Valuation Challenges and Pitfalls in Tax Cases

Published Categorized as Federal Income Tax, S Corporation Tax
Taxpayer: It’s All About Valuation; Irs: We’re Damned If We Do
Taxpayer: It’s All About Valuation; Irs: We’re Damned If We Do

Valuing property for tax purposes is complex and can be a critical issue as it can result in significantly higher or lower taxes.

The Garwood v. Commissioner, T.C. Memo. 2004-195, case offers a fascinating example of the challenges and pitfalls involved in valuation, particularly in the context of tax court cases.

This case involved the valuation of a taxpayer’s water rights. Both the IRS and the taxpayer presented valuation experts who arrived at vastly different values. Ultimately, the court disregarded both of them and came up with its own valuation. And get this, the valuation was lower than what the taxpayer reported on their income tax return. The IRS audited the taxpayer, presumably held an administrative appeal, and then litigated the case and lost–only to entitle the taxpayer to a refund in excess of what they reported on their tax return to start with.

While the court case involves the built-in gains tax, the same valuation issues arise in a number of different types of tax cases–from estate and gift tax to merger and acquisition cases.

Facts & Procedural History

The taxpayer was an irrigation business in Texas. It was an S corporation from 1948 until 1978, when a shareholder died and the trusts that inherited his shares were ineligible to be S corporation shareholder. As a result, the business operated as a C corporation from 1978 until 1997. On March 19, 1997, the business elected to be an S corporation. This is not a late S corporation election case, it is one that the election was simply made a second time.

At the time of the election, the business’s primary asset was the right to divert 168,000 acre-feet of water from the Colorado River at a specified diversion point near Garwood, Texas.

Texas water rights were regulated by the TNRCC, which had the power to approve or deny transfers and amendments to water use. A potential sale of a portion of the taxpayer’s water rights to Corpus Christi faced opposition from the LCRA and other parties. The 1997 legislative session led to a change in Texas water usage laws, including the Junior Water Rights Provision.

The business sold its water rights and related assets to the Lower Colorado River Authority and the city of Corpus Christi, Texas in 1999, and reported a built-in gains tax of $9,636,736 on its 1999 return. The taxpayer then filed an application to transfer the remaining portion of its water rights and subsequently reached a sale agreement with the LCRA. The LCRA recorded the water rights on its books at a fair market value of $75 million.

The IRS audited the return and determined a deficiency of $15,819,650 based on a different valuation of $76,609,000 for the water rights and investment portfolio.

The S Corporation Built-in Gains Tax

The built-in capital gains tax is a tax that S corporations have to deal with. It is set out in Section 1374.

Section 1374 requires that if a corporation holds appreciated capital assets before it makes an election under Section 1362 to be an S corporation and any of the appreciated capital assets are sold within 10 years of the election, the corporation will be subject to corporate-level tax on the amount the corporation realizes over its basis in the sold assets (i.e., it’s built-in gain).

The net recognized built-in gain is the lesser of the taxable income of the S corporation for the taxable year, considering only recognized built-in gains and losses, or the S corporation’s taxable income for the taxable year.

The proper valuation date for an asset with built-in gain that has an uncertain value is the effective date of the corporation’s S corporation election. The date of this election is part of the dispute in this case. The taxpayer elected to be an S corporation as of January 1, 1997, so it will be taxed on the built-in gain on its assets as of that date. The question was what was the value of the business assets as of that date?

Separately, it should be noted that similar valuation issues can arise in the distribution of S corporation assets. We also see disputes like this in those cases as well.

The Valuation Dispute

The taxpayer and the IRS presented expert witnesses to value the taxpayer’s water rights, but their estimates of fair market value differed significantly.

The taxpayer’s expert witness concluded that the value of the water rights was $10.7 million on the valuation date. The taxpayer’s expert whose report provided the valuation used in the preparation of the federal income tax return concluded that the value of the water right was $29,397,000. On the other hand, the IRS’s expert witness concluded that the value of the water rights was $45,809,384. The IRS’s notice of deficiency had used a $76,609,000 valuation.

The court noted that while expert opinions can assist in evaluating a claim, the court is not bound by these opinions and may reach a decision based on its own analysis of all the evidence in the record. It also noted that it can cherry-pick between the factors used by the experts. The court weighed each estimate by analyzing the factors they used to arrive at their conclusions. In doing this, the court concluded that the value was $22,532,519–which was even less than the amount the taxpayer reported on their income tax return.

The Takeaway

The Garwood case highlights several interesting issues related to valuing property for tax purposes. One issue is the role of expert testimony in tax court cases. In this case, both the IRS and the taxpayer presented valuation experts, but the court ultimately disregarded their opinions and arrived at a different valuation. The lengthy opinion suggests that the court may have had other evidence or circumstances that influenced its decision.

Another issue is the impact of the government’s initial valuation in a tax dispute. In this case, the government initially asserted a very high valuation, which may have undermined its case and made it more difficult to convince the court of a lower valuation.

Finally, the case highlights the importance of accurate valuation in tax matters. The taxpayer in this case initially claimed a much higher value than the court ultimately accepted, and as a result, the taxpayer ended up owing less in taxes than it had anticipated. Tax practitioners must carefully consider all relevant factors when valuing property for tax purposes, and they must be prepared to defend their valuations in court if necessary.

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