As much as tax accountants must stay apprised of developments in Congress and the workings of the IRS, valuation analysts also keep a close eye on the courts, as cases — many which have been winding their way through the system for years — offer important clues to successfully guide future litigation.
Here are a few which have caught our eye recently.
Hartman vs. BigInch Fabricators
Words Matter in Shareholder Agreement
Blake Hartman, a former officer and shareholder of BigInch Fabricators, was terminated from the company without cause in 2018. The shareholder agreement signed in 2006 by all shareholders, including Hartman, dictated that BigInch repurchase Hartman’s 17.7 percent interest and pay him the “appraised market value” as determined by a third-party valuation analyst.
The analyst hired by the company used the fair market value standard and discounted the share value by 32 percent based on its lack of marketability (DLOM) and lack of control (DLOC).
Hartman sued, saying that the discounts weren’t applicable because the shareholder agreement didn’t “contemplate a fair market value standard,” but rather an “appraised market value standard.” The trial court issued a summary judgment in the company’s favor, stating that the word “appraised” simply modified “market value,” and thus “market value” and “fair market value” meant the same thing.
Hartman appealed, and in May 2020, the Indiana Court of Appeals sided with him, reversing the trial court ruling by determining that DLOMs and DLOCs don’t apply to compulsory sale to a controlling party where there is a ready-made market. In this ruling, the majority opinion discussed the difference between valuing assets in a divorce—when no sale occurs—versus valuation involving a sale in a closed market, regardless of which standard applied.
The company petitioned for transfer of the case to the Indiana Supreme Court which, in early 2021, reversed the Court of Appeals ruling, finding that there was no “blanket rule” prohibiting discounts in a compelled buyback and reinforcing the idea that parties can enter into a contract using whatever terms they wish.
In its decision, the Supreme Court said that “under the plain language of this shareholder agreement—which calls for the ‘appraised market value’ of the shares—the discounts apply.”
The court explained further that prior case law regarding a statutory buyout “doesn’t control” in this case, “where the valuation term comes not from a statute but from a contract that contemplates the shares’ ‘appraised market value,’ not their ‘fair value.’” The court concluded that Hartman’s shares could indeed be discounted for lack of control and marketability.
Lesson learned: Words matter! While it might not make sense to discount a minority shareholder’s shares in every case, here the contract language ruled. The standard of value or valuation formula dictated by a shareholder agreement should be clearly expressed.
Warne v. Commissioner
Slight Discount Allowed in Estate Tax Dispute
In 1981, Thomas and Miriam Warne created a family trust which, over the ensuing decades, became the majority owner in five LLC real estate holding companies. Miriam Warne served as managing member until her death in 2014.
Over the years, Miriam gifted fractional interests in the five LLCs to her sons and granddaughters, but a family trust, of which Miriam was the trustee, held the majority interest in the LLCs. When she died, her sons donated 75 percent of one of the five LLCs—Royal Gardens LLC—to a family foundation and the remaining 25 percent to a church.
On the estate’s 2014 tax return, the estate reported the donation’s value to the foundation to be $19.2 million and the gift to the church at $6.4 million, which reflected 100 percent of the property’s value included in the estate. The IRS noted deficiencies in gift tax (based on a 2012 gift Miriam had made but not reported) and various estate tax deficiencies, one of which regarded the estate’s charitable contribution deduction for the donation split between the foundation and the church.
Regarding the estate tax deficiency, the IRS disagreed with the estate’s value, saying that the value of the contributions should be discounted because neither group received the actual, full value of the estate’s reported interest.
In a 2019 trial, both parties’ experts testified about the value of the estate’s various properties, with both sides arguing vigorously about DLOMs and DLOCs and the experts’ use of particular studies for calculation purposes. Regarding Royal Gardens’ charitable contribution discount, the estate insisted that discounts were inappropriate because the estate donated 100 percent of Royal Gardens to charities and therefore the estate was entitled to a deduction of 100 percent of Royal Gardens’ value.
Conversely, the Tax Commissioner argued that the value of the deduction should reflect the benefit the beneficiaries received. In his ruling, the tax court judge said, “In short, when valuing charitable contributions, we do not value what an estate contributed; we value what the charitable organizations received.” The IRS suggested a discount of 27.385 percent for the church gift deduction and 4 percent for the foundation deduction, which the parties eventually agreed to.
Lesson learned: Tax planning is important. Splitting the charitable contribution turned out to be a bad idea. While the estate had good intentions, the IRS and the tax court focused on what was received rather than what was given. Had the estate left 100 percent of Royal Gardens to one beneficiary, it would have avoided the discount issue.
Prince’s Estate Under Scrutiny
In celebrity valuation news, the estate of world-famous rock star Prince R. Nelson is currently in a major dispute with the IRS regarding the value of the musician’s estate. Not surprisingly, the IRS claims the executors have undervalued Prince’s estate.
Prince, who died without a will, left an estate valued by its executor, Comerica Bank & Trust, at $82.3 million. The IRS claims that the estate is worth double that figure, resulting in a $32.4 million tax deficiency. Among the assets at issue are various real estate holdings and the estate’s interest in music publishing, compositions, and recordings.
Across the music industry, Prince was notorious for forcefully protecting the rights to his music and image. That will continue now that Comerica is taking the role of fiduciary and ensuring Prince’s heirs benefit from his legacy. A review and trial appears likely.
Biggest lesson learned (so far): Leave a will.
The middle of a valuation or litigation is the wrong time to find out about precedent-setting cases. Contact Dembo Jones’ Certified Valuation Analysts today for strategic guidance and tactics in resolving matters in commercial litigation and family law.