Kaufman v. Commissioner – Part II: Back to School on Fair Market Value
In April 1999, the Tax Court issued a decision authored by Judge David Laro in KAUFMAN (ALICE FRIEDLANDER KAUFMAN v. COMMISSIONER, T.C. Memo. 1999-119, No. 17050-97 (April 6, 1999)). In that decision the appraiser for the taxpayer, Mr. Bret Tack, ASA, took it on the proverbial chin. Mr. Tack provided an appraisal of Seminole Manufacturing Company (“Seminole”) as of April 14, 1994. He concluded that the fair market value of the subject 19.9% interest of Seminole was $30.85 per share.
Mr. Tack’s conclusion was based on his overall valuation, which considered two transactions that occurred shortly after the valuation date at $29.70 per share (which were based on an appraisal rendered shortly before the valuation date). Tack’s report was reviewed harshly by the Tax Court and rejected. A decision was rendered in favor of the Internal Revenue Service.
To frame this issue, we begin with the conclusion of the Tax Court in KAUFMAN.
“Having done so [rejected Tack], we would typically proceed to value the estate’s shares on the basis of the record at hand. In the typical case, we find much information and data on the subject corporation, as well as financial studies and data which allow us to compute value and marketability discounts using MANDELBAUM (T.C. Memo. 1995-255, affd. 91 F.3d 124 (3d Cir. 1996)) [another opinion written by Judge Laro] and other factors mentioned above. The instant case, however, it atypical. Petitioners, in short, ask us to close our eyes to the inadequate record and adopt without adequate verification Mr. Tack’s conclusion and the managerial representations upon which he relied. We decline to do so. Valuation cases require that we determine a value based on the evidence at hand. Whereas we may determine a value with the assistance of experts, if we consider it helpful, we will not accept an expert’s conclusion when it is unsupported by the record. The record must be built by the parties to include all data that is necessary to determine the value of property in dispute. Valuation experts must perform unbiased and thorough analyses upon which we may rely. Where, as is the case here, the record falls short of the standard which we require, we are left to decide the case against the party who has the burden of proof. Because the petitioners bear the burden here, we sustain respondent’s determination, as modified by concessions in brief. We hold that the fair market value of the estate’s stock was $56.50 per share.”
KAUFMAN was appealed to the U.S. Court of Appeals for the Ninth Circuit, which rendered its opinion on March 15th of 2001, almost two years after the Tax Court’s decision (MORRISSEY, et. al. v. COMMISSIONER, No. 99-71013, March 15, 2001). The Ninth Circuit concluded as follows:
“The executors of the Estate of Alice Friedlander Kaufman appeal the judgment of the Tax Court assessing a deficiency of $209,546 against the Estate. We hold that the Tax Court disregarded what should have been dispositive, viz., the price at which stock owned by the Estate had traded between willing and knowledgeable buyers and sellers. Accordingly, we reverse the judgment and remand to the Tax Court for entry of judgment for the Estate.”
We originally wrote about KAUFMAN in the 1999-07 issue of E-LAW. This second E-LAW on KAUFMAN is prompted by the great Casey Stengel who, among other things, is reported to have said “It ain’t over ’til it’s over!” Mr. Tack will most likely concur. Yet unfortunately for him, having found that the dispositive evidence was disregarded, the Ninth Circuit did not address the Tax Court’s criticism of his report.
This one is probably over but, hopefully, a brief review of the issues can be helpful to business appraisers as well as to attorneys in future cases. The good news for readers of E-LAW (and us) is that our initial review of KAUFMAN identified the elements that ultimately resulted in its reversal.
Kaufman Was Controversial and Received Broad Exposure
KAUFMAN received a good bit of press in the valuation community, including the following:
- E-LAW 1999-07: “KAUFMAN v. COMMISSIONER – A Case for Well-Documented and Well-Reasoned Business Appraisals.” This case review considered the Court’s criticisms of the Tack report in the context of business valuation standards. However, I sided with Tack on several key points.
- Shannon Pratt’s Business Valuation Update, May 1999: “Taxpayer’s expert ‘unpersuasive’; record doesn’t meet burden of proof; IRS wins by default.” This review was written without editorial comment, and essentially reported what the case held. The article was also reprinted in Pratt’s JUDGES & LAWYERS BUSINESS VALUATION UPDATE that month.
- JUDGES & LAWYERS BUSINESS VALUATION UPDATE, June 1999. Mr. Tack wrote a rebuttal to the Court’s opinion that was titled “Expert dubbed ‘unpersuasive’ rebuts Judge Laro’s rejection.” In this article, Mr. Tack expressed concern that the earlier review “unfairly portrays me as having not done a credible valuation because it takes Judge Laro’s criticisms of my report at face value.” He then proceeded to address each of the Court’s criticisms. Suffice it to say that the pain he surely felt at the Court’s hand was clear in this rebuttal. Nevertheless, his rebuttal indicated that his report dealt head on with each of the Tax Court’s criticisms and was, in fact, compliant with prevailing business valuation standards.
