By Richard M. Morgan
The Tax Court in the recent Adell v. Comm. Case has made some very interesting determinations that will help in planning for the valuation of closely-held business interests. Estate of Franklin Z. Adell, Deceased, v. Commissioner of Internal Revenue, T.C. Memo. 2014-155 (August 4, 2014). At the outset, it is important for tax attorneys, CPAs and other business advisors to be aware that facts are critically important to the tax effects of any proposed transaction, including business valuations to be used on tax returns, and that planners are in the unique position of helping mold the facts that will exist at any particular point in time. The Adell case also teaches us to be aware of both the pros and cons of Buy-Sell Agreements and Employment Agreements, as well as the need to make sure that the business valuation appraisal you use for tax return filing purposes is the good appraisal, and not a cheaper one that you may not want to use if it is ever challenged.
The facts of the Adell case were very interesting and showed a family who likely abused its position to obtain improper personal benefits from a related public charity, and used the ill-gotten gains to live the luxury life. The business at issue had one client, a 501(c)(3) charity the family had set up to get specialized access to air its church based TV channel, “The Word.” The impermissible private benefits had not been discovered over many years, but then the family patriarch / 100% owner of the related for-profit business, STN.COM (C corporation) died. The IRS audited the decedent’s Estate Tax Return, IRS Form 706, and decided that the STN.COM valuation significantly undervalued the decedent’s business ownership interest. The Estate valued the business at $4.3 million, and the IRS valued the business at $9.3 million. If this were a war, I would say the Estate has pretty much won each and every round, but if the IRS does its’ job fully and properly, this matter is far from over. The abuse of charity related income tax issues could end up being huge, especially since the Court pointed these issues out in a footnote to the Tax Court opinion.
The Estate won on the business valuation issue, but likely could have done even better. Here is what we learned:
1. The Adell case is next one pointing out that “goodwill” involved in a business may, in fact, belong to the key employee and not to the business. In such a case, the business value would not include this goodwill, which would lead to a lower valuation.
2. Who owns this goodwill can be affected by any existing Buy-Sell Agreements and Employment Agreements. In this case, no such agreements existed, and the Court determined that the business did not own the goodwill at issue, and therefore the value was significantly lower than the IRS’ appraiser had determined. The lesson here is that the effect of Buy-Sell Agreements and Employment Agreements need to be considered, as either or both could have a valuation effect on a business. If the goodwill is owned by the business, the business value will be higher, and if the key employee owns the goodwill, the business value will be lower. The question for the planner is if you would rather the value be higher or lower for your intended planning purposes.
3. As to the ultimately determined value, the court went with the appraised value as stated on the originally filed Form 706. The Estate had obtained a much lower appraisal after the IRS dispute arose, but the Court determined that the amount on the Form 706 was an admission (against interest) and could not be lowered after the dispute arose. The lesson here is that it is better to spend the money on the front end to get the most appropriate appraisal than to go the cheaper route on the front end with the thought that a better (more expensive) appraisal can be obtained later if a dispute as to the value ever arises.
For a very interesting discussion of the Adell Case written by Owen Fiore, writing in the Leimberg Services, Inc. Newsletter, Click Here.