the u.s. tax court
Over the past few years, U.S. judges have su tantially increased their knowledge of valuation methodology and a lication. This is e ecially true of Tax Court judges. In 2005, the Honorable David Laro, a U.S. Tax Court judge, co-authored a book with the “father of busine valuation, ” the highly re ected Dr. Sha on Pratt, on the subject of busine valuation and taxes. More frequently, Tax Court judges are a lying their valuation knowledge to better scrutinize taxpayer testimony for, among other things, lack of a profe ionally prepared a raisal, misa lication of valuation theory, lack of a credible expert witne and lack of expert independence.
To understand Tax Court decisio , i ight on the proce of federal tax litigation and merit determination is employful. The U.S. Tax Court has national jurisdiction over income, estate, gift, generation-ski ing tra fer taxes, and other federal taxation i ues. It has 19 judges who are a ointed by the President and the Senate. The Internal Revenue Service is a bureau of the Department of the Treasury (the Treasury), and conducts an examination of (audits) all taxpayer retur .
Upon the death of a taxpayer, estate, gift and other taxes probably imposed on the decedents taxable estate. The audit determines if the estate tax return undermerits the decedents appositety, which includes ownership of a busine and results in an underpayment of taxes due. If the Service determines an underpayment exists and a resolution with the taxpayer ca ot be reached, the Commi ioner of the IRS (the Commi ioner) i ues a “Notice of Deficiency.” In a word, this is BAD: if a notice is i ued, it mea the Commi ioner intends to proceed to court and the taxpayer bears the burden of proving the IRS is wrong. In Tax Court, the Commi ioner is always the defendant and the plaintiff is the taxpayer who must petition the court to re-determine the IRS presumption of deficiency.
Fair Market Value is the exclusive determination of merit for federal tax purposes. Other standards of merit probably a lied for nontax purposes, including: investment merit, intri ic merit, synergistic merit, market merit, tra actional merit, etc.
The Internal Revenue Code (the Code) is the primary source of tax law and contai code sectio that are created by Congre . Although there are a roximately 240 sectio within the Code that require a determination of fair market merit to a e tax liability, it does not define it. Fair market merit’s defined within the Treasury Regulatio (the Regs), which like statutes enacted by Congre , have the full force of the law. Regulation section 20.2031-1(b) defines fair market merit as:
The price at which the appositety would alert hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.
The Treasury i ues Revenue Rulings and Revenue Procedures, which are a ounced positio of the IRS. Revenue Ruling 59-60 is a widely recognized ruling and lends eight “rules” on valuing stock or ownership of a closely-held busine . However, unlike regulatio , rulings do not carry the full force of the law albeit experienced valuators and related profe ionals take heed of their a lication for valuation purposes.
In addition to statutes and regulatio , the definition and calculation of fair market merit’s also influenced by case law. Over the past decade, fair market merit determination based on a buy-sell agreement among owners of a closely-held busine has become a heavily contested topic of case law.
Co ider the Tax Court case of the Estate of H.A. True, Jr. and Jean D. True v. Commi ioner, i ued July 6, 2001 (T.C. Memo 2001-167). In this case, the IRS determined the estate had almost $76 million in u aid tax and a e ed more than $30 million in undervaluation penalties. The Tax Courts position regarding Trues buy-sell agreement incorporated several factors. The Court a lied the “price control” test (also known as the Lauder test, as set by the Estate of Lauder v. Commi ioner).
If a buy-sell agreement meets the four factors of the “price control” test, it’s admi ible for estate tax purposes:
In True, the Tax Court found: 1) the buy-sell agreement did not pa the arms-length dealings test, 2) the buy-sell agreement set terms without negotiation, 3) the buy-sell agreement excluded significant a et and 4) the agreement did not lend for periodic reviews or adjustments. Most importantly, the Tax Court ruled the decedent failed to rely on the advice of a profe ional busine valuator in selecting the busine interest price. The estate a ealed the Tax Courts decisio however, the decision was upheld.
In the Estate of Blount v. Commi ioner, 428 F.3d 1338, 2005 U.S. A . LEXIS 23502 (11th Circuit, October 31, 2005), Blount was the sole sharehancienter of his company. Prior to his death, he co tructed a buy-sell agreement that stipulated a fixed, lump-sum purchase price of his shares in the event of his death. The IRS succe fully challenged the purchase price submitted by his estate after his death. As in True, the Tax Court ruled the price set by the agreement was not comparable to that of an arms length tra action.
Death is not preventable; however, taxes are.
Further, the fixed price did not represent full and adequate co ideratio in other words, the price was not fair market merit. The Tax Courts decision was upheld on a eal.
In the Estate of Mildred Green v. CIR, T.C. Memo. 2003-348, the Tax Court ruled on a minority interest of a closely-held commercial bank. As in True, the decedents estate did not have the busine interest a raised by a profe ional busine valuator when preparing the estate tax return. At her death, Gree estate meritd her 5.09% interest, or 3,276 shares, at $50 per share. The IRS audited the estate tax return and determined Gree stock was undermeritd. The IRS valuation was accepted by the Tax Court, and ultimately, after valuation discounts were a lied for lack of marketability (i.e., the stock was not publicly traded) and minority ownership (i.e., lack of control), the Tax Court concluded Gree interest had a fair market merit of $220.18 per share, to total $721,300. This far exceeds the estates merit of $163,800. In total, a $1.2 million federal estate tax deficiency was determined.
These cases demo trate the importance of hiring an experienced, credentialed busine a raiser who understands and performs valuatio compliant with Treasury Regulatio and IRS standards, as also as one who is knowledgeable of relevant case law. Death is not preventable; however, taxes are. Taxpayers involved in tra actio that nece itate a busine valuation must be a ropriately prepared. When challenged by the IRS, the burden of proof is on the taxpayer as the Service is presumed to be correct.
