…I did quite a bit of reading before selecting the Pluris DLOM Database.
Keith Sellers
University of North Alabama

BIG Loss for Estate of Richmond – With Penalties on Top

By : Espen Robak, CFA

In Richmond,[i] released yesterday, the Tax Court (1) contributed anew to the controversy over how the contingent tax liability for built-in capital gains should be valued; (2) set in motion forces that may further widen the circuit-split among U.S. courts of appeal on this issue; (3) completely rejected the income approach for an asset-holding entity; and (4) assessed very significant tax penalties with reasoning that is likely to put fear in the hearts of many taxpayers – all that in just a little over 50 pages.

It’s an action-packed tour de force by Judge Gustafson. The case revolves entirely around the valuation of shares in Pearson Holding Co. (PHC), a C-corporation which was formed in 1928 to manage a portfolio of equities for the descendants of Frederick Pearson and provide them with a stream of income. Helen Richmond died in December 2005 holding 548 shares in PHC. She was the second-largest shareholder, with 23.44 percent of shares outstanding.

The Tax Return

Form 706 was timely filed by executors that included at least one CPA. The estate’s interest was valued at $3,149,767 using an income approach. The NAV of PHC was stipulated at $52.1 million and the (unlevered) assets of the company included more than $50 million of common shares, mostly high-yielding large-cap stocks. The indicated NAV attributable to the estate was thus $12.2 million. In other words, the estate valued the interest at effectively a 74 percent discount from NAV. The Service valued the interest at $9.2 million in its notice of deficiency and the estate filed its petition in Tax Court shortly thereafter.

The 706 value was based on an appraisal by Peter Winnington, an accountant, and he in turn based his valuation on information relevant to PHC and the estate’s interest, including: several transactions in PHC stock that had taken place as recently as the 1990s, prior valuations of PHC stock for shareholders that had passed away previously, and general corporate and financial information on PHC and its portfolio. PHC had a long-standing policy of minimizing the “churn” of its portfolio, so most of its shares had been held for very long periods of time. As a result, most of the portfolio’s holdings were highly appreciated positions – to such an extent that PHC’s built-in gain (BIG) was $45.6 million, or more than 87 percent of its value. This, in turn, gave rise to a (stipulated) potential capital gains tax liability for the BIG of $18.1 million.

Since Mr. Winnington’s qualifications to perform this appraisal became a point of contention herein, it’s important to note that he:

  • Had received a BS degree in accounting and an MS degree in taxation.
  • Had 20 years of experience as an accountant, including audits, management advisory, litigation support, and tax planning, was a CPA, and held the CFP designation.
  • Chaired his firm’s corporate service department and sat on the firm’s executive committee.
  • Was a member of the AICPA, the Delaware Society of Certified Public Accountants, and the Wilmington Tax Group.
  • Had appraisal experience, having written 10-20 valuation reports and having testified in court.

Mr. Winnington provided an unsigned draft valuation report to the estate, but was never asked to finalize his report.

By the time the case went to trial, the parties had modified their positions. The estate now valued its shares at $5.0 million, based on a new appraisal from a new expert, who also testified. The IRS valued the shares at $7.3 million, but also wanted a 20 percent penalty for substantial valuation misstatement applied.

The BIG Discount

It is well-established that shares in a C-corporation with significant amounts of “trapped” BIG that are subject to corporate taxes are worth less than shares in similar companies that do not have such a potential tax liability. How much less is the question.

Our court system has a poor track record in resolving this issue. A widening circuit split has opened between two warring camps:

  • The 5th and 11th Circuit Courts of Appeals hold that the contingent BIG tax liability should be deducted from the value, dollar-for-dollar, as if the portfolio was to be liquidated in its entirety on the valuation date.
  • The 2nd and 6th Circuit Courts of Appeals, and the Tax Court, hold that the valuation should not assume immediate liquidation, but instead consider methods that the entity may use to maximize value by mitigating, or at least deferring, the gain and the payment of the tax.

