Elitsa L. Healy

The Importance of Relevant Data and Reasoned AnalysisThe recent U.S. Tax Court opinion in Kaleb J. Pierce v. Commissioner of Internal Revenue (T.C. Memo 202529) offers insight on several issues that regularly feature in the valuations of privately held business interests. By presenting an issue-by-issue analysis, the Pierce decision reinforces an important message for appraisers and estate planners: relevant data and reasoned analysis carry the day in court.BackgroundThe subject company, Mothers Lounge, LLC, an S corporation for tax purposes, sold mother and baby products. The company sold cheaply manufactured goods directly to consumers. The business relied on a “free, just pay shipping” no returns model, which afforded it a high profit margin, but came with a plethora of unsavory business practices, including copying competitor products, over-charging customers for shipping, undermining wholesalers and marketing affiliates, and suppressing customer reviews. The business history and practices detailed in the Findings of Fact are sufficient to raise eyebrows in a room full of former FTX executives. The dubious business model invited frequent litigation, with most lawsuits filed for trademark infringement. Two lawsuits were specifically described, one of which was for patent infringement and illegal marketing practices that had “ballooned into an existential threat.” Adding to these murky undercurrents were an affair of one of the business principals and a blackmail demand letter that spurred an FBI investigation. As noted by the Tax Court, these developments had “caused extreme dysfunction with the company’s management and demoralized the workforce” in the timeframe before the valuation date.The company’s business practices may have raised eyebrows, but they were lucrative. The first successful product, a nursing cover, illustrates the model (see Figure 1).Despite giving the product to customers for “free,” Mothers Lounge, LLC earned a healthy 64% contribution margin on each unit sold, which was more than sufficient to cover all other operating expenses of the business. In 2013, the company had an EBITDA (earnings before interest, taxes, depreciation and amortization) margin of 29%, which many readers will recognize as above average for a consumer products business. The company was debt-free and required minimal investments in depreciating assets, making EBITDA a good proxy for pre-tax cash flow. The Pierce court had to decide the proper value for gift tax purposes of two minority interests in Mothers Lounge, LLC that were transferred in 2014 (a 29.4% interest and a 20.6% interest).Expert WitnessesThe taxpayer’s expert prepared a valuation report submitted at trial. During the administrative appeal of the case in 2017, the taxpayer’s expert had also prepared a forecast for the business (the “2017 Forecast”). The taxpayer’s expert did not rely on the 2017 Forecast in his appraisal of the subject interests before the Tax Court, but the valuation expert for the IRS did. To recap, there were two valuation experts at trial, one for the taxpayer and one for the IRS. In preparing his appraisal, the IRS’s valuation expert relied on the 2017 Forecast prepared by the taxpayer’s expert, but the taxpayer’s expert did not rely on the 2017 Forecast in preparing his appraisal.Key IssuesForecastWhile both experts agreed on the application of the income approach, they relied on different forecasts. The forecast prepared by the taxpayer’s expert for his appraisal report relied on an analysis and assessment of relevant factors and market trends “known or knowable” as of the valuation date, which the Court deemed credible. In contrast, the IRS’s valuation expert relied on the 2017 Forecast “without independent verification,” which the Court easily rejected.The fact that the taxpayer’s expert prepared the forecasts underlying both his own report and that of the IRS’s valuation expert is a unique feature of the case. While the Pierce court deemed the forecast used by the taxpayer’s expert credible, it declined to ascribe weight to the 2017 Forecast used by the IRS’s valuation expert (which was prepared by the taxpayer’s expert). According to the opinion, the taxpayer’s expert “was in a time crunch” to prepare the 2017 Forecast and he ultimately relied on post-valuation data to support its projections. The Court noted that the 2017 Forecast lacked any analysis or discussion of the events surrounding the FBI investigation and inappropriately