Page 28 - Business Valuation for Estates & Gift Taxes

throughout this practice aid, valuation analysts often use case law and academic studies to provide sup-
port and direction for their own valuation reports; however, this practice (without further investigation
into the specific facts of each case, the methodologies used by the valuation experts, and the rigor used
to compile any academic study) will more likely than not result in conclusions of value that do not with-
stand the scrutiny of the courts. Because DLOC and DLOM can require a lot of professional judgment,
valuation analysts must make every effort to ensure their discounts are reasonable and well supported.
The case of Estate of Webster E. Kelley, et al. v. Commissioner, T.C. Memo 2005-235 is an expository
example of what can happen when this is not done.

Most of the issues in this case were resolved before trial, and therefore, the remaining issue was whether
the proper discounts were applied to a minority interest in an FLP that solely held cash. The experts’
discounts were as follows.

DLOC DLOM

Taxpayer 25% 38%
IRS 12% 15%

In its decision, the court ruled in favor of the IRS and noted that, "Although we find neither expert par-
ticularly persuasive on this issue, we will apply a 12-percent discount on the grounds that (1) respondent
has effectively conceded that a discount factor of up to 12 percent would be appropriate, and (2) peti-
tioner has failed to prove that a figure greater than 12 percent would be appropriate. See Peracchio v.
Commissioner, supra (using a 2-percent minority discount factor for the ‘cash and money market funds’
asset category of a family limited partnership)." On the issue of the DLOM, the court determined that a
DLOM of 20 percent was appropriate and its decision was based on same rationale used to decide on the
issue of which discount rate was appropriate.

While there is no guarantee the results would have been different had the valuation analyst prepared a
more thoroughly supported valuation report, the valuation analyst’s lack of analysis and support were
clearly a factor in how this judge ruled on the issues.

Tax-Affecting in Subchapter S Corporations

Historically, valuation analysts took the position that the assumed buyer of a subchapter S corporation or
an interest in this type of corporation would be a C corporation or other ineligible shareholder and there-
fore, a C corporation level of taxation was applied to adjusted earnings when valuing an S corporation.
In addition, it is common practice for valuation analysts to use the discount rates derived from the data
contained in Stocks, Bonds, Bills and Inflation and the Duff and Phelps Risk Premium Report when valu-
ing the corporation’s after-tax net cash flow.

In 1999, the Tax Court ruled in the case of Walter L. Gross, Jr., et ux., et al. v. Commissioner (Gross),
T.C. Memo 1999-254 that the net income of a subchapter S corporation should not be tax-affected be-
cause the corporation would not pay taxes. This case was appealed to and upheld by the 6th Circuit
Court of Appeals (88 AFTER 2d 2001-6858[272 F.3d 331]). Several additional cases have followed this
decision that have not allowed tax-affecting of subchapter S corporations. Three of these cases were de-
cided by the same judge that heard the Gross case.

Before deciding on whether to tax-affect an S corporation for valuation purposes, valuation analysts
should consider the facts and circumstances surrounding each valuation assignment. As stated through-
out this practice aid, courts rule on the facts presented to them and these facts will be unique in each

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