October 2014 Newsletter
Tax Court attributes significant value to personal goodwill in estate tax valuation case
Two months after the Tax Court decided the Bross Trucking case, it addressed the significance of personal goodwill in valuing the stock of a closely held corporation, STN.Com Inc. in Estate of Franklin Z. Adell , TC Memo 2014-155. The decedent, Franklin Adell, owned all of the shares of STN stock. His son Kevin was the president of STN and was instrumental in the development of its business.
STN provided cable uplinking for its only customer, the Word, which was a 24-hour, urban, religious programming station. Kevin had prior experience with religious programming and used his connections to garner the support of various religious leaders in launching the Word.
In valuing the STN shares for Franklin’s estate tax return, the estate appraiser used the discounted cash flow method, projecting future revenue for the five years subsequent to death. In determining the projected cash flow during that period, the estate’s appraiser reduced the cash flow by an economic charge for Kevin’s personal goodwill because STN’s revenue was dependent upon Kevin’s relationships. Kevin had no employment agreement with STN and was not subject to a covenant not to compete. The appraiser quantified the economic charge at between 37 and 44 percent of sales. There is no explanation in the decision as to how this very sizable charge was derived.
The Tax Court accepted this valuation, concluding that because Kevin was free to leave STN and compete against it, the large economic charge taken was warranted. This economic charge had an enormous impact on the value of STN, reducing the value by more than 70 percent from what it would have been without the economic charge.
This adjustment for personal goodwill was enormously beneficial to the estate, resulting in a final valuation which was about one-third of the IRS appraiser’s value. The reduction attributable to Kevin’s personal goodwill is conceptually similar to a loss of key person discount. However, the decisions authorizing such a discount have generally quantified that discount at 5 to 15 percent. The economic charge applied in the Adell case is tantamount to a loss of key person discount of more than 50 percent.
It remains to be seen whether this valuation approach to personal goodwill could supplant the much more modest loss of key person discount in the future. However, the taxpayer victories in Bross Trucking and Adell could also turn into a double-edged sword. The IRS asserted in Bross Trucking that the transfer of personal goodwill was a taxable gift. The court did not reject that possibility entirely, but found that the facts did not support that such a transfer was made. However, suppose Kevin Adell had used his personal relationships to help establish his children in a new cable uplinking venture. The rationale behind Bross Trucking and the quantification of personal goodwill endorsed in the Adell decision could result in the IRS asserting that Kevin Adell’s assistance to his children amounted to a multi-million-dollar taxable gift.
In the recent Tax Court case of Vision Monitor Software LLC v. Commissioner (September 3, 2014) , the Tax Court disallowed a taxpayer’s deduction for losses incurred by a partnership in which he was a partner because he did not have sufficient income tax basis in his partnership interest to deduct those losses. The taxpayer claimed that he obtained the needed basis by contributing his own promissory note to the partnership. The court denied the basis and pointed out that there is considerable previous case law that says a taxpayer does not have any tax basis in his own note.
The IRS also sought to impose the 20 percent substantial understatement penalty. One defense against the imposition of this penalty is the taxpayer’s reliance on professional advice. The partnership’s longtime attorney, who is a certified tax specialist, recommended the note contribution as a means of increasing the partners’ tax basis in the partnership. He gave this advice orally rather than in writing. In order to use reliance on professional advice as a defense against the substantial understatement penalty, the taxpayer must establish that (1) the advisor was a competent professional who had sufficient experience to justify reliance; (2) the taxpayer provided the advisor with the necessary and accurate information on which to base his advice; and (3) the taxpayer actually relied in good faith on the advisor’s judgment.
The court found all three of these conditions were satisfied and granted the taxpayer relief from the penalty. While there is no requirement that the relied-on advice be written, getting professional advice in writing is certainly the better practice. Whether the taxpayer acted reasonably in relying on this advice when several cases had already held that a taxpayer did not have any tax basis in his own note is a good question. The advisor made a weak argument that another case – one that granted the basis to the taxpayer – applied in this case, but the court held it was not applicable because the case was based on very different facts. The court nevertheless determined that the advice given by this advisor would seem reasonable to the taxpayer, who did not have deep knowledge of the tax law.
Shareholders of financially troubled S corporations may now be able to avoid the flow-through of taxes when the S corporation or its subsidiary files bankruptcy. In In re Majestic Star Casino, LLC , 716 F.3d 736 (3rd Cir. 2013), the Third Circuit Court of Appeals ruled that an S corporation shareholder, who may have received the benefit of years of flow-through income tax treatment from the S corporation, may avoid the flow-through of taxable gain or income in bankruptcy simply by revoking the S corporation election. The revocation converts the corporation into a C corporation, thereby trapping at the corporate level all income tax liabilities that the corporation incurs in bankruptcy. The losers are the corporation’s unsecured creditors, whose claims will now only get paid after the tax claims the corporation incurs in bankruptcy.