relied on post-valuation data. The Court pointedly stated that “this reliance blurs the line between information that was known or knowable as of the valuation date and the information that was not reasonably foreseeable as of the valuation date.”Tax AffectingBoth experts agreed that tax affecting the earnings of the company (an S corporation) was appropriate and used the Delaware Chancery method to calculate substantially equivalent tax rates (26.2% and 25.8%).The Court commented that tax affecting earnings of tax pass-through entities can be rejected where “a party fails to adequately explain” its necessity or where the experts “have not accounted for the benefits of S corporation status to shareholders.” We note that the 2017 Tax Cuts and Jobs Act brought C and S corporations closer to parity in taxation, diminishing the additional economic benefits formerly realized by owners of pass-through entities. Nonetheless, the Pierce opinion affirms that the valuation of an interest in a tax pass-through entity should account for the effect, if any, of tax status on the value of the interest.Discount RateMothers Lounge, LLC had no debt and both experts developed a cost of equity capital (COEC) discount rate using the build-up method. The key differences between the experts were in the presentation of the underlying data and the application of a company-specific risk premium (CSRP).The taxpayer’s expert used the Kroll Cost of Capital Navigator platform, which includes tables with output results, but does not present the underlying data. In contrast, the IRS’s valuation expert “provided a thorough review of his process and the academic papers that supported his equations.” Citing the lack of supporting data in the taxpayer’s expert report, the Court accepted the COEC rate concluded by the IRS’s valuation expert.Of particular interest is the issue of company-specific risk premium. The taxpayer’s expert added a CSRP of 5% to the build-up analysis, while the IRS’s valuation expert applied a 0% premium. In discussing the company-specific risk premium, the Court acknowledged that the build-up method allows for the consideration of such risks, but expressed concern that such risk factors may already be accounted for in other elements of the build-up approach (such as the size premium). Ultimately, the Court did not accept the premium applied by the taxpayer’s expert, who had cited five risk factors he considered in arriving at his conclusion for the premium. The Court chided the taxpayer’s expert for failing to provide sufficient details to allow the Court to understand the derivation of the selected premium. The Court’s conclusion confirms the need to support the application of a company-specific risk premiums with reference to available market evidence and the overall reasonableness of the resulting conclusion of value.Applicable DiscountsBoth experts applied discounts for lack of control and lack of marketability in the valuation of the subject minority interests.With respect to the discount for lack of control, the experts differed in the approach used to determine the discount and its application. The Court adopted the taxpayer’s expert 5% discount which was based on analysis of the company’s operating agreement, capital market evidence, and consideration of relevant facts and circumstances. In contrast, the IRS’s valuation expert applied a 10% discount, but only to the non-operating assets of the business. In its rejection of the latter approach, the Court once again cited the lack of underlying supporting data and analysis.The experts applied similar (25% and 30%) discounts for lack of marketability supported by detailed explanations of their methodologies and conclusions. The Court found the methodology used by the taxpayer’s expert to be “slightly more persuasive.” The Court once more expressed concern that the IRS valuation expert relied on the 2017 Forecast. Of note, the Court’s finding in favor of the (lower) marketability discount proffered by taxpayer’s expert was actually adverse to the taxpayer’s overall position.ConclusionThe material valuation issues in the Pierce case include the proper data to use in preparing a forecast, tax affecting pass-through earnings, and supporting appropriate risk factors and discounts to be applied in the valuation of closely held business interests. The Court’s consideration of each issue underscores the importance of marshalling relevant data and presenting reasoned analysis in valuation reports.

