When Louise Gallagher died in 2004, she was the largest owner of Paxton Media. Based in Paducah, Kentucky, Paxton owns 32 daily newspapers, numerous weeklies and WPSD-TV, an NBC affiliate serving parts of Kentucky, Illinois and Missouri. Ms. Gallagher’s 3,970 units constituted 15% of the value of Paxton Media Group LLC. Her estate tax return included the units at a value of $34,396,000. The IRS audited the return and after failing to settle issued a notice of deficiency based on a value of $49,500,000. Both parties commissioned new appraisers. The new appraisals were both lower, but almost as far apart $26,606,940 versus $40,863,000. Then the estate hired another appraiser, who closed the gap a little with a value of $28,200,000.
I’m going to spare you the suspense here and tell you that the Tax Court came in at $32,601,640. So the Government would have done better to accept the return as filed. I have a theory, though, that the real function of the estate tax is to serve as a white collar jobs program. With a little bit of luck we will be reading another case in a year or so about all the additional expenses that the estate will be deducting because of this litigation. The analysis that the Tax Court went through to arrive at its value, is, however, instructive and I would like to share some of the highlights. In the interest of score-keeping here is a list of the five appraisals with the names of the appraisers and the initials I’ll use in the discussion:
The Tax Court ended up accepting and working with the RCM and KTS appraisals noting where they differ:
The parties disagree over: (1) The date of financial information relevant to a date-of-death valuation of decedent’s units, (2) the appropriate adjustments to PMG’s historical financial statements, (3) the propriety of relying on a market- based valuation approach (specifically the guideline company method) in valuing the units, and, if appropriate, the proper manner of applying that method, (4) the application of the income approach (specifically the discounted cash flow valuation method), (5) the appropriate adjustments to PMG’s enterprise value, and (6) the proper type and size of applicable discounts.
Date of Financial Information
Ms. Gallagher died on June 27, 2004. The KTS appraisal uses PMG’s internalfinancial statements prepared as of June 27, 2004 and data from public companies for the quarter ended June 30, 2004. I’m guessing that PMG, which was an S Corporation, did June 27 financial statements in order to accommodate allocation of taxable income based on an interim closing of the books rather than the days method. RCM maintained that someone valuing the company on June 27 would have been constrained to use PMG’s internal information as of May 30, 2004 and public company data for the quarter ended March 28, 2004. The Court agreed with using the June numbers:
Petitioner argues that the June information was not publicly available as of the valuation date, preventing a willing buyer and seller from relying upon it in determining fair market value. That is not to say, however, that our hypothetical actors could not make inquiries of PMG or of the guideline companies (or of financial analysts), which would have elicited non-publicly available information as to end-of-June conditions. Moreover, we understand Mr. Thomson’s testimony to be that the June 2004 financial information accurately depicts the market conditions on the valuation date, not that a willing buyer and seller would have relied upon the data. Importantly, petitioner has not alleged an intervening event between the valuation date and the publication of the June financial statements that would cause them to be incorrect.
I would observe here that in the sale of this type of business there might be an adjuster clause to take into account the actual values of items such as cash, receivables and payable as of the closing date, which of necessity will not be known on the closing date.
Appropriate Adjustments to Historical Financial Statements
A valuation like this is heavily based on a prediction of future EBITDA (Earnings Before Interest Taxes Depreciation Amortization). The starting point will be the most recent earnings, but those earnings must be adjusted for non-recurring items.
The KTS appraisal made one adjustment to PMG’s income statements, subtracting a $7,895,016 gain on divested newspapers in 2000.
The RCM appraisal made, among other adjustments, the following three adjustments to PMG’s earnings: (1) Reduced PMG’s 2000 earnings before interest, taxes, depreciation, and amortization (EBITDA) by a $7,900,000 gain on divested newspapers, (2) subtracted from both EBITDA and earnings before interest and taxes (EBIT) a 2003 $700,000 gain from a life insurance policy PMG inherited through an acquisition, and (3) subtracted from both EBITDA and EBIT a 2003 $1,100,000 positive claim experience from PMG’s self-insured health insurance.
Respondent objects to those three adjustments. We are unclear as to why respondent objects to the 2000 newspaper divestiture adjustment since his own expert, on whose appraisal he relies, made the same adjustment. We thus consider respondent to have acquiesced to the adjustment. However, we disregard Mr. May’s self-insured health insurance and life insurance policy adjustments because he provides no explanation as to why the gains were non-recurring.
