Estate taxes are applied based on the value of assets that the decedent owned. Thus, unlike income tax which looks to sources of income, the estate tax focuses on the value of assets owned.
This raises questions as to what the fair market value is for assets on the date the decedent died. Opinions can vary widely on value, even among credentialed valuation experts. This results in a battle of the expert’s dispute when these cases are audited by the IRS and litigated.
The Estate of Mitchell, T.C. Memo. 2002-98 case provides an opportunity to consider these types of disputes.
Facts & Procedural History
John Paul “Jones” DeJoria and Paul Mitchell formed John Paul Mitchell Systems (“JPMS”) in 1979 to market hair care products through professional-only salons. JPMS was a major player in the hair care industry by 1984, with a sophisticated distribution network and hundreds of trained stylists. Mitchell was the creative force, and DeJoria managed daily operations. Until 1989, they were the only board members, set sales goals, and divided income equally each year. In April 1989, JPMS stock had not been registered under any securities law.
JPMS paid Mitchell over $10 million between August 1988 and April 1989, and both Mitchell and DeJoria were set to receive a $2 million salary and a $15 million management fee for fiscal year 1989. In 1987 and 1988, Minnetonka Corp. offered to acquire all of JPMS’s stock for $100 million and $125 million, respectively, but negotiations fell through due to disagreements on compensation levels. Mr. DeJoria claimed to have received a higher offer from Gillette but negotiations with them also ended. KPMG certified JPMS’s financial statements.
In July 1988, Mitchell was diagnosed with pancreatic cancer, which led to several surgeries and treatments. He continued as the creative force, spokesman, and executive of JPMS until January 1989. In February 1989, tests revealed a recurrence of cancer, and Mr. Mitchell refused chemotherapy. JPMS shifted its advertising campaigns away from Mitchell towards the products themselves. Mitchell died on April 21, 1989. As of that date, the common stock of JPMS was owned by undisclosed parties.
On its estate tax return, the estate valued the shares at $28.5 million. However, the IRS claimed they were worth $105 million upon audit. Tax litigation ensued. The court originally valued the shares at $41.5 million, but the case was remanded back to the court for further findings. The ultimate issue was to determine the fair market value of the shares at the moment of Mr. Mitchell’s death for estate tax purposes.
Estate Taxes & Valuation
Valuation issues are important in estate tax disputes because the value of the assets included in an estate determines the amount of estate tax owed. The IRS and the estate may have different valuations of the same assets, which can result in significant tax liabilities or refunds.
Estate tax disputes often involve assets that are difficult to value, such as closely held businesses, real estate, and artwork, and may require the use of expert appraisers and complex valuation methods. But the end goal is to determine the fair market value of the assets.
Fair market value for Federal estate and gift tax purposes means the price at which a property would be sold between a willing buyer and a willing seller, both having reasonable knowledge of relevant facts and neither being under any pressure to buy or sell.
There are several approaches to valuation methods, and each approach provides a different way to determine the fair market value of an asset. The three main approaches are:
- Market Approach: The market approach is based on the idea that the value of an asset can be determined by comparing it to similar assets that have been sold in the market recently. For example, the value of a house can be determined by looking at the sale prices of similar houses in the same area.
- Income Approach: The income approach is based on the idea that the value of an asset is determined by the income it generates. This approach is often used to value businesses or rental properties. The value of a business, for example, can be determined by estimating the future income the business will generate and then discounting that income back to its present value.
- Cost Approach: The cost approach is based on the idea that the value of an asset is determined by the cost to replace it. This approach is often used to value assets that have unique features or that are difficult to find comparable sales for. The value of a piece of artwork, for example, can be determined by estimating the cost to create a similar piece of artwork today.
The valuation method is important, but so too is the discount rate. In some ways, the discount rate is the most important aspect of valuations.
When valuing unlisted stock, it may be appropriate to apply a discount for lack of marketability, a discount for a minority interest, or a premium for control. Discounts for lack of marketability and lack of control are different when valuing stock of closely held corporations. The minority discount is designed to reflect the decreased value of shares that do not convey control of a closely held corporation. The lack of marketability discount, on the other hand, is designed to reflect the fact that there is no ready market for shares in a closely held corporation. A control premium represents the additional value associated with the shareholder’s ability to control the corporation by dictating its policies, procedures, or operations.
The Court’s 35% Discount Rate
In light of all the evidence presented, including the real-world acquisition offers and the expert testimony, the court found that the fair market value of the trust’s 1,226 shares of JPMS common stock as of the moment of the decedent’s death is $112 million. This value represents the acquisition value of all the nonpublicly traded stock of JPMS and reflects a control, nonmarketable value. No discount for lack of marketability was applied.
On the basis of a review of the entire record, the court arrived at a 35-percent discount rate that combines the lack of control and any additional lack of marketability attributable to that lack of control that is not reflected in the $150 million control, nonmarketable acquisition value.
So the estate valuation started with $56.1 million on the tax return. The IRS determined the fair market value to be $279 million, and the court’s final valuation amount was $152.7 million. This was about half of what the IRS was wanting, and more than 100% larger than the amount reported. Given the 40 percent tax rate, this resulted in a very large tax bill.
When I was at the IRS, I was taught that a discount rate that starts with a 1, 2 or 3 is okay, but a discount rate that starts with a 4 or higher is not. This case proves that. The court ended up with a 35% discount rate, which, is not much more than a guess put forth by the court. Valuation issues like this are difficult and, when raised by the IRS, will often result in significant estate taxes being due. Taxpayers are well advised to keep a reserve of liquid assets or act timely to request an estate tax installment payment agreement.