In the practice of professional services sometimes a single issue or event garners much attention. Such is the situation with the Connelly case and the valuation of an equity interest in a small building supply company, Crown C Supply (“CCS”).The question to be resolved in the case was how $3 million in life insurance proceeds received by CCS and purposed for the redemption of an equity interest from the estate of one of the company’s two shareholders should be treated when valuing the equity interest.The Connelly case attracted much attention when the United States Supreme Court agreed to hear it, and rightfully so, as few estate tax cases are heard by the highest court in the land.Much has been written about the case since then and the implications of the Court’s decisions for life-insurance funded entity purchase buy-sell agreements and business valuation are important to understand. We have written about the case in our most recent book published by the ABA, Buy-Sell Agreements: Valuation Handbook for Attorneys.Alongside a detailed analysis of these issues, however, it is instructive to also consider the timeless lessons that can be drawn from the case.These lessons become evident when one ponders the inevitable question: Why did the estate of a shareholder in a small, family-owned business with a value of less than $7.0 million have to appeal and argue its case in front of the United States Supreme Court?Some of the answers to the question lie in the errors, often ones of omission, that can be made by taxpayers when planning for the eventual estate tax liability from their ownership of a family-owned business.Four Lessons from ConnellyBelow we review four lessons that lie in the puzzle of the Connelly case.Estate Plans Accomplished Through a Family Business Will Inevitably Have Implications for All Stakeholders That Need to Be Considered and BalancedWhen the primary source of wealth is an interest in a family-owned business, there may be an understandable inclination for family members to implement an estate plan that will be executed within the bounds of the business.However, it is important to keep in mind that estate taxes are the responsibility of the individual shareholders rather than the family business.In the Connelly case, after the redemption of the deceased brother’s 77.2% controlling interest in CCS with $3.0 million in life insurance proceeds, the surviving brother’s pre-redemption 22.8% minority interest in the business effectively converted to a 100% controlling ownership interest. Thus, the redemption of the estate’s interest increased both the ownership share and basis of value of the surviving shareholder.The increase in value to the surviving shareholder was not captured by the transfer system in the sequence of steps and reportable transactions and therefore likely attracted greater scrutiny by the IRS.1To the Extent Shareholders Do Not Respect the Formalities of a Shareholders’ Agreement, Don’t Expect the IRS or a Court to Do So EitherWhen an estate plan is put in place, its provisions may require regular follow-up by the parties.It is not surprising that the time demands of running a successful business often limit the attention business owners can devote to estate plan requirements. Thus, estate plans can sit on the proverbial back shelf for years. Such lack of attention can unravel even well laid out plans.The Connelly brothers had entered into a stock-purchase agreement (“SPA”) with buyout provisions for their respective ownership interests in the event of the death of either brother.The SPA required the shareholders to annually determine the value of CCS shares and had provisions for an appraisal process to be used in determining the fair market value of CCS shares in redemption. None of these requirements were fulfilled by the Connelly brothers.Buy-Sell or Other Restrictive Agreements Need To Be Properly Drafted in Order to Have the Desired Effects for Estate Planning PurposesBuy-sell agreements (“BSAs”) are used by private business owners for a variety of purposes, including ownership control, succession planning, and liquidity needs. BSAs and similar restrictive agreements are also important tools in estate planning and can establish the value of an equity interest for estate or gift tax purposes.In order for an agreement transfer price to be considered as a factor in determining value for estate or gift tax reporting purposes, the agreement needs to meet three exception test requirements of Section 2703 of Chapter 14, namely, the agreement needs to be 1) a bona fide business arrangement, 2) not a device to transfer property for less than full and adequate consideration and 3) have terms comparable to similar arrangements entered into by unrelated parties in an arms’ length transaction.The IRS did not put forth an argument on whether the purchase price for Michael Connelly’s interest in CCS should be disregarded for estate tax reporting purposes based on the provisions of Section 2703 of Chapter 14.While such an argument was not part of the Connelly case, many legal commentators believe that the facts of the case should be examined with regard to both the provisions of Section 2703 and related case law.Estate Plans Should Incorporate Appraisals by Qualified Professionals When Fair Market Value Cannot Be Readily Established by Other MeansFair market value, defined as the price at which an asset would change hands between a willing