Five Takeaways for Family Business Directors from Kress v. U.S.

A recent federal court decision in a tax dispute represented a significant victory for family business shareholders.  The case (Kress v. U.S.) revolved around the value of a multi-generation family business, Green Bay Packaging (“GBP”).  Our colleague Chris Mercer wrote an extended review of the technical appraisal issues in the case which can be found here.

1. Contemporaneous Appraisals Are More Persuasive

The business valuation reports that were ultimately vindicated by the Court were those prepared in real-time in the ordinary course of business.  GBP had a legacy of regular appraisals that were apparently used for a variety of purposes.  In the Court’s eyes, the contemporaneous appraisals prepared by a qualified professional having a long history of familiarity with the company were more reliable than the valuations prepared long after the fact and rendered in the context of an already existing dispute.

• Does your family business have a program of regular appraisals performed by a reputable and qualified business appraiser?
• Do the appraisals reflect a consistent valuation methodology, adapted to the unique circumstances and economic conditions at each valuation date? 
• Are the conclusions of these appraisals used in contexts other than tax compliance (i.e., corporate planning, shareholder redemptions, etc.)?

2. S Corporations Are Not Worth More Than C Corporations

For decades now, the IRS has maintained that S corporations – since they do not pay corporate income tax –are inherently worth more than otherwise comparable C corporations.  Observers have long noted that this position defies common sense as S corporations have to make distributions to shareholders each year in amounts sufficient for the shareholders to pay their personal tax liabilities on S corporation earnings.  In other words, S corporations are burdened by taxes on income the same way as C corporations; the only difference is that S corporation income tax payments flow through the hands of shareholders before reaching the IRS coffers.

If your family business is an S corporation or LLC, does your valuation treat the company as if it were a C corporation?

The IRS’ stubbornness on this issue has been a nuisance to family shareholders more than anything.  Most experienced business appraisers, understanding the economic rationale summarized above, have ignored the preferred IRS position in measuring fair market value.  However, in so doing, all parties understood that they were inviting a potential challenge from the IRS.

GBP is organized as an S corporation, but the company’s appraiser opted to follow economic logic and treat the company as if it were a C corporation for purposes of the valuation.  In accepting the resulting valuation conclusion, the Kress Court effectively acknowledged the propriety of that treatment.  While the appraiser retained by the IRS applied corporate taxes as if GBP were a C corporation, he then increased the conclusion of value by adding an S corporation.  The Kress Court rejected that premium.

• How is your family business structured for tax purposes? 
• If your family business is an S corporation or LLC, does your valuation treat the company as if it were a C corporation
• The Tax Cuts and Jobs Act of 2017 has shifted the calculus on whether the S election is beneficial – have your tax advisors helped you assess whether S corporation treatment remains optimal for your family business?

3. Economic Conditions Matter

The gifts that were at the heart of the tax dispute were made in the years leading up to and at the start of the Great Recession.  The Kress Court criticized the report of the appraiser retained by the IRS for failing to give adequate consideration to the impact of the Great Recession on the fair market value of family businesses.

By preparing contemporaneous valuations, GBP’s appraiser was necessarily attuned to the economic dislocations of the time and how the value of the business was affected.  In particular, the contemporaneous appraisals assigned significant weight to indications of value derived under the market approach, which examined the observable pricing behavior for a representative group of comparable public companies.  Developing indications of value under the market approach for consideration in the overall conclusion helps to ensure that the valuation effect of current economic conditions is not overlooked or minimized.

• Does your family business operate in a cyclical or counter-cyclical industry? 
• How does your valuation take into account signals from the market? 
• Is your family business ready for the next recession?

4. Know Your Appraiser, and Make Sure Your Appraiser Knows You

GBP’s appraiser, John Emory, has had a long and distinguished career in the valuation profession.  Perhaps more important, it is evident from the Court’s decision that Mr. Emory had a thorough understanding of GBP’s business based on years of interviews with management.

In contrast, the Kress Court noted that the appraiser retained by the IRS had not spoken with GBP management beyond attendance at a deposition.  While much can be learned about a company from careful study of its financial statements, some aspects of the business are much easier to understand by being on-site and speaking with management.

• Does your family business have an ongoing relationship with an experienced and qualified business appraiser? 
• Has your business appraiser developed a thorough understanding of how your family business operates and the factors that make your family business valuable?

5. Don’t Get Greedy

Too often, family business shareholders think about valuation only from the perspective of minimizing gift and estate taxes.  While the Kress decision does not provide sufficient financial data from GBP to make relative value assessments, the Court’s adoption of the taxpayer’s appraisal suggests that the valuation was a valid determination of fair market value rather than a “low-ball” estimate intended to minimize tax payments.

Does the marketability discount applied reflect economic factors like expected distributions, the duration of illiquidity, anticipated capital appreciation, and the unique risks of illiquidity?

This is particularly evident in the marketability discounts applied in the taxpayer appraisals.  The taxpayer’s appraiser applied marketability discounts between 28% and 30%.  While the appropriate marketability discount depends on the specific facts and circumstances pertaining to the subject interest, the marketability discounts applied often correspond to the underlying economics of minority shares in the family business.  The marketability discount is not a tool for reducing taxes, but is instead a reflection of the economic reality of owning illiquid shares in a family business.

In short, while gift and estate tax compliance may be an important application of the valuation of your family business, it is not the only application.  As noted above, valuation conclusions will generally be more persuasive if they are used in multiple contexts beyond just tax compliance.  An aggressive valuation for tax compliance may carry unintended negative consequences elsewhere in your family business.

• As directors, how do you use appraisals of your family business? 
• Does the marketability discount applied reflect economic factors like expected distributions, the duration of illiquidity, anticipated capital appreciation, and the unique risks of illiquidity? 
• Does your family business have a redemption policy or buy-sell agreement?  If so, does it specify the “level of value” to be used?

Conclusion

The Kress decision is a welcome one for family businesses.  Our valuation professionals are eager to talk with you about how the lessons from Kress noted above affect your family business.  Call us today.