Key Business Valuation Issues Addressed by Tax Court Ruling


Article at a Glance:

  • Ramifications of the estate of Aaron U. Jones Estate Case impact valuations
  • $89 Million dispute leads to the IRS demanding $45 Million in taxes
  • Three approaches IRS revenue ruling 59-60 suggests the valuator use: income, market, and asset.
  • Prudent Valuators have the most recent income forecast to reflect market reality
  • The marketability discount (DLOM) can impact valuations and adequate documentation matters
  • Practical approach backed by current data eclipses the IRS’s theoretical approach

Ramifications: Aaron U. Jones Case

 Business valuation rules and norms frequently evolve as a consequence of IRS and Tax Court rulings. Every few years, a case comes along in which the judgment has an immense influence on the valuation field. Last year, the tax court resolved the case of the Estate of Aaron U. Jones. In its ruling, the court clarified its views on the treatment of business cross-ownership, the tax-effect of s-corporations, the right valuation approach for an asset-heavy business, the validity of revising financial, and other valuation-related issues.

$89 Million Dispute

 Let us begin with some background. The IRS filed a multi-issue case in the United States Tax Court against Aaron U. Jones about the taxes paid on gifts to his three daughters. These gifts came from his ownership in his two S-corporations, Seneca Sawmill Company (SSC) and Seneca Jones Timber Company (SJTC). The IRS disputed that the business appraisal was too low. The difference between the IRS estimate and Aaron Jones’ estimate is about $89 million. As a result, the IRS demanded taxes of about $45 million.

Cross-ownership Issues

 Aaron Jones owned SSC, a sawmill company, and SJTC, a timber wood company. One issue of this case was that these companies were functionally one business, as SSC owned 10% of SJTC. Both companies shared headquarters, key employees, and executives, as well as co-signed loans. Additionally, SJTC only sold timber to SSC. SJTC could not have operated independently of SSC, and Aaron Jones had no intention of selling the SJTC business. These facts proved that the companies were cross-owned and that the cross-ownership was legal and functional. Still, the IRS wanted to value them separately. 

 Yet, the court sided in favor of the private valuator, who appraised the companies as one interrelated entity. Using the most current financial data, the analyst valued the gifted part of Jones’ estate at $21 million instead of the $120 million the IRS had estimated. 

Pass-Through Taxation

 In this case, another critical issue was about the pass-through entity and how it is tax affected. Tax-affecting is not a new issue; there has been an ongoing debate about tax-affecting in the valuation field for many years. While a real-world practitioner knows that the buyer always thinks about the tax effect, the court had not spoken on this issue for over twenty years. In Jones’s case, the Tax Court sided with the expert, saying the tax-affecting makes the most sense. Do these lead us to the right approach to value a sawmill & timber company, an asset-heavy business?

Three Approaches: Income, Market, Asset

There are three main approaches that IRS revenue ruling 59-60 suggests the valuator should use: income, market, and asset. Usually, however, one approach makes the most sense for a particular business or industry. In SSC and SJTC, the IRS applied an asset approach, which is how timber usually gets valued. Contrarily, the private valuator used an income approach because the sawmill and timber company were so inter-linked, a decision with which the court sided. Not only did the use of these different approaches lead to a lower estimate, but the economic recession also had a notable impact on it.

Income Forecast

 Due to the recession, the estate re-did the financial forecasting, which had been done three months prior. The IRS, however, chose to use the old forecast. The private valuator argued against this choice as re-forecasting was necessary due to changing economic circumstances, and the court sided with him. This court ruling is particularly relevant in the climate of the COVID-19 pandemic, where many industries have seen grave aftermath. If you are appraising a business, it is prudent to have the most recent income forecast to reflect market reality.

DLOM Difference

 The court also decided on the marketability discount (DLOM), which can also impact the valuation. In this case, there was a considerable difference between the IRS and experts’ DLOM, being 35% and 30%, respectively. Siding with the appraiser’s estimate indicated that the court viewed the valuator’s documents as better justification for their DLOM number. The analyst must adequately document and support reports to have their value accepted in the court. 

Data vs. Theory

 From a practitioner’s perspective, The Jones’ Estate is a critical case as it validated the valuator’s approach and method of valuation. The valuator’s correct representation of the company’s structure and its impact on the value was crucial in the court’s judgment. This case demonstrates that analysts must make sure their valuation report and supporting documents support the conclusion. In the end, the court’s ruling favored a more practical approach backed by more current data over the IRS’s theoretical approach that used older forecasts and failed to account for changing economic conditions.

Evan M. Levine began his career in the summer of 1988 as the very first intern for New York City’s #1 insurance agency, Mass Mutual Life. From 1988 to 2009, he provided insurance-based financial planning advice to investment bankers, attorneys, and business owners in NYC.

With a strong desire to provide a higher level of objectivity and transparency, he became independent in 2009 and started a fee-only, registered investment advisory firm offering wealth management and retirement income planning services, specifically aging baby boomers.

In 2019, Evan M. Levine partnered with Nainesh Shah to form Complete Advisors LLC to help pre-retirees plan financially for what’s next in their lives. Born and raised in Whitestone, Queens, Evan currently lives on Long Island with his wife and two children. In his spare time he enjoys reading and playing golf and tennis.

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