The Court in Richmond simply notes that its opinion in this case is appealable to the 3rd Circuit Court of Appeals and finds:

“[T]he seller of the company with the contingent future liability would demand a higher price than the seller of a company with the unconditional current liability. As a result, despite contrary holdings by some courts, we find that a 100% discount would be unreasonable, because it would not reflect the economic realities of PHC’s situation.”

The Service’s expert developed a discount equal to 43 percent of PHC’s BIG tax liability based on a questionable methodology (analyzing the gains of closed-end funds) that the Court does not accept. However, the Court does consider this substantial discount as an admission on the Service’s part. The taxpayer’s expert applied a discount of 100 percent of the tax liability.

The Court’s own analysis provides a BIG tax discount range that brackets the Service’s “admitted” 43 percent and, thus, decides that this is the correct amount. The Court notes that PHC, despite its long-standing investment policies, had been advised in the past to diversify more, which would increase portfolio churn. The Service’s appraiser testified that a potential investor would expect that a portfolio like PHC’s would turn over within 20-30 years and the Court finds this reasonable. Projecting taxes due upon liquidation of the portfolio over those time frames, and discounting those tax payments back to the present at a range of discount rates, yields a value range for the liability.[ii]

The Income Approach

It is uncontroversial that the income approach is best applied when valuing operating companies and, also, that the methods under this approach are highly sensitive to the discount and growth rate assumptions applied.[iii] Still, a growing number of advisors have become advocates of the income approach for holding companies. In this reviewer’s opinion, the Court is correct when observing:

“The estate’s valuation method therefore ignores the most concrete and reliable data of value that are available – i.e., the actual market prices of the publicly traded securities that constituted PHC’s portfolio.”

That’s really the crux of the matter – the market has already considered the income approach! The question for the appraiser with PHC’s stock as his task is simply to consider the discount from the market’s valuation. That too is quite difficult, but doesn’t get easier by trying to “reverse engineer” the market’s valuation of the portfolio. In addition to the problems the Court identifies, the method also ties the value of the holding company almost entirely to its dividend policy – what proportion of the annual return of the portfolio does the company pay out to its shareholders. This “lever” then controls the valuation to a very considerable extent. The approach can yield values that are extremely low.

Marketability and Control Discounts

Both parties used data from closed-end mutual funds when estimating the discount for lack of control, a time-honored and widely-accepted technique. The Service’s appraiser took the average discount for the funds and “rounded down” to 6.0 percent. The taxpayer’s expert took the median discount of 8.0 percent. The Court disagrees with both, removes three outliers from the data, and takes the average of the remaining sample, deciding on a 7.75 percent discount.

Very little analysis appears (from the Court’s opinion) to have gone into considering the differences between the closed-end funds and PHC. In this reviewer’s opinion, that’s a mistake. First, the sample was 59 funds, which probably could have been narrowed further to match the investment profile of PHC’s portfolio.[iv] Second, closed-end funds have many advantages that may serve to mitigate the control discount, such as professional management, public oversight, a professional board, and SEC-reviewed financial reporting. Third, PHC is almost certainly smaller than the average fund, which may also tend to increase the discount.

Both parties used published studies of marketability discounts, including restricted stock and pre-IPO studies. However, all they considered were the averages published by the studies, rather than considering the unique characteristics of PHC and how those characteristics would tend to impact the discount. This is despite the well-established fact that the range of discounts indicated by such studies is vast. Also, the substantial differences reported in the studies are driven by financial and other variables that can be analyzed.

Ultimately, the Service’s expert chose a discount at the very bottom of the range of the study averages, while the taxpayer’s expert chose a discount at the very top of the range. The Court is unconvinced by either side and simply applies the average. It’s impossible to fault the fact-finder for doing so, when the analyses presented were so conclusory.

