Value of S Stock and SCINs for Gift Tax Purposes
In Dallas,1 Judge Colvin of the Tax Court—in a concise opinion—refused to “tax-affect” the earnings of an S corporation. Tax-affecting is the discounting of the estimated future corporate earnings based on an assumed loss of S corporation status and the imposition of corporate-level tax.2 The court also decided that the value of a promissory note containing a self-canceling clause, but without a premium component, is less than its face value. The court discussed as well the application of minority interest discounts and discounts for lack of marketability.
In the years 1999 and 2000, the taxpayer sold a total of 55% of the non-voting stock in an S corporation to trusts established for the benefit of each of his two sons, in exchange for cash and promissory notes from the two trusts. The notes were signed by the sons as trustees of the trusts. The taxpayer and his sons agreed to be bound by a value for the stock as set by an appraiser.
The promissory notes exchanged in the 1999 sale contained a self-canceling clause (i.e., a self-canceling installment note or “SCIN”), which provided that the notes would be deemed paid if the taxpayer died before the notes were paid in full. The promissory notes exchanged in the 2000 sale did not contain a self-canceling clause. The sale agreements for the 1999 sale and the 2000 sale both contained a share adjustment clause, which provided that in the event that the value of the stock sold was determined by the IRS to be greater than that determined by the appraiser, then the trusts would transfer to the taxpayer without any additional consideration a number of shares determined in accordance with a formula in an attempt to prevent a gift to the trusts as a result of the valuation of the stock by the IRS.
As part of the 1999 transaction, the taxpayer hired an appraiser to value the stock sold to the two trusts. In valuing the corporation, the appraiser used a capitalization of income approach, and opined that a reasonable buyer would assume that the corporation's net income should be reduced by 40% due to “tax-affecting.” In addition, the appraiser assumed that if stock of the corporation was sold to a third party, the compensation paid by the corporation to the taxpayer and his sons (who were officers of the corporation) would be reduced, thereby causing the income of the corporation to increase. The appraiser applied a 15% discount for lack of control and a 35% discount for lack of marketability.
With respect to the 2000 transaction, the corporation's chief financial officer and executive vice president used the methodology used in the 1999 appraisal to determine the sale price for the stock for the year 2000.
The IRS audited the taxpayer's 1999 and 2000 gift tax returns. During the audit, the IRS told the taxpayer's attorney that since the promissory notes used in the 1999 transaction contained a self-canceling clause, they were worth less than their face value because the notes would be canceled if the taxpayer died before the notes were paid in full. Shortly thereafter, the taxpayer and the trustees of the two trusts executed new promissory notes that were substantially identical to the original notes except that they did not contain a self-canceling clause.
As a result of the audit, the IRS determined that the taxpayer was liable for gift tax because: (1) the value of the stock sold in 1999 and 2000 was greater than that determined by the appraiser, and (2) the value of the 1999 promissory notes was less than their face value because of the self-canceling clause.
The taxpayer contended that the price paid for the stock was in fact its fair market value (“FMV”) because: (1) the price paid was set by the appraiser, and (2) the parties properly structured the sales of stock as arm's-length transactions. The Tax Court disagreed and held that the price paid for the stock was not an arm's-length price. According to the court, the transactions were designed to advance the taxpayer's estate planning goals as evidenced by the fact that the 1999 promissory notes contained a self-canceling clause and the 1999 and 2000 sale agreements contained share adjustment clauses. The court further noted that the taxpayer's sons were not represented by their own counsel in the transactions. Moreover, while recognizing that the fact that the taxpayer's sons did not negotiate the terms of the agreements is not dispositive of the issue, the court stated that it is nevertheless a factor suggesting the lack of an arm's-length transaction.
The court next turned to a discussion of the reports of the taxpayer's two appraisers and the IRS's appraiser and the experts' respective testimony. In addition to the appraiser that performed the appraisal for the 1999 transaction, the taxpayer obtained for trial the report of a second appraiser.
With respect to tax-affecting, the taxpayer's first appraiser reduced the corporation's projected income by 40% on the assumption that, after a sale, the corporation would lose its S corporation status. Similarly, the taxpayer's second appraiser reduced the corporation's projected income by 35% based on the fact that a shareholder is liable for income tax on S corporation profits even if those profits are not distributed to the shareholder.
The court found that there was no evidence in the record that the corporation expected to cease to qualify as an S corporation. The record also demonstrated that the corporation had a history of distributing enough earnings for the shareholders to pay their individual income tax on the corporation's earnings. Moreover, there was no evidence that the corporation intended to change its practice of making sufficient distributions to cover the stockholder's individual income tax liability. The court concluded that there was insufficient evidence to establish that a hypothetical buyer and seller would tax-affect the corporation's earnings, and therefore tax-affecting the corporation's earnings by the appraisers was not appropriate.
