Fifth Circuit, Reversing Tax Court, Clarifies Valuation of Privately Held Corporations

By Peter C. Barton and Clayton R. Sager

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Prior Law

Case law has long established that fair market value is the price a willing buyer would pay a willing seller, both having reasonable knowledge of the facts, and neither under compulsion. In general, when no recent transactions in the stock have occurred, there are two approaches to valuing a privately held corporation: the earnings-based method (calculated using income or cash flow) and the asset-based method.

Revenue Ruling 59-60, 1959-1 CB 237, specifies the following factors in determining the fair market value of a privately held corporation’s stock: earnings; financial position and book value; economic and industry outlook; management skills; dividend-paying capacity; goodwill; the size of the block of stock; and the value of similar businesses. Revenue Ruling 59-60 also states that, in general, earnings may be the most important criterion when valuing a business selling products or services, whereas the value of the assets may be most important in valuing an investment or holding company.

Facts of Dunn

Beatrice Dunn, owner of 63% of Dunn Equipment common stock, died in 1991. Dunn Equipment rents heavy equipment, with or without trained operators. From 1987 to 1991, Dunn Equipment paid no dividends, its officers were paid relatively low compensation, and it had an average annual cash flow of $286,421. In 1991, with assets of approximately $8.27 million and liabilities of $7.3 million, Dunn Equipment was a viable operating company with 134 employees and strong community ties. To sell, liquidate, or merge Dunn Equipment required a super majority (two-thirds vote of the outstanding shares) under state law.

On the estate tax return, decedent’s Dunn Equipment stock was valued at $1,635,465. The IRS valued the stock at $2,229,043 in the deficiency notice. Subsequently, in Tax Court filings, the IRS valued the stock at $4,430,238. The estate’s expert argued for assigning equal weight to the earnings-based value and the asset-based value, and for a 34% reduction to the asset-based value for the corporate income tax on liquidation of Dunn Equipment. This income tax flows from the accrued taxable gains on the disposal of equipment. The IRS based its value solely on the asset-based method, arguing that the lower value from the earnings-based method should be ignored because of the large difference between the two methods’ results. The IRS also allowed no reduction for income tax. Both parties subtracted discounts for lack of super-majority control and lack of marketability.

Tax Court Ruling

In its ruling, the Tax Court assigned a 35% weight to the earnings-based value and a 65% weight to the asset-based value, and then allowed a 5% reduction for income taxes from the asset-based value. The Tax Court ruled that the full asset-based value of Dunn Equipment was $7,922,892, and the full earnings-based value, using cash flow, was $1,321,740. Furthermore, the Tax Court allowed the two discounts, resulting in a value for the decedent’s 63% ownership interest of $2,738,558, which exceeded the value reported on the estate tax return by more than $1 million. The Tax Court noted, following Revenue Ruling 59-60, that perhaps no weight should be assigned to the asset-based value for an operating business. However, the court found that Dunn Equipment was at a low point in its business cycle in 1991; therefore, the low earnings-based value required a 65% weighting for the higher asset-based value to produce the correct overall value. Regarding the reduction from the asset-based value for income tax on the sale of assets, the Tax Court ruled that because the likelihood of liquidation for Dunn Equipment was low, the reduction should be 5%, not 34%. The estate appealed both this 5% ruling and the Tax Court’s assignment of the relative weights.

Fifth Circuit Ruling

The Fifth Circuit reduced the asset-based weight to 15%, increased the earnings-based weight to 85%, and allowed the full 34% reduction for income tax. The Fifth Circuit rejected the IRS’ contention that no weight should be given to the earnings-based value as “legally and factually absurd,” and characterized the Tax Court’s 65% weight to the asset-based value as “inconsistent with all findings and expressions of the court.” Agreeing with the Tax Court’s findings that Dunn Equipment’s liquidation was unlikely, that its fixed assets (the equipment) were not appreciating, and that it would continue as an operating business in the short and long term, the Fifth Circuit assigned a low weight to the asset-based value. The Fifth Circuit further found that Dunn Equipment was not at a low point in its business cycle, but rather that its earnings had been flat for the previous 10 years and were not expected to increase.

Regarding the reduction for income tax, the Fifth Circuit ruled that a buyer wanting to acquire a corporation’s assets that buys a majority block of its stock would insist that the price reflect a reduction for the full dollar amount of income tax on the sale of these assets. The asset-based method assumes the assets will be sold, either by Dunn Equipment to the willing buyer, or by the willing buyer of the stock to a third party. Therefore, the likelihood of liquidation is irrelevant. Conversely, this reduction for income tax would not enter into calculating the earnings-based value because the willing buyer would retain the assets to operate the business. Based on the Fifth Circuit’s rulings, and after subtracting the two discounts, the decedent’s stock would be valued at approximately $1,130,000, which is approximately $500,000 less than the estate tax return value.

Favorable Implications

Estate of Dunn provides taxpayers with two favorable rulings concerning the valuation of privately held corporations. Even though Dunn Equipment did not have significant cash flow, the fact that it was an operating business with reasons for not liquidating persuaded the Fifth Circuit to heavily weigh the earnings-based method, resulting in a much lower valuation. Of course, this ruling is most helpful in cases where the asset-based value significantly exceeds the earnings-based value. In addition, to the extent that the asset-based method determines the stock’s value, income tax on the sale of assets can be subtracted from that value.

Even though Estate of Dunn is binding only in the Fifth Circuit, the opinion is well reasoned and may affect future decisions in other circuits or in the Tax Court.