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"Losing My Religion" - An IRS Lament?

A recent tax court case allows me to dig up a reference to an R.E.M  hit single (never my favorite band, but, hey, any port in a storm).

 

Franklin Adell and his son, Kevin, founded the non-profit Word Network in 2000. By the date of Franklin's death in 2006, it had become the largest African-American religious network in the world, broadcasting Christian focused television and gospel music around the globe. STN.com, a for-profit company, which was wholly owned by Franklin, provided cable up-link services to mega churches using the Word Network. STN's only customer was the Word Network. Its president was Kevin, but Kevin had no employment contract with STN and had not entered into a non-compete agreement with STN. STN generated significant cash flows with family members receiving over $9 million in compensation in peak years in addition to perks, including Bentleys. Rolls Royces and a yacht with a crew on STN payroll.

 

On Franklin's death the Estate valued STN at $9.3 million. The IRS disputed the valuation and eventually valued the company at $26 million. The Tax Court ultimately accepted the Estate's $9.3 million (Estate of Adell v. Commissioner, 2014 Tax Ct. Memo LEXIS 153).
 

Both the Estate and the IRS recognized that Kevin was the driving force behind the success of the Word and by implication STN. The difference in values was based on differing approaches on how to quantify the effect of Kevin's role with STN.

 

The Estate's valuation expert adjusted STN's operating expenses to include a charge for the use of Kevin's personal goodwill. The expert considered that a willing buyer of STN would consider that in order to sustain STN's revenues, it would have to retain Kevin and, in the absence of a non-compete agreement from Kevin, the cost to do that was estimated to be about 40% of revenues. This suggested a reduction in STN's annual cash flows of between $8 - $12 million which resulted in the relatively low $9.3 million valuation.
 

The IRS expert recognized Kevin's importance to the business but determined that a willing buyer would have to compensate Kevin at around 8% of sales or $1.3 million. The IRS expert did not add a further economic charge for the use of Kevin's personal goodwill. As a result, STN's cash flows were projected to be much higher, supporting a $26 million value.

 

The Tax Court noted Kevin's personal goodwill was not owned by STN and that Kevin's contacts were key to the growth and continued profitability of STN. The Court accepted the Estate's estimate of the appropriate economic charge for the use of the personal goodwill. It also criticized the IRS position on the basis that not only did it not include an economic charge for the use of the personal goodwill, but also the compensation for Kevin should have been higher than the $1.3 million estimate.

 

The case points to the need to take care in determining the market value of the services provided by key employees and officers - whether this is reflected in an adjustment to compensation or an "economic charge" to compensate for the use of personal goodwill. If there is no non-compete agreement in place, it is arguable that the adjustment of compensation to market value should reflect the potential impact on cash flows of the employee competing. Even if there is a non-compete agreement in place, the market compensation should reflect the cost of the employee ceasing to work for the company - that key employee needs to have a market based incentive to continue working.

 

The case also points to one way of dealing with the question of valuing personal goodwill - if an owner's compensation is adjusted truly to reflect the value of the owner to the business, then the cash flows, after the adjusted compensation, will theoretically only reflect the business goodwill - all of the personal goodwill will have been taken into account in the compensation adjustment and no further adjustment will be required.

 

And this is the point where, channeling Michael Stipe, I admit that "I've said too much". But there may be some more on this case in next month's article.