Estate of Richmond v. Commissioner Rebutted
by JAMES LISI, CVA MBA
July 2017

This article published in the September 2017 issue of Santa Barbara Lawyer

Since 1998, appellate decisions in Estate of Eisenberg and Estate of Davis cases allowed 100% of Built-In Gain Tax Liability (BIGL) to reduce company value in estate tax matters.  Just as case law seemed to settle the side issues regarding Built-In Gain Tax Liability (BIGL), the IRS introduced a new methodology to quantify the BIGL; one based on future events.  After three recent Tax Court cases, the Estates of Litchfield, Jensen and Richmond, this thinking has evolved and, in Richmond, resulted in a misguided, severe reduction in BIGL value, based upon faulty application of theoretical formula.  If the IRS continues litigating, this issue will end up before the Supreme Court, so it is critical that sound economic and accounting principles be presented in comparison to the fallacy of Richmond Tax Court’s analysis.

Accrual Accounting Approach

The 1998 cases align with accrual accounting practice.  In accrual systems, revenue is recognized when it is earned.  This practice is used to avoid misrepresentation to investors and taxing authorities.  Under accrual framework, the liquidation date for the BIGL asset is not material because recognition is based on the date earned.  When the valuation date is selected, the asset value and its tax obligation to government are earned together.  Said another way, fixing the appreciated market value at a specific date, fixes the tax on the same date.  Compliance with accrual principles results in 100% BIGL and remains the most defensible value.

Where Things Went Wrong

Estate of Borgatello v. Commissioner T.C. Memo 2000-264 was the first to speculate on BIGL with Time Value of Money (TVM) modeling based on exit value.  The estate brought the argument, not the IRS.  The estate used a ten-year time horizon, with a 2% asset appreciation rate and an 8.3% investor rate of return.  These assumptions resulted in a $3.3 million BIGL versus the accrual value of $5.1 million.  The difference of $1.8 million was then subject to tax.  It was a deliberate increase of estate value.

In all of the post-1998 cases, an estate’s argument for 100% BIGL held, until Estate of Litchfield v. Commissioner, T.C. Memo. 2009-21, when the IRS emulated Borgatello and introduced TVM to discount BIGL.  Although the IRS’ TVM argument was disregarded, Litchfield resulted in a decision for use of 90.5% of BIGL based on the subjective opinion that the future nature of the tax payment would compel the FMV buyer and seller to negotiate a reduction.

In addition to the rejection of Litchfield TVM analysis, Borgatello’s TVM eventually discredited itself over time.  Based on actual appreciation of the estate’s assets, which we can now observe retrospectively, the estate should have been taxed on a reduced value, not an increased value.  The appreciation forecast was very wrong.  Any TVM analysis where the appreciation grows faster than the investor’s required rate of return will decrease estate value, growing the future tax liability.  In this regard, TVM is an unbounded projection that can be used to justify any opinion. So now, TVM analysis had been argued in Tax Court several times, and was conceptually defeated – until its resurrection in Estate of Richmond v. Commissioner, T.C. Memo 2014-26. 

Avoiding TVM, the IRS argued to reduce BIGL value in Richmond with transaction data, but the evidence failed to prove their case.  Then, surprisingly, the Tax Court imposed the defeated IRS TVM of Litchfield in their decision and there was no opportunity to rebut their analysis.  The Tax Court asserted that the BIGL does not have the same character as debt, because payment can be indefinitely postponed, and imposed a discount on the accrual value of BIGL.  The facts of the case applied through their TVM would have resulted in a 97% discount, so instead they truncated the reduction to 57%.  How nice of them.

The tax court did not look at the investment case.  It took present value of BIGL as its future value for TVM (essentially sending it from the present backward in time), which fails to meet economic standards.  Not only is the conclusion infeasible, it amounts to the hypothetical buyer accepting a large double tax on the asset purchase - a discount to the seller now and payment of the full tax at liquidation.  This is what happens when the untrained dabble in economics. 

Economic Justification – Modeling Cash Flows

Now it is possible to model the value of the BIGL based on a distant future exit event, but this requires the use of Net Present Value (NPV) analysis, not TVM.  Even though we can perform NPV analysis and rebut the one-way discount bias, it brings two questions to bear, 1) should we be valuing based on future speculations and 2) how likely is it that we find a fair answer?

Use of NPV

NPV is best used to compare alternatives, which is the exact situation we have with BIGL.  The question:  Is a buyer willing to pay a premium to buy a stock having a lower value than the same asset without liability found on the open market?  If the buyer benefits by buying the stock of the corporation over the alternatives, yes, they may be willing to pay more. 

In our case, the competing projects are 1) value based on buying the asset outside the company and 2) value based on buying company stock (the asset inside the company) and 3) not investing at all.  The options must be modeled from beginning to end, not only just the tax liability isolated from other investment factors.  Here is the investment scenario for buying the asset outside the company.

Outside Basis	$5,000
Entry	--------------Distributions----------------				Exit
Pre-Tax Cash Flow	($5,000)	$100	$100	$100	$100	$7,154
Tax	($35)	($35)	($35)	($35)	($754)
Cash Flow to Investor	($5,000)	$65	$65	$65	$65	$6,400

 

Here is the investment scenario for buying the company stock instead.