- VALUATION STRATEGIES, July/August 1999: “Are Business Valuation Standards Being Invoked by the Tax Court?” A somewhat revised version of E-LAW 1999-07.
- SHANNON PRATT’S BUSINESS VALUATION UPDATE, September 1999: “Mercer Scrutinizes Tax Court.” This article was a review of the VALUATION STRATEGIES article.
This list is not exhaustive but suffice it to say that the KAUFMAN case was the subject of debate among appraisal professionals.
Issues Raised in Kaufman
Our initial review of KAUFMAN was based solely on a reading of the case (based on our experience with this case and with numerous others, we attempt to obtain the appraisal reports when conducting in-depth case reviews). In that initial review, I suggested that there were underlying issues related to the credibility of a taxpayer’s fact witnesses in Court, the quality of the business appraisal reports, and the credibility of expert witnesses, including consistency between reports and testimony. These issues appear to have influenced Judge Laro’s opinion considerably, and the Ninth Circuit’s not at all. As noted in E-LAW 1999-07, KAUFMAN raised three important questions for consideration by appraisers.
- What constitutes an arm’s length transaction in the stock of a closely held company – in the real world?
- When can an actual transaction provide evidence of fair market value?
- What is the net asset value method and how is it considered by business appraisers?
The Ninth Circuit’s reversal of KAUFMAN was based primarily on issues 1 and 2 above, which obviously relate to the definition of fair market value. The third issue was not raised in the appellate court’s opinion.
The Ninth Circuit’s Opinion
The appellate decision consists of five pages. In that space, the Ninth Circuit got down to the issues of the case.
The subject interest of Seminole represented 19.9% of the common stock of the company. As noted above, there were two transactions approximately contemporaneous with the valuation date (of 3.25% and 4.67% interests, respectively). The transactions occurred at $29.70 per share, which was close to Tack’s conclusion, derived using normal valuation methodologies, of $30.85 per share. He concluded that “one [indication] supported the other” in his rebuttal letter (cited above). He further stated in that letter:
“Judge Laro claims that these transactions were not arm’s length. As I understand it, the term “arm’s length” refers to the relationship of the parties and not to the level of due diligence conducted by the buyers or sellers.
These transactions were certainly arm’s length in that the individuals who transacted in the shares, while distantly related, were certainly not close, could not remotely be considered as the natural objects of one another’s bounty and clearly [were] not interested in entering into a transaction in which they would be enriching the other party at their own expense.”
In my review, based on the information in the decision, I agreed with Tack. As noted in E-LAW 1999-07:
“We do not know from the record the weight attached to the transactions by Tack. But the Court disagreed with any reliance on the two transactions noted. The Court dismissed Tack’s considerations of the transactions as being indicative of fair market value. While the parties were made aware of the Merrill Lynch report’s conclusion before they sold their shares, they conducted no financial analysis, did not read the Merrill Lynch appraisal, and nevertheless engaged in the transactions based upon representation of that report’s conclusion as $29.77 per share. The Court concluded that the transactions were not arm’s length in nature, and that the parties acted without full knowledge. There was, however, no mention in the decision of compulsion on either party’s part.
From the discussion in the case, it appears that the transactions may have been what I would consider arm’s length. In the real world, arm’s length transactions do not necessarily suggest that all parties are fully informed. Appraisers and others sometimes confuse what may be arm’s length transactions where people act in their own interests and without compulsion, often without full knowledge, with the hypothetical transactional requirements of fair market value. The Court in this case appears to be requiring that a real world transaction meet the hypothetical requirements of fair market value, rather than asking whether that transaction provides evidence of fair market value. This is not a distinction without a difference.”
The Ninth Circuit decision noted the following:
“Each seller subsequently testified before the Tax Court that the price was fair and that the sale had been under no compulsion.”
“The Commissioner tries to make something out of the family connections of the sellers with the buyers. They were not especially close. Hoffman had an uncle related by marriage to Weitzenhoffer’s uncle; there is no English work to name this relationship. Branch was Weitzenhoffer’s first cousin. Each seller testified that there was no intention to make a gift to Weitzenhoffer.”
