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Winston Churchill and the Tax Affecting of Pass-Through Entities

This article is as close as it gets in the valuation world to the “Extra, Extra… Read all about it” scene in a 1930s movie.

 I was delighted to learn about the recent case of Estate of Aaron Jones v. Commissioner, T.C. Memo. 2019-101 (Aug. 19, 2019) for two reasons.  (I know, it’s hard to believe that anybody can be delighted by a Tax Court case)

 

First, the Court allowed the valuation of an operating company based on its cash flows to take account of the tax burden of the owners, even though the company was an S Corporation. In recent years, the IRS has been able to point to a string of cases (starting with the Gross case) which confirmed their position that for valuation purposes the cash flows of a pass-through entity should not be taxed.

 

You may recall that earlier this year a federal district court accepted tax affected valuations of an S Corp (this was the Kress case that I went on ad nauseum in my last three emails). In this case, we have an opinion from the Tax Court essentially to the same effect. The taxpayer, Mr. Jones, had made a gift of shares in a large lumber business that he owned. The IRS claimed that the gift had been undervalued by $45 million on the gift tax return.

 

The expert for Mr. Jones projected the cash flows of the business, applied a tax rate of 38% but adjusted the final value upwards by 22% to reflect the tax benefits that the owner of the gifted interests would enjoy as a result of the company’s S Corp. status. The IRS argued that a 0% tax rate should be applied (although notably, the valuation expert for the IRS chose not to rebut the taxpayer’s position on tax affecting).

 

The Court accepted Mr. Jones’ expert’s opinion. It distinguished this case from the Gross case where, based on the experts’ opinions, the Court had been presented only with a black-and-white choice of applying a 40% tax rate or a 0% tax rate. In this case, the Court was persuaded by an approach which recognized both the tax burden and also the potential benefit of owning an interest in a pass-through entity rather than applying a zero-tax rate.

 

The second cause of delight stemmed from the following statement by the Court: “We are mindful that the science of valuing closely held companies usually results in a "terminological inexactitude,” in the words of Winston Churchill”. It is somewhat embarrassing that, as an Englishman, I had never heard this phrase before. When I looked up the quote it became clear that Churchill was using this phrase as a euphemism for an untruth. The distress I felt at the Court dissing the valuation profession was outweighed by my joy that the term will now become part of my everyday vocabulary!