The court distinguished a case decided by the Delaware Chancery Court3 that applied tax-affecting to determine whether minority stockholders received fair value for their stock in a merger. The Dallas court held that fair value in minority stock appraisal cases is not the equivalent of FMV for gift tax purposes.
The court next discussed whether, for purposes of determining the value of the stock, the earnings of the corporation should be increased based on the assumption that the taxpayer and his two sons were receiving unreasonable compensation. This assumption was based on the theory that such compensation would be reduced voluntarily or as a result of litigation brought by a minority shareholder if a minority block of stock in the corporation was sold to an unrelated investor. The court concluded that such an adjustment to earnings was not required because: (1) the record did not contain the factual analysis customarily used in deciding whether compensation was unreasonable, and (2) there was nothing in the record to suggest that the corporation was planning to change the manner in which it paid the taxpayer and his sons.
The court next discussed the proper amount of the discount for minority interest and lack of marketability. The court ruled that a discount for lack of voting power, in addition to a discount for minority interest, was not appropriate. The court believed that any anticipation of minority shareholders pooling their votes was too speculative.
The appraiser for the taxpayer and the appraiser for the IRS both concluded that a minority interest discount of 15% for non-operating assets was appropriate, and the court accepted their conclusion. Similarly, the court agreed with the IRS's appraiser that a minority interest discount of 20% for operating assets was appropriate.
With respect to a discount for lack of marketability, the taxpayer's appraiser concluded that a 40% discount was appropriate while the IRS's appraiser concluded that a 20% discount was proper. The court accepted the conclusion of the IRS's appraiser.
Next, the court analyzed whether the values of the promissory notes exchanged in the 1999 transaction were less than their face value because the notes contained a self-canceling clause. The taxpayer contended that the self-canceling clause should not be given any effect because the promissory notes were ambiguous as to whether they were self-canceling. Alternatively, the taxpayer argued that inclusion of the self-canceling clause in the promissory notes was a drafting mistake.
The court held that the self-canceling clause must be given effect because the court believed that the promissory notes unambiguously provided that they were self-canceling. One of the taxpayer's attorneys who advised the taxpayer regarding the 1999 and the 2000 transaction testified at trial that the intent of the clauses was to treat the unpaid portion of the notes as a gift from the taxpayer to his sons in the event of the taxpayer's death before the notes were paid in full. A memorandum to the attorney's file, which corroborated his testimony, was introduced into evidence at trial. Moreover, the self-canceling clauses were not the result of mistake, undue influence, fraud, or duress. The taxpayer did not present any evidence on the FMV of the 1999 promissory notes. Having rejected the taxpayer's arguments, the court therefore accepted the IRS valuation of the 1999 promissory note in an amount that was approximately 25% less than its face amount.
Finally, the court addressed the share adjustment clause. In its opening brief, the IRS contended that the share adjustment clauses were void because they are against public policy. In his brief, the taxpayer did not respond to the IRS's argument. Therefore, the court deemed this issue conceded because of the taxpayer's failure to respond.
This case illustrates the importance of properly planning the implementation of an estate planning technique as well as adequately preparing for trial. At the planning stage, the taxpayer should have included a premium component in the promissory notes to compensate the taxpayer for the self-canceling feature of the notes. Dallas lends judicial support to the necessity for a premium component in such notes—a fact which many estate planning attorneys have long recognized.
At the trial stage, an attorney preparing a case for trial must thoroughly review the experts' reports that are to be introduced into evidence and must adequately prepare witnesses who are to testify at trial. In Dallas, the testimony at trial of the taxpayer's two estate planning attorneys was contradictory. In addition, the court stated that the report and testimony of the IRS's appraiser were more convincing, cogent, and thorough than the reports and testimony of the taxpayer's appraisers. The court said that the taxpayer's second appraiser was substantially unfamiliar with his report and that his report contained passages that were lifted verbatim from the report of the taxpayer's first appraiser. In determining the discount for lack of marketability, the taxpayer's second appraiser failed to use discount studies that covered the period 1999 and 2000. Furthermore, the taxpayer, other than arguing that the self-canceling clause should be ignored, failed to present any evidence regarding the FMV of the 1999 promissory notes.
1 TC Memo 2006-212, RIA TC Memo ¶2006-212, 92 CCH TCM 313.
2 See Gross, TC Memo 1999-254, RIA TC Memo ¶99254, 78 CCH TCM 201 aff'd 88 AFTR 2d 2001-6858, 272 F3d 333, 2001-2 USTC ¶60425 (CA-6, 2001); Bogdanski, Federal Tax Valuation, ¶6.03[e][i].
3 Del. Open MRI Radiology Associates, P.A. v. Kessler, 898 A2d 290 (Del. Ch., 2006).