IRS Continues to Attack Discounts

Having an independent appraisal of closely-held corporate stock for gift or estate tax purposes is becoming a virtual necessity no matter the dollar value of the gift or estate. However, even an independent appraisal will not guarantee that you will not end up in court with the IRS. A recent case illustrates the IRS attack on an independent appraisal.

What Was At Issue and Parties Contentions:

The dispute was over the various discounts that were applicable in valuing two 25.77% gifts made to Robert and Lee on November 2, 1992.   Independent appraiser, Alex W. Howard of Howard Frazier Barker Elliott, Inc., valued the two gifts at $7.4 million each at the time of gift. At trial, this value was lowered to $6.9 million. Each party stipulated that the value of the estate before various discounts was $80.1 million based on the net asset value method.

The following is a summary of the discounts in dispute and each party's contention.

Definitions:

Blockage Discount -

In this instance, this discount would arise from the fact that the block of Winn-Dixie stock was large enough to be subject to various restrictions under SEC section 144 and, therefore, could not be disposed of immediately.

 

Built-In Gains Tax -

This was the tax which would be generated largely from the sale of the Winn-Dixie stock since Mr. Davis obtained a significant portion of the stock for minimal consideration.

 

Minority discount -

This discount arises due to the fact that the stock being gifted could not in and of itself control the direction of the company, i.e. could not influence management, declare dividends, etc. Therefore, since the net asset value method results in a value that only a controlling shareholder could realize, a discount to reflect this lack of control is necessary.

Marketability discount -

Since the subject stock is not traded on a public market, it would be more difficult to find a buyer for this stock than a similar stock that was traded on the public market. Therefore, a discount to reflect this lack of marketability was warranted in this instance.

 

Valuation Experts

Taxpayer

Alex W. Howard, ASA, Howard Frazier Barker Elliot Shannon Pratt, ASA, Willamette Management Associates

IRS

John A. Thomson, ASA, Klaris, Thomson & Schroeder

Court Decision and Why
The Court's decision on each of the above discounts and their reasons are as follows:

Blockage Discount - None.

Taxpayer's experts offered two different methods to support a blockage discount. Court rejected both, because IRS's expert proved that although the Winn-Dixie stock would have to be sold over a period of time, the fact the stock's market price was on a rising trend would eliminate any discounts due to the higher prices that would likely be realized in the future.

Built-In Gains Tax - Court estimated this discount to be about 11%.

Normally, the Court has not allowed any discount for built-in gains tax if there is no evidence that the corporation will be liquidated in the near future. In this instance, the IRS attempted to use case history to support no discount. However, even the IRS's expert agreed that a potential buyer of the subject interest would take the tax into account when considering the value of the minority interest even though liquidation was not imminent. Mr. Howard subtracted the entire built-in gain tax while Mr. Pratt and Mr. Thomson included the effects of the gain in their marketability discount. The Court agreed with Mr. Pratt and Mr. Thomson.

The marketability discount is discussed below.

Minority Interest Discount - As there was little disagreement between the two parties, they stipulated 15%.

It should be noted however, that this is significant in that 85% of the holding company's assets were publicly-traded stock that already includes a minority discount.

Marketability Discount - Court applied total discount of 35%, however, 11% was attributable to the built-in gains tax.

All the experts cited the various restricted stock and initial public offering studies that estimate the lack of marketability discount associated with closely-held stock. However, Mr. Thomson, the IRS's expert, utilized these studies as merely a benchmark and then analyzed the subject stock and its unique characteristics to determine the most appropriate discount. Mr. Howard and Mr. Pratt failed to provide as clear analysis of the subject stock as Mr. Thomson, so the Court accorded more weight on Mr. Thomson's testimony and marketability discount selection of approximately 23%.

As this court case shows, it is likely that the IRS is going to be attacking the various discounts applicable to closely-held stock as opposed to the underlying value conclusions. It is important that your appraiser fully justify the discounts utilized in the valuation.