Taxpayers made gifts and sales of interests in a privately held S Corporation on June 4, 2014. The IRS audited the gift tax returns and determined a federal gift tax deficiency. The discounted cash flow model was determined to be the most appropriate test of value. The court meticulously reviewed the expert reports and testimony presented by both the taxpayer and the IRS.

Key findings of the court related to valuation included the following:

• Cash flow projections: The court found the taxpayer expert’s projections credible, based on industry data and accounting for known and knowable market trends as of the valuation date.
• Tax effecting: The court acknowledged that tax affecting S Corporation earnings may be necessary when valuation data is based on C corporations, which do pay taxes. The court adopted the Delaware Chancery method for tax effecting.
• Discount rates: The court emphasized that company-specific risk adjustments must not include factors already accounted for in other components of the discount rate. The court rejected the taxpayer expert’s company-specific risk adjustment due to insufficient explanation and quantification of the underlying risks.
• Long-term growth rate in terminal value: The court adopted the taxpayer expert’s long-term growth rate based on long-term GDP growth, rejecting the IRS expert’s reliance on inflation alone without adequate explanation.
• Nonoperating assets: The court accepted the taxpayer expert’s analysis of excess cash, determining that calculating working capital as a percentage of sales was more reasonable than the IRS expert’s calculation based on a percentage of assets.
• Lack of control discount: The court rejected the IRS expert’s 10% lack of control discount applied only to nonoperating assets due to lack of support and improper limitation of its application. The court found the taxpayer expert’s 5% lack of control discount reasonable, based on the operating agreement and analysis of control premiums in similar industries.
• Lack of marketability discount: The court adopted the taxpayer expert’s 25% lack of marketability discount, which was based on comparable companies, an analysis of the specific characteristics of the subject company, and the transferred interests. The IRS expert’s approach failed to make similar adjustments and relied on unreliable cash flow forecasts.

The court’s rigorous examination of the expert reports underscores the critical importance of presenting a well-substantiated and meticulously documented valuation analysis. Valuation experts must provide clear justification for all assumptions and support any applied discounts with credible empirical studies and robust analytical frameworks.

Chaffe & Associates, Inc. (“Chaffe”) provides highly specialized investment banking services to its clients including a full suite of transactional advisory services along with valuations for a multitude of needs. Chaffe leverages both of these core competencies
to create a powerful finance firm that always places its clients first. Founded in 1982, our clients range from sponsors, founder-led and family-owned businesses to publicly traded corporations spanning a broad spectrum of industries. Chaffe has qualified, credentialed
appraisers that provide comprehensive reporting for tax compliance.

Vanessa Claiborne, CPA, ABV, ASA
President & CEO, Shareholder
vbrown@chaffe-associates.com