In my last article, I discussed the March 2019 decision of Kress v. United States. In Kress, both the expert for the IRS and the expert for the taxpayer applied a tax rate when valuing a minority ownership interest in an S Corporation. This was different than what the IRS has done in most cases since Gross v. Commissioner. I asked if it signaled that the IRS is realizing that the valuation community was correct in the assumption that taxes matter when valuing an S Corporation.
Since this last article, there was a new tax court decision which I believe furthers the argument against the IRS’s stance in Gross. The decision in Jones v. Commissioner was filed in August of 2019. The case centered on gifts of stock in two interrelated S Corporations. One was an operating timber mill and the other company owned timberlands, planted and harvested trees, and sold logs to the first company and others.
I think two important issues in the case were addressed in the decision. The first issue centered on whether an income approach or an asset approach should be used to value the company owning the timberlands. This company had a long history of managing the timberlands and was the primary supplier of raw logs to the timber mill. The court concluded that it should be valued using an income approach (which resulted in a lower value) because there was little likelihood that it would liquidate its assets and eliminate the supply of logs for the mill. Even though it held land and timber, it also operated as a supplier and had been doing so for years.
The second issue once again centered on tax affecting the earnings of an S Corporation. In this case the IRS argued the “law” aspect of Gross in that tax affecting was not allowed in that case. The court in Jones explained that Gross did not prohibit tax affecting the earnings of a pass-through entity, but rather the finding was fact based on the specific facts of the Gross case. The valuator, for the taxpayer in Jones, presented a detailed fact based analysis of tax affecting the earnings and developed a pass-through premium (derived from dividend tax avoidance) based on the analysis. The taxpayer’s valuator argued that the fact pattern was different than the facts in Gross. The taxpayer prevailed.
This is the second case this year that went against the findings in Gross. We will have to wait and see if these cases are signaling a change in the way the IRS addresses the valuation of pass-through entities including, S Corporations, Limited Liability Companies, and Partnerships. This is the second case where I believe the tax court got the decision correct.
Should you have questions regarding this case or business valuation in general, please contact me, T. Eric Blocher CPA, ASA, CVA, Principal & Director of Business Valuation Services with McKonly & Asbury at firstname.lastname@example.org.