Lucero v. United States – Court Rules “Severely Distressed” Company was Overvalued

The U.S. District Court for the District of New Mexico recently held that the plaintiffs, a married couple, were entitled to a tax refund for a 2014 court settlement that included stock in a private business. Here’s why the court determined that the stock was significantly overvalued for federal income tax purposes.

Why the Plaintiffs Amended Their Return

The wife was an employee at Good Technology Corporation (GTC), a private business, until July 2012. In October 2012, she sued GTC for disability discrimination and wrongful termination, and the parties settled in April 2014. The only financial information that GTC gave the plaintiffs was a list of stock sales between March 2012 and November 2013. The most recent sale was for $2.38 per share.

The settlement agreement called for a $500,000 cash payment, a $1.75 million payment to a trust, and 650,000 shares of GTC’s common stock. The agreement stated that the stock’s value was $1,547,000 ($2.38 per share × 650,000 shares).

The plaintiffs relied on the value in the agreement when reporting settlement proceeds on their 2014 tax return. They subsequently filed an amended return, reducing the stock’s value to $0.57 per share. The IRS denied the refund claim, and this lawsuit followed.

How the Experts Valued the Shares

The plaintiffs hired a business valuation expert who appraised the stock using the market approach. Then he applied discounts for lack of control and marketability of 25% and 18%, respectively, to arrive at a minority, nonmarketable value of approximately $0.57 per share.

The expert rejected the cost and income approaches because the “cash poor” company had negative earnings, working capital, and book value. Moreover, the company’s Altman Z-score indicated that it was “severely distressed” and “unlikely to survive the next two years.”

The IRS valuation specialist didn’t perform a formal appraisal of the stock. Instead, he asserted that the stock’s value was at least $2.38 per share, based on the value stated in the plaintiffs’ settlement agreement and a recent merger transaction in which GTC’s stock was valued at $4.92 per share.

The appropriate standard of value for federal income tax purposes is fair market value. The court ruled that the settlement agreement didn’t reflect fair market value, because the parties weren’t willing participants. The court also held that the merger was based on fair value, an entirely different standard of value.   

Why the Plaintiffs Prevailed

The court ruled that the analysis from the plaintiffs’ “experienced” business valuation expert was “thorough and credible.” As a result, it valued the stock at $0.57 per share, upholding the plaintiffs’ amended return and refund.