Apparently, as the judge hearing the evidence, Judge Laro had questions about the credibility of these witnesses, which was one of the underlying issues noted at the outset. But the Ninth Circuit disagreed with the Tax Court on the issue of the relevance of the transactions and considered them to be arm’s length in nature and providing “good evidence of the fair market value.” In disagreeing, the definition of fair market value was cited, and then the Court noted:
“[Definition of fair market value]. The willing buyer and willing seller are to be postulated, not as a particular named X or Y, but objectively and impersonally. As the Tax Court itself has held, the Commissioner cannot “tailor ‘hypothetical’ so that the willing seller and willing buyer were seen as the particular persons who would most likely undertake the transaction.” Actual sales between a willing seller and buyer are evidence of what the hypothetical buyer and seller would agree on. [citations omitted]
No good reason existed to reject the sales by Branch and Hoffman as evidence of the fair market value of Seminole stock on April 14, 1994. The sales took place close to the valuation date. The sellers were under no compulsion to sell. There was no reason for them to doubt Weitzenhoffer’s report of the Merrill Lynch valuation.
That the final report was delivered only in July did not undercut the weight of the formal opinion letter written in March. The sellers had no obligation to hire another investment firm to duplicate Merrill Lynch’s work.”
In the original Tax Court decision, the Court suggested that Tack “ignored the value that inured in the estate’s shares on account of the fact that Seminole was a family-owned business that was intended by the shareholders to be kept in the family.” In E-LAW 1999-07, this point was addressed in the context of the relevant restrictive stock agreement, saying:
“It appears that the Court is turning an economic disadvantage (restrictions on transfer) into an apparent advantage in the decision. In this case, the Court attributed motives to family members to buy minority stock at apparently attractive values in order to avoid shareholder litigation from outsiders. It is hard not to suggest that there is an element of family attribution in this portion of the Court’s decision.”
The concept of fair market value does not attribute value to family relationships not available to hypothetical buyers and sellers. Tack was criticized for ignoring such relationships. In reality, he looked at the evidence and found that the transactions were arm’s length. The Ninth Circuit agreed, and addressed the issue further:
“The Tax Court also engaged in the speculation that the Estate stock could be sold to a non-family member and that, to avoid the disruption of family harmony, the family members or Seminole itself would buy out this particular purchaser. The law is clear that assuming that a family-owned corporation will redeem stock to keep ownership in the family violates the rule that the willing buyer and willing seller can not be made particular. [citing ESTATE OF JUNG]. The value of the Seminole stock in Alice Friedlander Kaufman’s hands at the moment she transferred it by death cannot be determined by imagining a special kind of purchaser for her stock, one positioning himself to gain eventual control or force the family to buy him out.”
(The Tax Court was also swayed by this argument in SIMPLOT. We disagreed with it in that case, as well.)
The judgment of the Tax Court was reversed by the Ninth Circuit, and the case was remanded to the Tax Court for entry of judgment for the estate.
The “No Expert Testimony on Direct” Rule
Another important observation was made by Paul Hood, writing in STEVE LEIMBERG’S NEWS OF THE WEEK [www.leimbergservices.com]:
“Some of the problems in this case could have been resolved if the taxpayer’s expert would have been permitted to testify on direct. Over the past few years, the Tax Court has liberalized its evidentiary rules. Now seems an appropriate time for the Tax Court to at least reconsider the “no expert testimony on direct” rule as well. Perhaps it is time for the Tax Court to consider scrapping this rule altogether.”
Thanks go to Paul for this observation about direct testimony in Tax Court. Mr. Tack would likely have been better able to present his report and major arguments in direct testimony to lay the groundwork for adversarial cross-examination. As a business appraiser who has been subjected to vicious cross-examination within moments of taking the stand, I concur with a call for reconsideration of this “no expert testimony on direct” rule.
Readers can draw their own conclusions about the Ninth Circuit’s reversal of KAUFMAN. As an appraiser and newsletter writer, let me conclude with three observations:
- Bret Tack should hopefully feel good about it, even though his name is not mentioned in the appellate decision. No expert likes to be written about in a court opinion in a fashion that can undermine his or her credibility in future engagements. His conclusion was affirmed by the Ninth Circuit, even if his report was not openly vindicated. And the Ninth Circuit’s reversal of KAUFMAN adds credence to his rebuttal of the other aspects of his appraisal criticized by the Tax Court.
- I’m glad we wrote about the case originally in an “evenhanded” manner. Our 1999 review was balanced and on point, even in the context of this reversal by the Ninth Circuit.
- And, I’m gratified that we identified the critical issues in the case and took a stand on them.
Upon first reading KAUFMAN, there appeared to be a call to a higher standard for business appraisers, and, therefore, it was discussed in the context of business valuation standards. The points made in E-LAW 1999-7 and in the article for VALUATION STRATEGIES were good but the crux of the reversal by the Ninth Circuit flowed from the definition of fair market value and an appraiser’s interpretation of how two fairly contemporaneous transactions in a private company’s stock provided evidence for the fair market value of the subject interest.
It is clear that appraisers must understand not only the definition of fair market value, but also the nuances of its implementation and interpretation. In reversing KAUFMAN, the Ninth Circuit has taken business appraisers and the Tax Court to school on this subject.
Reprinted from Mercer Capital’s E-Law Newsletter 01-03, April 9, 2001.