Inside Basis	$1,000
Entry	--------------Distributions----------------				Exit
Pre-Tax Cash Flow	($3,600)	$100	$100	$100	$100	$7,154
Tax	($35)	($35)	($35)	($35)	($2,154)
Cash Flow to Investor	($3,600)	$65	$65	$65	$65	$5,000

 

What gives rise to the possibility to apply a discount is the comparison of the alternatives at the investors required rate of return.  We lack space to develop this fully here, but the full paper showing how these variables play out can be found at sbvaluations.com/store.

Importantly, the result of comparative NPV analysis will offer an economic settlement range that we can calculate, and it will not be unbounded like TVM.  It will provide sensible positions for buyer and seller to take, because both the accrual value and the investment analysis are valid negotiating positions.  Here, the buyer argues for 100% BIGL, while the seller asks for a 25% BIGL discount.  Experience in M&A indicates that the buyer gets most of the advantage for taking on the investment risk, while the seller moves to an off-risk position.  So, the likely BIGL discount would be under 10%. -nothing like the 57% discount dictated in Richmond.

Synopsis

As displayed by the true outcomes of Borgatello, the potential for both discounts and premiums exist with speculative analysis.  Time alone does make inside basis more valuable; but it is one of several variables that need to be examined, the others being the original basis, distributions, appreciation, and investor rate of return. 

With NPV comparison, technical issues with amateurish application of TVM are eliminated.  While the effect of time increases the value of buying stock, discounts never exceed 100% of BIGL, for example.   

However, futuristic analyses have applicability, error, judgement and bias issues.  Thoughtful consideration of cash flows is required to simulate the buyer’s decision to purchase.  Simple linear projections at a fixed appreciation rate are superficial examinations of conditions unlikely to give a fair result.  Within a fifteen-year time horizon we would expect recessions to occur, population changes and technology effects that alter long term value.  The impact of predictable events needs to be explicitly considered.  However, making predictions of these elements over long time periods is troublesome, as we know they will be wrong.  The only facts available in all of this analysis is the current value and basis of the asset.  The remainder is opinion disguised in a mathematical formula.

Conclusions

The over-simplification and misapplication of economics in Richmond is frightening - speculation masquerading as scientific analysis.  The mixing of present and future values misrepresented the character of the investment, and no transaction data is available to show that BIGL discounting behavior exists in markets. 

Because it avoids multiple assumptions of opinion, the best valuation approach is to use 100% of BIGL based upon principles of accrual accounting and the avoidance of double taxation.  It provides a fair result without speculating.

Unfortunately, both concepts - accrual value and investment analysis - have validity.  If speculation is lawfully acceptable, investment analysis with NPV is the correct assessment of the future exit question.  NPV frames a negotiation range between hypothetical buyer and seller.  However, we must accept that premiums are just as suitable as discounts depending on the investment case.  Overperforming assets will show a range within which to negotiate a discount to BIGL, while underperforming assets may demonstrate that a premium is necessary to induce a buyer to accept the inside basis depending on time to exit.  This fits the common-sense rubric on both ends of the question.  Economics appear to lead toward a central tendency of 25% discount to 15% premium.  

It is remarkable that Tax Court decisions over the last fifteen years have not analyzed this problem correctly.  In the end, using future exits is an extensive valuation project that incorporates less fact than opinion.  It frames debate, but arguments will need to be had on time horizon, projected returns and appropriate discount rates.  This kind of conjecture appears to be contrary to good policy, but now taxpayers are placed in position of defending against the Tax Court TVM.  With proper method, an IRS challenge can be reliably tempered or completely refuted.  With Richmond established as a challenge to accrual valuation, especially with its gross error, it is time that proper analysis be brought to light.

 

For more information contact: 

James Lisi

[email protected]

 

James Lisi, CVA, MBA

Owner, Santa Barbara Valuations Inc.

Partner, American ValueMetrics

James A. Lisi is owner of Santa Barbara Valuations and a partner at American ValueMetrics with fourteen years valuation experience and twenty years in executive and strategic positions at Fortune 100, Private Equity and his own personally held businesses. 

His valuations focus on closely-held companies for tax and financial reporting, while his advisory services support start-up growth companies, transactions and other projects for company owners. He has worked with clients in technology, internet, aerospace, industrial distribution, consumer goods and services, franchises, food and beverage, and financial services.  He has extensive operating experience in manufacturing, distribution, rental and youth services. 

Jim is a member of the National Association of Certified Valuators and Analysts (NACVA), holding the Certified Valuation Analyst (CVA) designation.  He is a California state-appointed member of the California Coastal Loan Committee, and a member of Tech Coast Angels, Rotary International and Provisors.  Mr. Lisi also taught finance in Antioch University’s MBA program. 

Rooted in industrial engineering and acquisitions, Jim brings the structured approach of an engineering economic analysis together with the proper application of finance and market principles in his valuations.  Where required, the reports satisfy regulatory requirements for the IRS, ERISA and DOL. 

Mr. Lisi has an MBA from UC Irvine and BSIE from the University of Michigan.