Estate of Jones: Valuing Gifts of LP Interests in Income-Producing Real Estate
The U.S. Tax Court addressed several important business valuation issues in a recent gift tax case. Here’s an overview of why the court applied the income approach, not the cost approach, to value a limited partner (LP) interest in a timber business, as well as how it handled the use of management’s projections and the tax-affecting of the earnings of a “pass-through” entity.
In May 2009, Mr. Jones gifted the following business interests to individual family members and various family trusts:
- 1,300 shares of class A voting stock in Seneca Sawmill Co. (SSC),
- 10,256 shares of class B nonvoting stock in SSC, and
- 10,267.67 LP units in Seneca Jones Timber Co. (SJTC).
SSC is a lumber manufacturer that sells lumber around the United States, primarily for use in the housing industry. In 1986, the company elected to be taxed as an S corporation.
SJTC is a limited liability partnership (LLP), created in 1992 to acquire, hold and manage timberlands. SJTC’s holdings were intended to be SSC’s inventory. SSC served as the general partner for SJTC, making all of its management decisions. As of the valuation date, SSC’s largest supplier of logs was SJTC.
The IRS didn’t submit a valuation of SSC and largely accepted the valuation methods that the estate’s expert used to value SSC. So, the primary issue in this case was the fair market value of an LP interest in SJTC.
The 2009 gift tax return reported that the value of each LP unit was $350. After receiving a deficiency notice from the IRS, the estate hired another business valuation expert who estimated that the value of each LP unit was $380, an increase of about 9% over the amount reported on the original gift tax return. In contrast, the IRS’s expert opined that the value of each LP unit was $2,530, more than six times the amount set forth by the estate’s expert.
Holding Company vs. Operating Company
The IRS’s expert contended that SJTC was a holding company that should be valued using the cost (or asset-based) approach. Conversely, the estate’s expert argued that SJTC was an operating company that should be valued using the income approach.
The Tax Court determined that SJTC had aspects of both an operating company and a holding company. But, after accounting for SSC’s control of SJTC and the economic interdependence between the companies, the court found it unlikely that the partnership would sell its underlying assets (the timberlands). Therefore, it decided that the discounted cash flow (DCF) methodology used by the estate’s expert was the more appropriate way to value SJTC.
Management’s Projections and Tax-Affecting
The IRS criticized two aspects of the DCF analysis. First, it argued that revised projections prepared by management in April 2009 were “unreliable.” But the court accepted them as inputs into the DCF model, because they were the most current projections available, and management had relied on them for business decisions at the valuation date.
Second, the IRS argued against the application of a 38% combined state and federal corporate-level rate to SJTC’s earnings before interest and taxes. SJTC (an LLP) is a so-called “pass-through” entity. That means it doesn’t pay taxes at the entity level; instead, earnings are passed on to the partners and taxed at their individual tax rates.
To reflect the benefit of avoiding taxes on future dividends paid out to partners, the estate’s expert applied a premium in his DCF analysis. The court said his tax-affecting methodology “may not be exact, but it is more complete and more convincing than respondent’s zero tax rate.”
Court Sides with Estate’s Expert
Ultimately, the Tax Court accepted the values set forth by the estate’s expert in their entirety, including his application of a 35% discount for lack of marketability. The estate admitted to owing a deficiency of roughly 9% from the amount originally reported on the 2009 gift tax returns, but the court rejected all the IRS’s arguments on the valuation of the LP interests that were presented in court.