In Majestic Star Casino , one of the debtors was a corporate subsidiary of an S corporation for which a qualified S corporation subsidiary (QSub) election had been made, thereby causing the debtor QSub to be treated as a disregarded entity for federal income tax purposes (akin to a division of the S corporation parent). After the debtor QSub filed chapter 11 bankruptcy, the S corporation’s shareholder revoked the S election for the parent (which was not in bankruptcy). This also revoked the QSub election for the debtor QSub, with both the parent and the debtor QSub becoming C corporations. The debtors, which were effectively controlled by their creditors, sought to avoid the revocation of the S election. The Third Circuit concluded that neither the parent corporation’s status as an S corporation nor the debtor’s status as a QSub was “property” for bankruptcy purposes. Moreover, even if the debtor’s QSub status was property, it would not be property of the bankruptcy estate but of the S corporation or its shareholder. As such, the debtors did not have standing to challenge the revocation of the S election.
Whether a tax attribute is property of a bankruptcy estate has long been debated. The Third Circuit is the first circuit court to rule on whether an entity’s tax status as an S corporation is property of a bankruptcy estate, and it declined to follow a number of lower court decisions which held that an S election is property. Those courts analogized an S election to a net operating loss that a C corporation may carry back or carry forward, which has been held to be property. The Third Circuit disagreed, stating that unlike an NOL, an S election is “entirely contingent on the will of the shareholders” because it may be revoked or terminated at any time. The Third Circuit added that an NOL has a readily determinable value while an S corporation status does not, and even if the S election had some value to the debtor, this alone does not equate to a property right under the bankruptcy laws.
The Third Circuit also expressed concerns that if the S corporation’s shareholder could not revoke the S election, the S corporation’s shareholder would incur undue hardship on account of having to pay tax on the flow-through of gains or income the debtor incurred in bankruptcy from the sale of assets and cancellation of debt, while the creditors receive the distributions. The Third Circuit did not, however, address that this also occurs with partners in a partnership bankruptcy. Even worse, while an S corporation shareholder may exclude cancellation of debt income if the S corporation (and not just a QSub, as in Majestic Star Casino ) receives a discharge in bankruptcy or is insolvent, these exclusions only apply to partners of a partnership in bankruptcy if they themselves receive a bankruptcy discharge or are insolvent. But an S corporation provides rights, including the right to revoke the S election at any time and avoid the flow-through of future taxable income, and burdens that differ from a partnership. It therefore could be considered inequitable to eliminate a specific right afforded S corporation shareholders but not partners of a partnership.
Nevertheless, permitting an S corporation shareholder to revoke the S election also causes undue hardship to the bankruptcy estate and its unsecured creditors. The bankruptcy estate does not get the benefit of any prior year losses, such as an NOL carry forward had the debtor always been a C corporation, to offset taxable income the corporation recognizes in bankruptcy. Moreover, an S corporation shareholder could revoke the S election and impose a tax liability on the bankruptcy estate at any time, even post petition, without warning or notice, which could severely inhibit the ability of the bankruptcy estate to plan for such tax liability or reorganize in a chapter 11 case.
In the end, the Third Circuit found that the S and QSub elections were not property and that the equities favored the shareholder. While the ruling provides an advantage to those using S corporations, it also may make lenders more cautious about extending credit to S corporations. And although the Third Circuit is influential in bankruptcy law, there are authorities in other circuits, though not at the circuit court level, to the contrary. Thus, one can expect bankruptcy trustees and creditors to continue to vigorously oppose revocations of S elections.
The IRS Office of Professional Responsibility (OPR) stated in OPR Bulletin 2014-12, released earlier today, that a corporation must provide a power of attorney to any employee that it authorizes to dispute tax issues before the IRS on the corporation’s behalf. OPR published this guidance in response to field questions regarding the effect of Circular 230 and OPR’s jurisdiction over the corporate officers or employees identified in Form 4764, Communications Agreement, LB&I Examination Plan, for purposes of referrals for alleged Circular 230 misconduct.
Circular 230 regulates representation activity by those who represent and otherwise “practice” before the IRS. The OPR Bulletin states that the LB&I Communications Agreement will suffice when a corporate employee is “merely providing or accepting information to, or from, the IRS,” because no representation activity or “practice” is occurring. However, when the employee “advocates, negotiates, disputes or does anything which goes beyond mere delivery of facts, general explanation, or acceptance of materials,” the employee is practicing before the IRS, and therefore Form 4764 is insufficient. If the corporation wants a specific employee to advocate, negotiate, or dispute issues with the IRS on behalf of the corporation, a Form 2848, Power of Attorney, must be obtained from the corporation authorizing that representation. Form 2848 must be signed by a duly elected officer or director of the corporation.