Why did the IRS attorneys object to an adjustment that their own expert had conceded? They’re attorneys. Objecting is what they do. The more interesting question is why the RCM appraisal did not include any commentary on why the life insurance and health insurance adjustments were not recurring. Perhaps, being number crunchers, the appraisers thought it was apparent, as do I. The $1,100,000 in 2003 could have a substantial effect on the valuation, particularly if some sort of weighted average of EBITDA was being used. I guess the advice that appraisers might take away from this is what I used to tell my kids when they were little – Use Your Words.
The Court found that the four public companies (Journal Register Co., Lee Enterprises, Inc., the McClatchy Co., and Pulitzer, Inc) used in the KTS appraisal were not similar enough to PMG and rejected this approach. The companies are all much larger than PMG, included more specialty publications and three of them were beginning to enter develop on-line publications.
Discounted Cash Flow Valuation Method
The discussion here really gets into the weeds. Which appraiser was better at projecting future newsprint cost is an example of something that must be resolved, so I will gloss over much of the discussion. One issue that is significant is tax affecting the earnings. This is an S corporation, so we shouldn’t really have to consider taxes – right?That’s pretty much how the Court saw it:
Mr. May tax affected PMG’s earnings by assuming a 39-percent income tax rate in calculating the company’s future cash flows, before discounting PMG’s future earnings to their present value. He also assumed a 40-percent marginal tax rate in calculating the applicable discount rate. In contrast, Mr. Thomson disregarded shareholder-level taxes in projecting both the company’s cash flows and computing the appropriate discount rate.
Mr. May failed to explain his reasons for tax affecting PMG’s earnings and discount rate and for employing two different tax rates (39 percent and 40 percent) in doing so. Absent an argument for tax affecting PMG’s projected earnings and discount rate, we decline to do so. As we stated in Gross v. Commissioner, the principal benefit enjoyed by S corporation shareholders is the reduction in their total tax burden, a benefit that should be considered when valuing an S corporation. Mr. May has advanced no reason for ignoring such a benefit, and we will not impose an unjustified fictitious corporate tax rate burden on PMG’s future earnings.
Here is another instance of an appraiser not using his words, although the tone of the decision seems to indicate that it would not have helped.
Both appraisers used a Weighted Average Cost of Capital to discount the projected cash flows. The Court generally does not think that WACC is applicable to closely held companies, but allowed it in this case since the appraisers agreed on it in concept. I won’t comment on the detail it went into in comparing the way each appraiser computed WACC other than to say that it kind of makes me suspicious that the Court came up with 10%, seeing how easy that makes the math, but that’s pretty cynical.
Having arrived at the value of the discounted cash flow, enterprise value is determined by adjusting for excess or inadequate working capital and subtracting debt. Once again the RCM appraisal is faulted for not enough words:
We do not find Mr. May’s analysis to be persuasive. Mr. May once again failed to explain why the public companies that he deemed to be not comparable to PMG under the guideline company method provide a sufficient comparison upon which to base a working capital adjustment. We lend little weight to his seemingly contradictory positions. In addition, although explaining the need for a working capital adjustment under the guideline companies methodology, he failed to do so under the DCF method despite applying the adjustment to the results under both methods. For these reasons, we disregard his working capital deficit adjustment.
The RCM appraisal had also had an add-in to reflect the benefits of PMG being an S corporation. The Court indicated that this was taken care of by its assumption of a 0% corporate tax rate.
There was also a small difference in the debt numbers based on timing and questions about how the stock options might affect enterprise value.
There was not a lot of controversy here. Although the Court did not think the studies the experts used were necessarily applicable to long term closely held companies, they both used pretty much the same studies, so the marketability discount of 31% allowed by the Court was not a significant adjustment either way. Oddly the taxpayer’s expert did not have a minority discount while the government’s did. Apparently the minority discount was built into the RCM method for computing discounted cash flow. The Court ended up increasing the minority discount allowed in the KTS appraisal from 17% to 23%.
I find it intriguing that of the five valuations the one that the Court came closest to was the value on the return as filed. They hadn’t even hired an appraiser for that one, but were using the valuation the company used for other purposes. Even though the Court came out closer to the RCM appraisal, they more often than not seemed to like the conceptual approaches in the KTS appraisal, although sometimes the Court indicated that when the two appraisers agreed on something the Court would go along, but didn’t necessarily approve. The clearest thing that came out is that its holding inGross v Comm to not tax affect S Corporation earnings does not require a lot of fancy math. It appears that the RCM appraisal would have done better with more words and less math. After all Tax Court judges are lawyers.