The Penalty Phase

Finally, the Court simply notes that its concluded value, which is $6.5 million, is more than double the value reported on the 706 – an open and shut case for a “substantial” valuation understatement penalty? That depends on whether the taxpayer had “reasonable cause” for making the error and acted in “good faith.”

The Court agrees with the taxpayer that valuing the estate’s interest in PHC is difficult.[v] It follows logically that getting it wrong in and of itself cannot be sufficient reason for the penalty – it requires genuinely bad behavior (as has been held in many prior cases). Since the estate did rely on competent legal and accounting advisors – and an appraisal – what went wrong here? The Court notes that “to establish good faith, taxpayers cannot rely blindly on advice from advisers or on an appraisal” and continues:

“On the record before us, we cannot say that the estate acted with reasonable cause and in good faith in using an unsigned draft report prepared by its accountant as its basis for reporting the value of the decedent’s interest in PHC on the estate tax return. Mr. Winnington is not a certified appraiser. The estate never demonstrated or discussed how Mr. Winnington arrived at the value reported except to say that two prior estate transactions involving PHC stock used the capitalization-of-dividends method for valuation. Furthermore, the estate did not explain – much less excuse – whatever defects in Mr. Winnington’s valuation resulted in that initial $3.1 million value’s being abandoned in favor of the higher $5 million for which the estate contended at trial. Consequently, the value reported on the estate tax return is essentially unexplained.” (Emphasis added)

As the Court concludes, “even by the estate’s lights, the value on the estate tax return needed explaining, but no explanation was given.”


Where do we even start with this one? Perhaps by first noting that both sides were ably assisted by some of the best counsel available and well-known and established valuation advisors. Yet there are aspects of this case that, at least on a first read, do not seem to make a great deal of sense.

The Court’s analysis of the misvaluation penalty issue will probably be the one area that will gain the most immediate attention in this case. I do not want to hide the fact that, as the head of a valuation firm that does nothing but valuation work, this decision is at least superficially appealing. Valuation being as tricky an issue as it is, experts whose “day job” is something very different (accounting, in this case) probably would be better off without dabbling in the valuation arena. As would their clients. Having said that, this decision seems unduly harsh and I have a hard time believing it will survive on appeal. Mr. Winnington simply wasn’t that badly qualified. (It is also unclear what "certified" means in this context.) I do agree he got the valuation wrong, and chose poorly when deciding his valuation methods, but if these kinds of errors are enough to make it unreasonable for taxpayers to rely on an appraisal, then I believe there are many, many taxpayers that should be alarmed today.

The case is also highly instructive on the BIG discount issue and, to a lesser degree on marketability and control discounts. It’s surprising to see so little effort apparently made on the latter two discounts in particular, when even a few points either way makes a significant difference to the outcome – especially when penalties apply on top.

Espen Robak, CFA, is President and founder of Pluris Valuation Advisors LLC and resides in the firm's New York City headquarters. Comments or questions are welcome at erobak@pluris.com

[i] Estate of Helen P. Richmond, Deceased, Amanda Zerbey, Executrix, Petitioner v. Commissioner of Internal Revenue, Respondent, T.C. Memo 2014-26, filed February 11, 2014.

[ii] The range of discount rates was 7 percent to 10.27 percent, based on various methods. The resulting value range was $5.5 million to $9.6 million, as compared with the Service’s admission of $7.8 million (which is 43 percent of the stipulated $18.1 million BIG tax liability and 15 percent of the entire NAV of the company).

[iii] The taxpayer’s appraiser had published valuation textbooks stating that, in fact, the method used was highly sensitive to small variations in the discount rate.

[iv] For example, the funds sample may be narrowed down by size, yield, and investment strategies (sectors, types of companies, etc) to better match the subject company.  

[v] The estate notes the wide dispersion of values computed for the interest, from just over $3 million to well above $9 million as evidence for that. However, it should be noted that once more well-established valuation experts started working on the valuation for the trial, the differences narrowed substantially. 

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