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Court of Appeals Favors Taxpayer in Valuation Dispute

By July 1, 2001July 12th, 2023Finance & Wealth Management4 min read

A popular national business magazine recently reported that “the late Richard Simplot’s 24% voting stake in Boise’s J.R. Simplot Co., started by billionaire dad J.R. Simplot, is worth only $54,450 despite total company value (1993) of $830 million, the year of death.” What a result! A 24% voting stake in a company worth $830 million is valued at only $54,450 for estate tax purposes? Well, it’s not that simple.

The company had two classes of stock, voting and non-voting stock. What is extremely unusual about the Simplot case is that the voting stock comprised only about 1/20th of 1% of the total outstanding stock of the company (more precisely, 0.00054 of the company stock – that’s a lot of zeroes after the decimal point!), and the decedent owned 24% of that voting stock. In addition, the decedent owned about 2.79% of the non-voting stock. All together, the decedent owned only about 2.801% of the total outstanding stock of the company.

The IRS maintained in the estate tax audit that the voting stock should be valued at a whopping $801,994 per share (compared to $3,585 per share for the non-voting stock), and assessed an estate tax deficiency of about $17.7 million and a penalty of $7 million. The Tax Court generally agreed with the IRS’s approach, and held that about 3% of the equity value of the company should be attributed to the voting stock, even though it only represented about 1/20th of 1% of the total outstanding stock. The Tax Court ended up valuing the voting stock at $215,539 per share and the non-voting stock at $3,417 per share. (The Tax Court held there was a tax deficiency of about $2.2 million, but agreed that no penalties should be applied because the estate relied on the advice of its long-term advisor, Morgan Stanley.)

On appeal, the federal appeals court in San Francisco rejected the approach of the IRS and the Tax Court. The court focused on what a hypothetical buyer would pay for the stock. The Tax Court had concluded that a buyer would pay a huge premium for the minority interest in the voting stock based on a variety of assumptions about a potential buyer, including that a purchaser might be willing to wait a long time without any return on his investment, that the purchaser might be able to combine with other holders of the voting stock to obtain control, and that a purchaser might think he could bring about improvements in the management and profitability of the company. The appeals court rejected that reasoning as being based on “imaginary scenarios” and emphasized that the value should be “what a willing buyer would have paid for the economic benefits presently attached to the stock.”

Part of the appeals court reasoning is that if the decedent had control of the company, he only owned about 2.8% of the stock (and the voting and non-voting stock had similar rights except for the right to vote). Even a control block of stock should be valued at a premium only if the owner can use the control “in such a way to assure an increased economic advantage worth paying a premium for.” For example, the court noted that the voting shareholders would be liable for a breach of fiduciary duty to the other shareholders if they used their control to give other businesses that they owned special advantages in dealing with the Simplot company.

Two other cases recently decided by the same court of appeals have also ruled in favor of taxpayers by reversing Tax Court opinions for misapplying the “hypothetical buyer” standard for valuation.

What does all of this mean for planners for family businesses? First, appellate courts are criticizing the Tax Court for fashioning its own valuation standards instead of determining what a purely hypothetical buyer would pay for an asset. Second, the case illustrates that using voting and non-voting stock can be very helpful in planning. In this case, the decedent maintained a substantial amount of input to the voting control of the company but only continued to own a very small interest in the company. Many business owners find that possibility most intriguing. Typically, the voting stock will comprise about 5-10% of the outstanding stock. But in this case, premiums were not applied even where the voting stock was a much smaller percentage (only 1/20th of 1%) of the total outstanding stock (where the taxpayer owned a minority interest in the voting stock.) Third, the case highlights the importance of using qualified appraisal experts in valuing stock for estate and gift tax purposes. Fourth, the courts continue to apply substantial minority/marketability discounts in valuing business interests. Aside from the fiasco of assigning a huge premium to the voting stock, even the Tax Court had recognized that a 35-40% marketability discount applied in valuing the stock.

This article was written by Steve R. Akers. Steve R. Akers, J.D., partner with Ernst & Young U.S. LLP, is the director of the estate and business succession planning practice for the Southwest Area of Ernst & Young. Steve has previously served as chair of the State Bar of Texas Real Estate, Probate and Trust Law Section, and currently serves as assistant finance officer of the American Bar Association Real Property, Probate and Trust Law Section.