Discounts Granted to S-Corporation Interests

Estate of Marjorie Litchfield et al. v. CIR, T.C. Memo 2009-21

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Facts: Decedent’s estate held interests in two closely held S-corporations, LRC and LSC. LRC had a net asset value of $33,174,196 with built-in capital gains of $28,762,306 and LSC’s net asset value was $52,824,413 with $38,984,799 of built-in capital gains.

The estate’s valuation expert discounted the estate’s 43.1% stock interest in LRC by 17.4% for built-in capital gains taxes, 14.8% for lack of control, and 36% for lack of marketability, giving LRC a fair market value of $6,475,000. For LSC, the estate’s expert applied a 23.56% discount for built-in capital gains, an 11.9% discount for lack of control and a 29.7% discount for lack of marketability, giving the estate’s 22.96% interest in LSC a fair market value of $5,748,000.

The Service audited the decedent’s estate tax return and valued the estate’s interest in LRC at $10,300,207 ($3,825,207 higher than the value determined by the estate’s expert) and in LSC at $8,762,783 ($3,014,783 higher than the value reported by the estate). After paying the estate tax deficiency found by the Service, the estate filed suit for a refund for overpayment of estate taxes. The estate and the Service agreed as to the net asset value of both LRC and LSC, leaving the Tax Court to determine the discount that should be used for built-in capital gains taxes, lack of control and lack of marketability.

Ruling: The Tax Court emphasized that the resolution of valuation issues typically involves an approximation of value and that the value reached by the Court does not need to be tied to specific testimony or evidence if it is within the range of values supported by the evidence. When discussing the nature and applicability of the various discounts at issue in this case, the Court pointed out that knowledgeable buyers would negotiate discounts in the price of the stock to estimate, on the basis of current tax laws, the corporate capital gain liabilities due upon sale or disposition of the corporation’s assets, as well as the standard lack-of-control and minority interest discounts.

After establishing the valuation methodology, the Court compared the two valuation reports. For the built-in gains discount, the estate’s expert consulted with the officers and board of directors of LRC and LSC concerning their plans for selling the corporation’s assets, reviewed board meeting minutes and tracked historical asset sales. In contrast, the Service’s expert based his built-in capital gains discount solely on LRC and LSC’s historical asset sales. The Court held that the expert’s assumptions relating to asset turnover were based on more accurate data and accepted the estate’s expert’s built-in gains discounts of 17.4% and 23.6%, for LRC and LSC, respectively.

Both experts calculated similar lack-of-control discounts for LRC’s farmland and related assets and used lower lack-of-control discounts for LRC’s securities. However, the estate’s expert used a weighted average to account for the fact that LRC has significantly more farmland than securities, whereas the Service’s expert used a straight average. Because of the Service’s expert’s failure to take into account the difference between LRC’s assets, the Court held that the estate’s expert’s 14.8% lack-of-control discount for the estate’s LRC minority stock interest is appropriate. The Service’s expert applied the same 5% discount to LSC’s securities as he applied to LRC’s securities, even though the estate’s 22.96% interest in LSC was significantly smaller than its interest in LRC. Because the Service’s expert failed to consider the smaller holding in LSC, the Court held that the estate’s expert’s 11.9% lack-of-control discount for LSC was appropriate.

The Court found that the estate’s expert’s respective 36% and 29.7% discounts for LRC and LSC were high and stated that the estate’s expert used some outdated data relating to restricted stock discounts, resulting in higher marketability discounts than those reflected in benchmark studies that included all components of lack-of-marketability discounts. The Court concluded that discounts for lack of marketability of 25% and 20% should apply to the estate’s respective LRC and LSC minority stock interests. The Court found that the estate’s 43.1% interest in LRC was worth $7,546,725, and its 22.96% interest in LSC was worth $6,530,790. Those respective values were $1,071,725 and $782,790 higher than the estate’s expert calculated, but were $2,753,482 and $2,231,993 less than the values determined by the Service’s expert.

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