Kress v. US – A Pivotal Case Regarding Tax Affecting S Corporations
On March 25, 2019, Judge William C. Griesbach Chief United States District Judge for the United States District Court for the Eastern District of Wisconsin issued his findings of fact and conclusion of law in the matter of James F. Kress and Julie Ann Kress (Plaintiffs) v. United States of America (Defendant), United States District Court, Eastern District of Wisconsin, Case No. 16-C-795 (Kress v. US).
The Plaintiffs filed suit against the Defendant for a refund of taxes paid related to the transfer, by way of gifts, of minority interests in a family-owned business.
While the court addressed numerous issues that involve the valuation of minority interests in a closely held business, the findings could prove to be pivotal regarding the tax affecting of earnings of S corporations and other pass-through entities.
Since the 1999 Gross v. Commissioner court ruling, the Internal Revenue Service (Service) has been successful in attacking valuations that include tax affecting of pass-through earnings arguing that tax affecting should not be allowed since S corporations do not pay corporate level taxes. The Service’s argument ignores the fact that many such companies pay dividends to shareholders to meet the tax burden generated by the ownership in a pass-through entity. Subsequent rulings such as Heck v. Commissioner, Wall v. Commissioner and Dallas v. Commissioner have effectively upheld the Gross ruling although the rationale against tax affecting varies from case to case.
The Plaintiffs gifted minority shares of Green Bay Packing Company, Inc. (GBP), a family-owned subchapter S corporation, to their children and grandchildren during the tax years 2007, 2008 and 2009. GBP, formed in 1933, is a vertically integrated manufacturer of corrugated packaging, folding cartons, coated labels, and related products.
John Emory of Emory & Co. LLC prepared annual valuation reports for GBP beginning in 1999 and completed the appraisals used by the Plaintiffs for their gifts in 2007, 2008, and 2009. Mr. Emory concluded that the fair market value of the gifted shares were $28.00 per share, $25.90 per share $21.60 per share for the respective tax years. As a result, each of the Plaintiffs paid $1,219,241 in aggregate tax with respect to the gifted shares, for a combined total of $2,438,482.
The Service challenged the reported amounts on the Plaintiffs’ tax returns by letter dated November 30, 2010 and subsequently issued separate Statutory Notices of Deficiency on August 19, 2014. In December 2014, the Plaintiffs paid the gift tax deficiencies and accrued interest, totaling $2,218,466. The court did not disclose how the Service determined the deficiency amounts.
Subsequently, the Plaintiffs filed amended gift tax returns for tax years 2007, 2008, and 2009 seeking a refund for the additional federal taxes and interest they paid. Ultimately, the Plaintiffs initiated a lawsuit on June 24, 2016, to recover the additional gift tax and interest they were assessed.
The court heard testimony from three separate valuation professionals, John Emory and Nancy Czaplinski of Duff & Phelps who provided testimony for the Plaintiffs and Francis Burns of Global Economics Group who provided testimony for the Defendant.
Tax Affecting S Corporation Earnings
John Emory in his now decades old appraisals, tax-affected the earnings of GBP as if it were a C corporation. Mr. Emory did not complete a formal income approach arguing that the market approach was a more appropriate methodology since there were a sufficient number of comparable companies available for consideration in each tax year. However, as the court noted, “he incorporated concepts of the income approach into his overall analysis.” The effect of the tax treatment in the Emory appraisals provided no economic benefit for GBP because of its S corporation status.
Mr. Burns determined indications of value utilizing both a guideline company method under the market approach and a capitalization of earnings method under the income approach. Interestingly, Mr. Burns also applied an effective tax rate to GBP’s earnings as if it were a C corporation. The significance here is that, as indicated previously, the Service’s position has been that earnings of pass-through entity earnings should not be tax-affected because they do not pay corporate level taxes. Mr. Burns then applied a S corporation premium to account for the tax advantages associated with the subchapter S status of GBP.
In response to the criticism that Mr. Emory did not employ a separate income approach, the Plaintiffs retained Nancy Czaplinski to prepare a report using a combination of the market approach and the income approach. Under her capitalized economic income method, Ms. Czaplinski did not tax affect GBP’s earnings rather she adjusted the discount rate in the income approach to reflect an equivalent after-corporate and after-personal tax return. Under her discount dividend method, she used a tax rate based on three- and five-year averages and on the prior year effective date. In her market approach, Ms. Czaplinski used pre-tax multiples, which resulted in no difference in value relative to a C corporation because of GBP’s S corporation status. While it does not appear that the court accorded any weight to Ms. Czaplinski’s report, the court was not critical of her approaches and assumptions.
According to the court filing, John Emory and Nancy Czaplinski did not consider GBP’s subchapter S status to be a benefit that would add value to a minority shareholder’s stock because a minority shareholder could not change GBP’s corporation status.
Ultimately, the court found that Mr. Emory’s valuation was the most sound. Although the court accepted the tax-affected treatment of earnings by both Mr. Emory and Mr. Burns, the court rejected the S corporation premium applied in the Burns report.
The court stated that “GBP’s subchapter S status is a neutral consideration with respect to the valuation of its stock.” Additionally, the court noted disadvantages, “including the limited ability to reinvest in the company and the limited access to credit markets” stating that it is “unclear if a minority shareholder enjoys those benefits.”
