Often, the value of assets can determine tax consequences. This applies in a number of areas including charitable donations, asset allocation on sale transactions, income tax on liquidation of a corporation, gift tax, and estate tax. Because the value of assets determines the amount of tax payable in these and other situations, it is critically important to determine the proper value of assets. Typically, this work is performed by valuation experts who are engaged by the taxpayer or their other advisors. Valuation cases where courts analyze the work of those experts are common.
Facts
A recent case Tax Court case involved valuation of a business where there was “backstabbing, infidelity, and blackmail.”[1] In this case, husband and wife were 50/50 owners of Mothers Lounge, LLC (“Mothers Lounge”), which was taxed as an S corporation. On June 4, 2014, both husband and wife gifted a 29.4% interest and sold a 20.6% interest in the Mothers Lounge to two irrevocable trusts.[2] Each sale was in exchange for a promissory note equal to $3,419,000.[3] Each gift was reported to have a value of $4,880,400. These valuations were audited by the IRS.
Mothers Lounge operated in the baby product industry. The business practices of Mothers Lounge were less than savory. The owners would find successful, quality products they could have manufactured cheaply. Then, they would offer coupons or other means of “selling” the cheap, knock-off products to price sensitive customers for free as long as the customer would pay shipping costs which were inflated. The business model was to charge a shipping fee in excess of the costs to Mothers Lounge of both manufacturing and shipping of the product, with that excess representing the business’ profits. There was no return policy. The business operated through separate subsidiaries so that customers could not bundle shipping of purchases and so that customers would not connect the products as coming from the same seller.[4] Mothers Lounge marketed to customers in magazines, in-store advertising, and spam emails. It was important that customers were not able to comment or otherwise provide online feedback viewable to other customers given the cheaply made products Mothers Lounge was selling.
Due to this business model, Mothers Lounge struggled to adjust to increasing online sales, particularly sold on Amazon. Likewise, Mothers Lounge could not find a way to market their products on Amazon’s third-party fulfillment services where Amazon listed the product on their website and shipped the products using their shipping rates. To add to these problems, Mothers Lounge was a defendant in two separate lawsuits alleging trademark and patent infringement. These lawsuits were initiated by companies whose products Mothers Lounge had copied.
In addition to these business risks, in 2013, the husband received an anonymous blackmail demand threatening to disclose evidence of an affair he was having with an employee. This blackmail was accomplished through an illegal computer tracker that retrieved keystroke data. After the affair was found out by the wife-owner, she forbade her husband from attending any further trade shows. These trade shows were where the husband-owner found new products to copy and engaged in critical information gathering discussions. At the same time, husband and wife struggled to operate the business as successfully as in the past due to a lack of trust and second guessing.
It is in the context of these events that the couple engaged in estate planning. Part of that estate planning involved succession planning for Mothers Lounge, which resulted in the gifts and sales. The couple reported the gifts on a 2014 Federal gift tax return. They did not report the sales as non-gifts.[5] The IRS audited the gifts and sales, ultimately determining the couple undervalued the gifted and sold interests. By the time the matter reached the Tax Court, the IRS’ valuation expert valued the gifted 29.4% interests at $5,784,421 and the sold 20.6% interests at $4,053,029. The taxpayers had new valuations performed which valued the gifted 29.4% interests at $3,913,000 and the sold 20.6% interests at $2,741,000 (less than reported on the gift tax return).
Discussion
The Tax Court went through a rigorous analysis of the valuation reports and testimony of the valuation experts, Jeffrey Pickett for the taxpayers and Mark Mitchell for the IRS. A number of issues discussed in the case which are worth noting:
- Post-Valuation Date Facts. The opinion is clear, and the experts were examined at trial, about whether any of their opinions were supported by facts which were not known or knowable on the valuation date. This is important because the valuation should be performed “without regard to hindsight” with events subsequent to the valuation date not to be considered unless reasonably foreseeable on the valuation date.[6]
- Valuation Methods. The Tax Court did a good job of walking through different valuation methods. First, actual sales of stock made on an arm’s length basis in the ordinary course of business should be considered. When there are no such sales, as was the case here, courts should consider one or more of three alternative approaches: (1) the market approach, (2) the income approach, and (3) the asset-based approach. Both experts agreed that the valuation should be based on the income approach using discounted cashflow method. There was no comparable sale to use the market approach and the company had virtually no assets meaning the asset approach would significantly undervalue the company. They agreed that, for this going concern, the income approach was most appropriate.
