Court opts for estate valuation two thirds lower than IRS expert's estimate. Thomas Berg Jr. leads the financial-services valuation practice at FMV Opinions, a valuation and financial advisory services firm.

Overview

Last summer's Tax Court decision in Kohler v. Commissioner, T.C. Memo. 2006-152 (25 July 2006) rejected the value determined by the Internal Revenue Service's expert and accepted, in total, the value that the taxpayer's expert determined. The decision is worth examining because the court was faced with an IRS value that was more than three times higher than the taxpayer's.

Background

Kohler, Wisc.-based Kohler is a 120-year-old manufacturer of plumbing products, home furnishings, generators, engines, and switchgear that also owns and operates hospitality and real-estate businesses. It is a private company, mainly owned by the Kohler family.

In March 1998 Frederic Kohler, brother of Kohler chairman Herbert Kohler Jr., died without a will.

The estate-tax return reported that the stock held by Frederic Kohler's estate was worth approximately $47.0 million on the alternate valuation date. The IRS determined the Kohler stock to be worth approximately $144.5 million -- a difference of nearly $100 million.

Facts

Kohler has paid dividends to its shareholders at least annually since about 1900. Kohler's stated policy was to reinvest at least 90 percent of its earnings in its business each year, with 7 to 10 percent of earnings paid to shareholders as dividends.

Kohler generally used two types of projections to plan for its business: a management plan and an operations plan. The management plan was given to outsiders intending to transact with Kohler and was intended to be a good predictor of the company's performance. The operations plan was a projection of what could theoretically be achieved in a perfect environment. The operations plan was built on the assumptions that each business unit would maximize its results and no contingencies or unforeseen events would occur.

Kohler re-organized its stock on 11 May 1998 with a view to acquiring the 4% of stock the Kohler family did not directly or indirectly control. Non-family shareholders were were offered a $52,700 per share buy-out price. Some of these shareholders exercised their dissenters' rights and litigated with Kohler to achieve substantially higher prices (up to $135,000 per share) for their shares in various settlements. But these prices included settlement of a claim of breach of fiduciary duty, and both parties agreed that these inflated value transactions didn't provide an indication of value for the stock held by the estate. The court agreed, noting further that between the transactions and the valuation date Kohler's capital structure and certain attributes of the shares had changed.

Analysis

The court reviewed the qualifications of the IRS' valuation expert and the estate's two valuation experts and ultimately gave no weight to the IRS expert's opinion. The court had misgivings about the IRS expert's valuation because of the following factors.

The expert's report "...was not submitted in accordance with the Uniform Standards of Professional Appraisal Practice (USPAP)." The court particularly noted that USPAP certification "...assures readers that the appraiser has no bias regarding the parties, no other persons besides those listed provided professional assistance, and that the conclusions in the report were developed in conformity with USPAP."
The expert "...admitted that his original report submitted to the court before trial overvalued the estate's Kohler stock by...more than 7% [due to an error he subsequently corrected at trial]. This is not a minor mistake. When we doubt the judgment of an expert witness on one point, we become reluctant to accept the expert's conclusions on other points."
The expert "...did not understand Kohler's business.... He decided the expense structure in the company's projections was wrong and decided to invent his own.... He did not discuss his fabricated expense structure with management...." In contrast, one of the estate's experts had periodically valued Kohler's stock over several years.
The expert "did not use a dividend-based method under the income approach, although the record reflects that periodic dividends were the primary means of obtaining a return on Kohler stock due to the privately held nature of the company."

In contrast, the court found the valuations of the estate's experts, "thoughtful, credible, ...thorough and consistent with traditional appraisal methodologies for closely held companies...."

Conclusion

No written opinion can convey every factor that goes into determining the credibility of one expert over another. In the Kohler case, however, Judge Kroupa specifies four particular factors that colored her decision.

The lack of USPAP certification
A significant error uncovered at trial
A failure to understand the business and not reviewing assumptions with management
Ignoring a dividend-based approach for a company that has paid dividends for over a century.

The Kohler case suggests that estates and their advisors should review any business valuation report to ensure the following issues have been addressed -- particularly with a to ensuring USPAP certification, correcting mathematical errors, conducting sufficient due diligence and reviewing major assumptions with management and providing logical reasons for selecting or rejecting available valuation methodologies. -FWR

This is not intended or written to be used by any taxpayer or advisor to a taxpayer for the purpose of avoiding penalties that may be imposed upon the taxpayer or advisor by the IRS. This writing is not legal advice, nor should it be construed as such.

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