In Estate of Franklin Z. Adell, Deceased, Kevin R. Adell, Temporary Co-Personal Representative v. Commissioner of Internal Revenue, T.C. Memo 2014-155, released yesterday, the issues to be determined by the Court include the value of a 100 percent interest in STN.Com, Inc. (“STN”) and whether an estate tax valuation understatement penalty applies.
Mr. Franklin Z. Adell (Mr. Adell) passed away on August 13, 2006. Included in Mr. Adell’s Estate was a 100 percent interest in STN, a cable uplinking company. STN was started by Mr. Adell and his son, Kevin Adell (Kevin) in Detroit, Michigan. Mr. Adell owned 100 percent of STN and Kevin served as STN’s president. Prior to forming STN, Mr. Adell and Kevin were involved in the cable uplinking business for television programming and were moderately successful at it, it seems, before forming “The Word Network” (The Word). STN’s sole business purpose became to broadcast The Word, a 24-hour urban religious programming station. Kevin was familiar with religious programming and gained the support of various notable religious leaders in the Detroit area that agreed to help Kevin launch The Word. DirecTV became interested in broadcasting The Word, but required it be a non-profit entity to use the broadcasting space. Accordingly, the Adells formed an Internal Revenue Code (IRC) Section 501(c)(3) non-profit organization to operate The Word with Mr. Adell as president and director and Kevin as treasurer, secretary, and director. Even though The Word was a non-profit organization, 95 percent of the revenue from the Word went straight to STN, a for-profit corporation pursuant to the terms of a Services and Facilities Agreement (Services Agreement) whereby STN essentially provided the services to effectively run The Word’s operation. The Services Agreement provided that The Word pay STN a programming fee equal to the lesser of actual cost or 95 percent of net programming revenue received by The Word. Significant expenses of STN (relative to revenue of The Word) consisted of officers’ compensation to Mr. Adell and Kevin, as demonstrated below:
Estate Tax Return
The Estate filed the Form 706 estate tax return reporting a value of $9.3 million for the Estate’s 100 percent interest in STN based on a valuation report submitted with the Form 706. The Estate’s expert utilized a discounted cash flow approach to value STN considering that STN received 95 percent of its revenue from The Word as consideration. The Estate’s expert made adjustments to the income statements to reflect normalized ongoing performance including a reduction in officers’ compensation to reflect market rates. The Estate’s expert also included an economic charge for personal goodwill given Kevin’s personal relationships with the directors of The Word and considering that Kevin did not have a non-compete agreement with STN. To account for these factors, the Estate’s expert adjusted operating expenses to include an economic charge ranging from 37.2 percent to 43.4 percent of historical sales and 43.7 percent to 44.1 percent of projected sales. In determining a rate of return, the Estate’s expert added a 3 percent company risk premium to account for risk associated with The Word as STN’s sole customer. The Estate’s expert determined a rate of return of 20 percent. The Estate later amended the estate tax return on August 10, 2010 (nearly four years after Mr. Adell’s date of death) reporting the value of the STN stock to be zero as of the date of death.
Notice of Deficiency
On November 9, 2010, the IRS issued a notice of deficiency of nearly $39.7 million. The IRS determined a value for the STN stock of over $92.2 million compared to the $9.3 million value that the Estate reported on its original estate tax return. (The notice of deficiency did not reference the Estate’s amended return that reported a zero value for the STN stock.)
Follow-On Estate Valuation Reports
The Estate’s expert submitted a second valuation of STN stock at trial in 2012. In this report, the Estate’s expert utilized an adjusted book value method to value the stock at $4.3 million relying upon an independent valuation report of STN’s tangible personal property. The Estate’s expert admitted to mistakenly not accounting for the provision in the Services Agreement in his prior valuation that limits STN’s revenue to the lesser of 95 percent of The Word’s revenue or actual cost. The Estate’s expert concluded that the provision prohibited STN from generating a profit, and therefore, the income approach was not an appropriate method to value the STN stock.