Discounts for Lack of Marketability
The discounts for lack of marketability was another area addressed by the court. The Defendant’s expert applied marketability discounts of 10.8% for the 2007 tax year, 11.0% for the 2008 tax year and 11.2% for the 2009 tax year. Although Mr. Burns cited restricted stock studies and the costs of going public as considerations, the court noted that Mr. Burns’ marketability discounts were significantly below those of the other expert witnesses. In addition, the court cited that the discounts were also below the discounts applied by Mr. Burns in a separate valuation of an investment holding limited partnership whose underlying stock was relatively more liquid than stock in GBP. The court also criticized Mr. Burns’ use of the costs of going public in determining the marketability discounts since GBP was not likely to pursue a public offering. As a result, the court noted that the discounts assessed by Mr. Burns seemed unreasonably low.
Ms. Czaplinski applied a 20% discount for lack of marketability in each year. In determining her discounts, Ms. Czaplinski considered company and industry characteristics, including the stock restrictions in GBP’s bylaws and GBP’s S corporation status. She concluded neither the stock restrictions nor the S corporation status affected the marketability discount.
Similar to Mr. Burns’ approach, Mr. Emory considered the restricted stock studies. He also consulted pre-IPO studies, the financial position of GBP, the payment of dividends, GBP’s management, the possibility of any future public offering, GBP’s status as an S corporation and the provision restricting the transfer of stock among non-family members in GBP’s bylaws. Mr. Emory’s marketability discounts were the highest of the three experts but are lower than discounts he had applied in prior appraisals. Mr. Emory applied a 30% discount for the tax years 2007 and 2008 and a 28% discount for the tax year 2009.
While the court viewed Mr. Emory’s report as more credible, the court adjusted his discounts for lack of marketability downward by 3% in each tax year to 27% in 2007 and 2008 and 25% in 2009. Although Mr. Emory gave only minimal consideration to the family transfer restriction provision, the court ruled that the Plaintiffs did not meet the burden of proof that such restriction was not a device to diminish the value of transferred assets. Neither the Burns report nor the Czaplinski report considered family restrictions in their determinations of marketability discounts.
Other Valuation Considerations
Other considerations cited by the court with respect to the valuation reports include the public guideline companies observed in the market approach and applied by each expert. At issue was the number of companies observed by each expert and the inclusion or exclusion of one or more of the guideline companies, particularly one that was considered to be an outlier.
The court also criticized Mr. Burns overall mathematical approach to value rather than utilizing judgement citing that Mr. Burns did not account for the 2008 recession in his market approach though he stated that the market approach is effective in capturing the financial conditions at the time in the marketplace. Both the Emory report and the Czaplinski report considered the effects of the recession for the tax year 2009.
In addition, although Mr. Burns attended the deposition of GBP’s Chief Financial Officer, the court credited Mr. Emory for interviewing management, reviewing prior-years’ reports, and analyzing the guideline companies and the multiples they yielded. Further, the court credited Mr. Emory for analyzing GBP’s debt and management philosophy, and for reviewing the business metrics including price, book value, earnings, dividends, EBITDA, assets, and sales on a “holistic” basis to determine a value that best fit the guideline companies.
The court also criticized Mr. Burns treatment of the identified non-operating assets of GBP, which were comprised of an investment holding subsidiary, group life insurance policies and two private airplanes. Mr. Burns added the value of the non-operating assets to the value of the Company’s operations applying only a small discount to the investment holding entity value. The court stated that “a minority shareholder has no control over the use or dissipation of the assets and cannot realize the value of the assets until GBP is sold.” The court then opined that “because there is no expectation of liquidation, Burns’ treatment of the non-operating assets overstated the value of the stock for each year in question.”
Due to the methodology employed by Mr. Emory, the value of the non-operating assets, beyond any income provided to GBP by such assets, was not considered.
The following table provides a summary of: 1) the original value per share for each stated tax year as determined by John Emory; 2) the Service’s determination of value giving rise to the deficiency amounts; 3) the values determined by Nancy Czaplinski in her expert report for the Plantiffs; 4) the values determined by Francis Burns in his expert report for the Defendants; and, the court’s ultimate determination of values.
The major takeaway from Kress v. US is the court’s acceptance of tax affecting the earnings of an S corporation as if it were a C corporation. Additionally, rather than just accepting the tax treatment, the court went on record to state that the tax status has a neutral effect on the value of a company’s stock. This provides some vindication to valuation experts who have long argued against the rulings in Gross and other related cases.
In addition to the question of whether to tax affect, the court addressed several other valuation issues. Ultimately, the court concluded that given his failure to consider appropriate comparable companies under the market approach and the impact of the economic recession, his improper treatment of the non-operating assets, and his application of a low discount for lack of marketability, Mr. Burns overvalued the minority shares of GBP stock for each tax year.
The thoughtfulness and thorough nature of the court’s decision should be instructive to valuation professionals going forward particularly in litigated matters. In addition, while this case was not decided in tax court, the court’s acceptance of tax affecting S corporation earnings and the marketability discounts allowed will likely have significance for future gift and estate tax valuations.