Jones Case is a Tax Court Precedent for Valuation Professionals
By Baria Jaroudi, CPA/ABV, CVA, CBA
In the matter of Estate of Aaron U. Jones v. Commissioner (T.C. Memo. 2019-101), the Tax Court ruled and upheld on August 19, 2019, that tax affecting the earnings of an S Corporation and limited partnership using the income approach for gift tax purposes is appropriate. This is a major development since the rejection of tax affecting in the Gross (T.C. Memo. 1999-254, 1999 WL 549463, aff’d, 272 F.3d 333; 6th Cir. 2001) case more than 20 years ago.
Aaron Jones founded Seneca Sawmills Co. (SSC) in Eugene, Oregon in 1954. SSC is a lumber manufacturer that rapidly expanded its operations by growing its log yards and purchasing several mill facilities. SSC was heavily dependent on timber purchased from federal lands. Therefore, Jones looked for alternatives to relying on timber from federal lands and began purchasing timber land from other parties. In 1992, Jones formed Seneca Jones Timber Co. (SJTC), an Oregon limited partnership, to hold, invest in and acquire the timber lands he purchased. SJTC’s purpose was to manage tree farms and supply timber to SSC.
SSC owned a 10% interest in SJTC as the sole general partner. Both companies had essentially the same ownership, shared the same management team and shared the same headquarters. Even though the companies were separate legal entities, they operated in unison to further SSC’s sawmill operation.
In 1996, Jones created a succession plan to ensure that the family business remained in operation indefinitely. To this end, on May 28, 2009, pursuant to the plan, Jones made several gifts of his SSC and SJTC’s interests to his three daughters and to the benefit of his daughters’ trusts. Jones’ gifts were not deathbed declarations and he survived his gifts for about five years. In 2013, the Internal Revenue Service (IRS) issued a notice of deficiency in gift tax of about $45 million.
Usually, the taxpayer bears the burden of proof that the Commissioner’s determinations are erroneous. The Estate stated that a complete and conclusive documentation of an accurate valuation of the interests in both companies is adequate enough to shift the burden of proof under section 7491(a) to the IRS.
The Estate hired Robert Reilly (stated as Richard in the case) from Willamette Management Associates. Reilly valued both entities and concluded a value higher than the original value, but much lower than the proposed IRS valuation as presented below.
|SSC class A (Voting) per share||$325||$390||$1,395|
|SSC class B (Non-Voting) 1 per share||$315||$380||$1,325|
|SSC class B (Non-Voting) 2 per share||$315||$380||$1,325|
|SJTC Limited Partnership||$350||$380||$2,530|
|Share/Units||Value of Block|
|IRS Expert||Court Ruling|
|SSC class A (Voting) per share||$422,500||$507,000||$1,813,032||$507,000|
|SSC class B (Non-Voting) 1||$1,512,000||$1,824,000||$6,359,568||$1,824,000|
|SSC class B (Non-Voting) 2||$1,718,640||$2,073,280||$7,228,709||$2,073,280|
|SJTC Limited Partnership||$3,593,685||$3,901,715||$25,780,000||$3,901,715|
Both parties submitted expert reports providing a valuation of the units gifted in SJTC limited partnership. The Estate submitted a valuation of the stock of SSC, while the respondent submitted a rebuttal expert report critiquing that valuation.
The Estate’s expert valued SSC and SJTC using the discounted cash flow method (DCF) under the income approach and the guideline public company method under the market approach and concluded a value of $20 million and $21 million for SSC and SJTC respectively, on a non-controlling, non-marketable interest basis.
The IRS critiqued the taxpayers’ DCF and stated it improperly tax affected the earnings since there was no evidence that SJTC would become a C corporation. Furthermore, the IRS expert stated a zero tax should be applied and appropriately reflect SJTC’s pass through status, but did not provide a reasoning for a zero tax affecting. Reilly cited Bernier v. Bernier (873 N.E.2d 216; Mass. 2007) and argued that zero tax affecting would only overvalue both entities.
The court cited Gross and other cases that did not tax affect and indicated they were specific cases with specific circumstances. The court stated the expert’s “tax-affecting may not be exact, but it is more complete and more convincing than respondent’s zero tax rate.” Another dispute between the parties was whether SJTC should be valued using an asset-based approach method or an income-based approach method, and whether SJTC is treated as an operating company that sells a product or a holding company that simply holds timber as an investment for its partners.
The IRS argued that SJTC should be valued using an asset-based approach, since it is more like a holding company owning real estate and timberlands. Reilly argued that SJTC operates as an operating company that plants trees and harvests and sells the logs and, therefore, should be valued on a going concern basis with a relative consideration specific to its earnings. Based on the operating agreement, SSC would not allow the timber to be sold to a third party, by farming tree land. Therefore, SJTC should be valued under the income approach as an operating company.
The Estate also stated SJTC and SSC should be treated as a single business operation despite being separate legal entities. The court agreed that both companies were closely aligned and interdependent; however, when valuing SJTC, it is appropriate to take into account its relationship with SSC.
The court concluded that SJTC has aspects of both a holding company and an operating company and concluded that an income-based approach, like Riley’s DCF method, was more appropriate than the IRS Respondent’s NAV method.
Ultimately, the court adopted Reilly’s conclusion presented in his report without adjustments and upheld the tax affecting of a pass-through entity, which is an extremely meaningful decision and tax court precedent for valuation professionals.
About the Author:
Baria Jaroudi, CPA/ABV, CVA, CBA, is a senior manager at Briggs & Veselka Co., PC. Jaroudi performs valuations for closely held businesses for estate and gift, financial reporting and family law matters. Briggs & Veselka is Houston’s largest independent CPA firm and the third largest in the Southwestern United States. For any comments, you can contact Jaroudi@firstname.lastname@example.org.