The Estate hired a second expert that used the net asset value method to value the STN stock at $4.3 million, also relying upon an independent valuation report of STN’s fixed assets. The Estate’s second expert noted that the Services Agreement stated that, “any reduction in salaries would result in a dollar for dollar reduction in revenue…” thereby restricting a hypothetical willing buyer from reducing salaries to market levels to generate a profit. The Estate’s second expert also noted that a hypothetical buyer could not increase profits by giving himself a high salary given that STN’s already over market officers’ compensation would not be approved by a third party, and therefore, the income approach was not an appropriate method to value the STN stock.
IRS Expert’s Valuation Report
The IRS’s expert valued the STN stock using a discounted cash flow method concluding at a value of $26.3 million. The projected cash flows utilized by the Estate’s expert assumed that The Word would continue its practice of paying STN 95 percent of its revenues rather than STN’s actual costs. The IRS’s expert adjusted officers’ compensation to market rates. To account for risk associated with Kevin’s personal goodwill, the IRS’s expert concluded that Kevin be compensated at 8.1 percent of sales to retain Kevin as an officer of STN. The IRS’s expert determined a 25.5 percent rate of return and applied a 20 percent discount for lack of marketability in arriving at the $26.3 million value.
Both parties changed their positions over the course of the original estate tax filing, notice of deficiency, original petition, and answer to the Court. At trial, the Estate claimed a fair market value of the STN stock of $4.3 million on the valuation date and the IRS claimed a fair market value of the STN stock of $26.3 million on the valuation date. However, the Court views the Estate’s first reported value of $9.3 million as an admission by the Estate that can only be refuted later by the same party with “cogent proof that the reported value was erroneous.” During trial, the Estate also filed a motion to shift the burden of proof to the IRS under IRC Section 7491(a) which the Court denied given the Estate’s inconsistent positions regarding the value of STN stock.
Regarding the issue of the value of STN stock, the Court finds that STN was actually profitable, despite what the Services Agreement says, and it was reasonable to assume that it would continue to be profitable. Management made no indication that The Word would enforce the revenue limitation but rather projected sales growth for STN. Additionally, the Court notes that STN could potentially expand its operations to provide uplinking services to other customers besides The Word. Therefore, the income approach is the most appropriate method for valuing a company like STN and the Court rejects both applications of the adjusted net asset value method for these reasons.
The IRS expert’s report is rejected because it underestimates Kevin’s personal goodwill and its contribution to the business. Kevin’s connections were what drove the business. Furthermore, the IRS’s expert estimates a reasonable salary for Kevin of only $1.3 million, or 8.1 percent of sales. The Court finds that the Estate’s expert more correctly estimated Kevin’s reasonable compensation at $8-12 million (including both compensation and a charge for his personal goodwill). In the end, the Court gives no weight to ANY of the valuation experts testifying at trial, and places all the weight on the first report for the Form 706. Therefore, the Court has no need to address estate tax valuation understatement penalties.
An entertaining and highly instructive case, the Estate of Adell provides many important lessons for taxpayers and their advisors. The Court treats the first valuation for Form 706 as an admission by the Estate as it has many times before. This serves as a reminder to taxpayers to “get it right the first time.” The circumstances in this case are unique with STN’s lack of adherence to the Services Agreement, and the range of value opinions in this case is dramatic, which can be intimidating from a valuation understatement penalty standpoint. The Court seems to have placed substantial weight on STN’s actual profits rather than the legal limitations on its ability to make a profit. However, a hypothetical willing buyer of STN would have investigated the Services Agreement with The Word and discovered that its revenue was limited to cost. A buyer would also have considered Kevin’s role and the fact that he had no employment contract or non-compete agreement. Therefore, it could be argued that the $4.3 million value determined using the adjusted net asset method by the two follow-on experts is reasonable. Another interesting adjustment was the IRS expert’s application of a 20 percent lack of marketability discount for a 100 percent interest. Unfortunately, the case sheds no light on the expert’s rationale for applying such a discount. While the Estate’s original valuation ultimately prevails, the other valuations prove useful in providing alternative viewpoints on valuation issues and from a procedural standpoint.