenged the gift tax valuations and four years later told the Kresses that their tax payments were deficient, claiming they owed almost double the original amount.

In late 2014, the Kresses paid up—rendering to the IRS a total of $2.2 million more in deficiencies and interest.

Wasting no time, the Kresses then also filed amended gift tax returns—along with a lawsuit asking the court for a refund of the $2.2 million in additional taxes and interest. A trial took place in August 2017.

Valuations Challenged

In the trial, both the Kresses and the IRS presented testimony from highly qualified valuation experts. The Kresses’ first expert, John Emory, had prepared valuations for the company for many years. It was Emory’s valuation opinions on which the Kresses had relied for their gift tax calculations. Among other criticisms, the IRS objected to his sole use of the market approach.

The Kresses’ second expert, Nancy Czaplinski, also provided testimony, along with a new valuation report, which used both the market (weighted at 14 percent) and income (weighted at 86 percent) approach.

The IRS provided its own unnamed appraiser as well, who produced the valuation numbers used to calculate the tax deficiencies.

The IRS also retained Francis Burns, whose conclusion of value—using both the market (weighted at 60 percent) and income (weighted at 40 percent) approaches—was higher than both Emory’s and Czaplinski’s but lower than the unnamed IRS appraiser.

(Note that given the lower valuation by Burns—the IRS’s expert—the Kresses knew at the outset of the trial that they were due a substantial refund even as they went into court.)

Both Emory and Burns tax-affected GBP’s S corp earnings. Czaplinski avoided the tax-affecting question by using pre-tax multiples in her calculation. (It’s unclear whether the IRS’s initial appraiser tax-affected the earnings in his or her calculation.)

What the Court Found

The court found merit in many aspects of all of the appraisals, although it didn’t agree with all of the conclusions of any of the four valuation analysts.

While the court slightly reduced Emory’s discount for lack of marketability (DLOM) from 28 percent to 25 percent, it generally appreciated his initial valuation work, noting his understanding of the company and his overall analysis. In its discussion, the court didn’t seem to mind his sole reliance on the market approach, noting that he “incorporated concepts of the income approach into his overall analysis.”

The court also seemed to appreciate Burns’ work, though it seemed slightly concerned that he used only two guideline companies in his appraisals. As for Czaplinski, the court didn’t seem bothered by her lack of tax-affecting because it felt she had dealt with the issue appropriately and didn’t find fault in her applying an S corp premium to reflect the tax advantages related to S corp status.

The court considered Emory’s value of $21.60 per share, the IRS’s value of $50.85 per share, Burns’ value of $40.05 per share and Czaplinski’s value of $25.06 per share. In the end, the court concluded the fair market value was $22.50 per share, only 4.2 percent higher than Emory’s original value.

What the Court Found

This case is rife with valuation issues, from which equity adjustment model should be used to the treatment of non-operating assets, but tax-affecting rises to the top. By accepting tax-affected values without fuss, the court hinted at recognition that tax-affecting of pass-through entities is appropriate in valuation, acknowledging that there are tax consequences for pass-through entities that should be accounted for in valuations.

(It’s worth noting that other Kress family members had likely been gifting stock for years using Emory’s tax-affected valuations without IRS objection. Seamlessly accepting most of Emory’s conclusions underscores this court’s recognition that tax-affecting has merit.)

There is no doubt that this case leaves a cleft in the IRS’s long-standing position on tax-affecting. While it is not a precedent-making decision—and the court didn’t address tax-affecting in a larger sense in its ruling—Kress will be referenced by accountants, attorneys and valuation analysts for years to come. This is especially true in the many ongoing cases where the IRS is arguing against tax-affecting and for a premium in the valuation of S corps relative to similar C corps.

Here, the taxpayer clearly won.

Interested in this or other valuation court cases? Our valuation team would be happy to discuss them with you. Call us at 434.296.2156 or email us at info@hwllp.cpa.

Source: Business Valuation Resources

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