buyer and a willing seller when neither is under any compulsion to buy or to sell and both have reasonable knowledge of relevant facts, is the standard of value for estate and gift tax reporting purposes.When fair market value cannot be readily established by reference to market or transaction prices, the opinion of a management representative will not be a suitable substitute for the opinion of a qualified appraiser.One of the missing puzzle pieces in the Connelly case is the appraisal of the subject interest by a qualified appraiser.The SPA had specific provisions for an appraisal process for shares subject to redemption, but this process was not followed by the parties. Rather, the redemption price was agreed upon in an “amicable and expeditious manner” by the estate executor and a son of the decedent.Counsel for the estate argued that the $3.0 million redemption price “resulted from extensive analysis of CCS’s books and the proper valuation of assets and liabilities of the company. Thomas Connelly, as an experienced businessman extremely acquainted with Crown C’s finances, was able to ensure an accurate appraisal of the shares.”These decisions made by the parties in the Connelly case ultimately failed to establish a supportable fair market value conclusion for the subject interest.Defining Fair Market Value and Selecting Qualified AppraisersFair Market ValueFair market value is referenced in the Connelly SPA as part of the definition of appraised value per share. Fair market value itself, however, is not defined in the SPA.Without a specific, clear definition of fair market value, such as that from the ASA Business Valuation Standards or the Internal Revenue Code, the interpretation of fair market value is left to the appraiser(s).In the Connelly matter, upon a triggering event two appraisers were to be engaged (one by CCS and one by the selling shareholder). Should the opinions of these two appraisers diverge by more than 10% of the lower appraised value, a third appraiser could have been engaged. The SPA as drafted opened the door for three interpretations of fair market value. And with multiple interpretations comes the increased likelihood of litigation.Appraiser QualificationsAdditionally, if the qualifications of an appraiser are not specified, just about anyone can do the appraisal.The Connelly SPA mentions that an appraiser “shall have at least five years of experience in appraising businesses similar to the Company.” That’s it. The SPA makes no mention of formal education, valuation credentials such as ASA, ABV, or CVA, or continuing education and training requirements.What could happen if an unqualified appraiser is hired to perform a valuation? A recent tax court case, Estate of Scott M. Hoensheid, deceased, Anne M. Hoensheid, Personal Representative, and Anne M. Hoensheid, Petitioners, v. Commissioner of Internal Revenue Service, Respondent (T.C. Memo 2023-34), addressed this situation head-on.While the case was related to the donation of closely held stock, not using a qualified appraiser had a damaging impact on the taxpayer.The company whose shares were subject to the charitable gift had been marketed for sale by an investment banker prior to the gift. In court, the petitioners argued that the investment banker was qualified to prepare the appraisal for charitable giving purposes because he had prepared “dozens of business valuations” over the course of his 20+ year career as an investment banker.According to the Court, an individual’s “mere familiarity with the type of property being valued does not by itself make him qualified.” The Court further noted that the investment banker “does not have appraisal certifications and does not hold himself out as an appraiser.”The end result for the taxpayer in Hoensheid: the Tax Court found that the taxpayer failed to comply with the qualified appraisal requirements and denied the charitable deduction.Appraisal StandardsOccasionally, buy-sell agreements lay out the specific business appraisal standards to be followed by the appraiser.Standards most often cited in buy-sell agreements are the Uniform Standards of Professional Appraisal Practice (commonly referred to as “USPAP”), the ASA Business Valuation Standards, AICPA’s Statement on Standards for Valuation Services No. 1 (commonly referred to “SSVS”) and NACVA’s Professional Standards.The Connelly SPA did not reference any of these standards.Without any appraisal standards referenced, any appraiser elected to perform a valuation under the SPA who was not a member of one of the national appraisal organizations has no requirement to follow any set of standards or code of ethics.Final ThoughtsThis tale of a small building supply company making its way to the Supreme Court emphasizes how significant — and tricky — managing business and family interests can be.Aside from the issues surrounding how to treat life insurance proceeds, Connelly is a vivid reminder of the simple errors of omission that can spiral into monumental issues, and it highlights some timeless lessons about the necessity of dotting i’s and crossing t’s in estate planning and business agreements. It also underscores the importance of clearly defining fair market value, ensuring appraisers are properly qualified, and strictly adhering to appraisal standards.This whole saga reminds us of the importance of getting things right from the start to avoid a domino effect of complications down the road.