On the heels of the Kress v. United States gift tax case, in which a federal district court affirmed the practice of tax affecting pass-through entities (PTEs) for valuation purposes, the U.S. Tax Court recently accepted a taxpayer’s tax-affected valuation in the case of Estate of Jones v. Commissioner.
This new case represents a big win for taxpayers—and for valuation analysts who have been seeking acknowledgment of the validity of tax affecting S corps, limited partnerships, and other PTEs. As part of his estate plan, Aaron Jones gifted his daughters shares in two closely related companies. The IRS challenged the valuation of one of the companies—SJTC—and notified Jones that he owed nearly $45 million in gift tax.
Interestingly, the tax-affecting piece of the case didn’t focus on tax-affecting per se but on how to tax affect. The court noted that both the IRS and Jones recognized that a hypothetical buyer and seller would indeed consider the tax consequences of SJTC’s limited partnership form but disagreed about how to do so. The IRS argued that tax affecting was improper where SJTC had no tax liability on the entity level and unfairly favored a hypothetical buyer over a seller. The estate argued that a zero tax rate on the entity inflated the value of SJTC, and a hypothetical buyer would recognize that partners would have to pay income tax at ordinary levels whether or not SJTC made cash distributions.
The court noted that Gross, the widely cited case that disallowed tax affecting, involved a different situation than Jones and accepted the family expert’s tax-affected valuation. The court said that the expert’s “tax-affecting might not be exact, but it is more convincing and complete” than the IRS’s position. Valuation analysts will no doubt study Jones for further insight into this issue.
For more information on this issue, please contact Chris Volz, Partner and Director of Business Valuation and Litigation Services.