- Income Approach, Discounted Cashflow Method. The opinion walks through the method to be used in rendering an opinion of value under the discounted cashflow method (“DCF”). Using DCF, value is determined by adding: (1) the present value of the business’ projected cashflows for a discrete period, (2) the present value of the business’ terminal value (cashflows into perpetuity), and (3) the value of the non-operating assets. In discounting cashflows both for the business’ value over a discrete period and its terminal value, the discount rate used must be determined. The Tax Court stepped through each expert’s opinions with respect to each of these items, agreeing with one expert on certain items and the other expert on other items.
- Tax Affecting. There has been an ongoing debate with the Tax Court regarding its acceptance of “tax affecting” which taxpayers often argue to be necessary “to account for the fact that valuation data used in valuing S corporations is based on data from C corporations, which pay an entity-level tax.” The idea is that for DCF valuations, cashflows for S corporations should account for the fact that the shareholders pay tax on the business’ income whereas the corporation does in C corporations. As such, without “tax affecting” an S corporation’s earnings to reflect this imbedded tax liability passing through to the shareholders, cashflows would be pre-tax and overstate the value of the entity. While the Tax Court reiterated that there is no rule generally allowing tax affecting, it would be permitted here since both experts agreed it was appropriate. When tax affecting is permitted, the rate to be used to reduce cashflows is important. This rate is set to put the S corporation’s cashflows on par with that of a C corporation. Therefore, it must capture the pre-tax nature of cashflows, but also the fact that there is likely a lower overall effective tax rate on S corporations than C corporations.
- Expert Examinations. In analyzing the items described above, the Tax Court meticulously reviewed the reports and testimony of the experts. When either of the experts did not have clear data supporting an opinion, the Tax Court largely disregarded that opinion. For example, the Tax Court disregarded Mr. Mitchell’s forecasting of revenue and expenses because he used the taxpayers’ prior report “without any independent analysis” (saying the court can “easily reject” those projections “as knockoffs”). Rather, he took the assertions in that report as reasonable and used them without conducting his own analysis. Also, the Tax Court sided with Mr. Mitchell’s discount rate because Mr. Pickett “did not provide the underlying data” needed. This level of critique carried through each element of the valuation analysis.
Ultimately, this case was a taxpayer victory, but to what extent is currently uncertain. Although the Tax Court determined which expert’s report should be followed as to each aspect of the valuation, the opinion does not provide us with the final valuation numbers. Rather, the court sent these decisions back so that updated valuation numbers could be calculated.
Conclusion
Valuation cases are common. In each of those cases, there may be something to learn. In Pierce, the court provided a very thorough discussion of the level of rigor required of valuation experts as well as certain valuation methods and principles. As an example, for those reviewing reports based on the DCF method, this case may be a useful roadmap to that review.
Beyond the academic value of this opinion, it is clear from a review of the court’s analysis how important well qualified appraisers, performing a complete and thorough analysis, are in substantiating tax positions. For those of us who regularly rely on valuations and are asked by clients about the costs of those valuations, this opinion is proof that the costs of a well-prepared appraisal are clearly justified. Especially in sophisticated estate planning transactions, the costs of having your valuation disregarded are much more than the costs of getting it right initially.
[1] Pierce v. Commissioner, T.C. Memo 2025-29.
[2] As an aside, the names of these two irrevocable trusts were the Kaleb Jeremiah Pierce Irrevocable Trust and the Jeanette Court Pierce Irrevocable trust which matches the spouse’s names. I question whether these were spousal lifetime access trusts (“SLATs”). If so, at least from the opinion, it does not appear the IRS argued for application of the reciprocal trust doctrine. For a discussion about the reciprocal trust doctrine, see Devin Mills, “Spousal Lifetime Access Trust Basics,” March 1, 2022, https://www.esapllc.com/slat-planning-2022/.
[3] The sale transactions were actually to a Giving Stream, LLC which was owned 50/50 between the two trusts.
[4] Subsidiaries included Milk Bands, LLC; Udder Covers, LLC; Seven Slings, LLC; Hotslings LLC; Carseat Canopy, LLC; Baby Leggings, LLC; Rufflebuns, LLC; Nursing Pillow, LLC; Belly Button, LLC; and Breast Pads, LLC.
[5] Proper reporting of a transaction as a non-gift can start the statute of limitations on assessment of gift tax. See Treas. Reg. § 301.6501(a)-1 and 301.6501(c)-1.
[6] Estate of Gilford v. Commissioner, 88 T.C. 38, 52-53 (1987).
