United States District Court Strikes Blow Against the Undead!

Sometimes things happen that make one believe in Providence. There I was, musing on which riveting aspect of business valuation practice to regale you with this month and, frankly, having a bad case of writer's block. Then from the blue, I received an e-mail from a business valuation publication highlighting the recent case of  James F. Kress and Julie Ann Kress,  v. United States of America,  (Case No. 16-C-795, United States District Court Eastern District of Wisconsin, March 25, 2019) – and what a case it was! All singing, all dancing from a valuation perspective, it will provide me with material for two (maybe three) of these e-mails!

Where to start? Well, the case may have put a stake through the heart of the contention held dear by the IRS that S corporations should be valued effectively assuming no tax is paid on their profits. (Please note, by my use of the stake metaphor you should not conclude that I am comparing the IRS to blood-sucking creatures of the undead realm)

No tax means more cash flow and more cash flow means higher values. In a line of cases starting with Gross v. Commissioner (1999), the IRS contended and the Tax Court accepted the application of a zero percent tax rate to pass-through entity earnings resulting in a large valuation premium.

In the Kress case, the IRS challenged the values of gifts made by Mr. and Mrs. Kress from 2007 to 2009 of stock in Green Bay Packaging (“GBP”), a very large manufacturer of cardboard packaging. GBP was an S-corporation.

The taxpayers had engaged two valuation experts to value the gifts – both effectively applied their valuation methods to after-tax cash flows.

And then the twist – the expert engaged by the IRS also applied C-corporation tax rates to the company’s cash flow, a position contrary to the zero percent approach previously advocated by the IRS. Granted, the IRS’ expert then adjusted the company’s value upwards to reflect tax advantages associated with the company’s S-corporation status. Whether the adjustment is warranted or not, the key point is that the IRS appeared to accept that tax-affecting was appropriate.

The court also accepted tax-affecting and rejected the S-corporation adjustment. It opined that “GBP’s subchapter S status is a neutral consideration with respect to the valuation of its stock. Notwithstanding the tax advantages associated with subchapter S status, there are also noted disadvantages, including the limited ability to reinvest in the company and the limited access to credit markets.”

To dampen the excitement, it's important to note that this is not a U.S. Tax Court decision and it does not make precedent. There is no indication yet whether the no-tax affecting argument will stay dead after this assault or re-animate through an appeal – like all good vampire movies there may yet be a sequel.