NCCIBA PRESENTATION RECENT COURT CASES William C Herber

NCCIBA PRESENTATION RECENT COURT CASES William C. Herber Shenehon Company November 16, 2006

Mike & Caroline Huber TC Memo 2006 -96 Filed May 9, 2006 Valuation of Gifts Judge Goeke

Facts of Case n n n This case concerns the proper amounts of gift tax. Huber stock was not publicly traded, and petitioners valued their gifts on the basis of the prices Huber used for shareholder stock transactions. We hold that the transactions in question are evidence of an arm’s-length price and support the values petitioners set on their gifts.

Operations n n Huber operates a diversified business with annual sales in excess of $500 million during the years in question. Huber is a privately held corporation, but its governance structure strives to emulate public companies by maintaining a high level of communications with its 250 shareholders. Since 1993, Huber has retained Ernst & Young (E&Y) to annually appraise the Huber shares.

Operations - continued n n n Although Huber has no formal stock buy-back program, its bylaws authorize it to redeem stock from Huber shareholders. The board is empowered to authorize redemptions and set the price at which such redemptions are offered. During the years 1996 to 2000, the board authorized 14 redemptions. In 1996, Huber bought back shares at the E&Y value. (Note, this was a discounted value not fair value. ) Huber’s bylaws provide the corporation the right of first refusal to purchase shares offered outside the Huber family at the price specified in the bylaws. Huber has the irrevocable option to purchase the shares at the lower of the offer price, the book value, or the formula price set by the bylaws.

Ernst & Young Report n n n E&Y does not perform any other auditing functions for Huber. E&Y has used a consistent methodology for valuing Huber shares, which is comparing Huber to comparable publicly traded companies. E&Y applies a 50 -percent lack of marketability discount from the freely traded value of the shares. Although shareholders are not generally sent copies of the E&Y reports, the reports are available for inspection by Huber shareholders. No one at Huber ever indicated what value or discount was wanted before E&Y completed the reports. Mr. Francis did not receive draft reports in advance. From 1994 to 2000, there have been approximately 90 transactions of Huber shares between shareholders.

Main Issues The parties dispute whether sales of Huber stock at the value set by E&Y qualified as an arm’s length sale.

Other Comments The CEO’s acceptance of an artificially low E&Y value for Huber stock would be against both his own economic interests and those of Huber and its shareholders. The success of this centenarian company and the vast acceptance of the E&Y price by its 250 shareholders strongly suggest that the sellers of E&Y stock had every reason to believe that they were obtaining a fair price for their shares.

Conclusion Not only have petitioners prevailed on all of the factors listed in Morissey v. Commissioner, 243 F. 3 d 1145 (9 th Cir. 2001), but several other facts already discussed make their case stronger than that of the taxpayers in Morissey. We conclude that the sales of Huber stock established in the record are arm’s-length sales that demonstrate the best reference for the valuation of Huber shares on petitioners’ gift tax returns.

Michael Caracci Sta-Home Health Agency No. 02 -60912 Judges: Jolly, Wiener, and Rosenthal – United States Court of Appeals for the Fifth Circuit Appealed from the Decision of the United States Tax Court

Basic Facts Three privately held home healthcare agencies were converted from a non-profit to profit. n The IRS challenged what the exchange was transacted at. n The IRS contended the taxpayers received a net benefit of 18. 5 million. n

Basic Facts - continued At trial the IRS conceded the notice of deficiency was both excessive and erroneous. n The expert for the IRS also had errors in his report (forgot to take out the debt). n The tax court also made errors in coming up with its own valuation as it had rejected everyone else. n

Basic Facts - continued Home health care agencies in Mississippi converted from a (501 c) non-profit to a Scorp. n 95% to 97% of business was from Medicare and Medicaid reimbursement, of which 0. 7% of Sta-Home’s submitted costs were disallowed. n Sta-Home had little ability to make a profit. n

Basic Facts - continued To ease this precarious financial situation, Sta. Home required its newly hired employees to forgo pay for the first month of employment. Sta-Home paid this amount only when employees left the company. Sta-Home also underpaid salaries and wages during the year, using year-end “bonuses” to make up unpaid compensation amounts. Sta. Home also deferred or accrued contributions to employee benefit plans. These efforts to ease cash-flow difficulties affected all Sta-Home’s employees, including the Caracci family members.

The Experts n n n Taxpayers experts spent 8 weeks in Mississippi studying the assets and liabilities. Wilhoite (IRS expert) spent only two days in Mississippi to study the Sta-Home entities in order to value their assets and liabilities and spent one of those days in a hotel room tracking down lost luggage. In short, neither the Commissioner nor his expert witness did the work necessary to perform an asset-valuation analysis of the Sta-Home entities throughout the extended audit period or during the Tax Court litigation.

The Experts - continued n n The Commissioner’s expert, Wilhoite, lacked the specific information about the Sta-Home entities necessary to value their assets, particularly the intangible assets. Wilhoite assumed that those intangible assets had significant value to potential purchasers, despite Sta. Home’s history of losses. Wilhoite used market-based and income-based approaches to assign values to all Sta-Home’s assets in general, without valuing any of Sta-Home’s assets in particular.

The Experts - continued n n The Tax Court adjusted bonuses on 1. 7 million to make the company show a profit. These “bonuses” were unpaid, deferred employee pay, rather than discretionary bonuses. The deferred wages for existing employees, along with deferred first-month wages for newly hired employees, were mechanisms the taxpayers used to continue to operate despite their perennial cashflow problems, their lack of profitability, their increasing operating losses, and their increasing deficits. The commissioner acknowledged before the Tax Court that the salaries and bonuses were neither excessive nor unreasonable.

Conclusion This case began and ends with the Commissioner’s refusal to recognize the legal effect of its own errors. n The Commissioner presented an expert who used an inappropriate valuation method and lacked basic factual information essential to the asset valuation he was called on to provide n

Conclusion - continued n n The Tax Court erred as a matter of law when it failed to find for the taxpayers after it rejected much of the Commissioner’s expert’s opinion and instead proceeded to use bits and pieces from that opinion to value the Sta-Home assets transferred to the newly created nonexempt entities. The Tax Court erred as a matter of law in the valuation method it selected. In the process of arriving at and applying that method, and in struggling to make that method make sense, the Tax Court made a number of clearly erroneous factual findings. These errors led the Tax Court to reject the taxpayers’ expert.

Estate of Amlie TC Memo 16039 -02 Filed April 17, 2006 Date of Death October 18, 1998 Judge Gale

At Issue: 1. The fair market value of First American Bank Group, LTD (FABG). The main question to be resolved is whether an agreement restricting the sale of the stock fixes the stock value or should it be disregarded in determining value for Federal Estate Taxes. (Amlie owned a small minority position in the bank). 2. The Fair Market Value of five parcels of agricultural land.

The 1994 Agreement In 1994, Mr. Hill the controlling shareholder, agreed to sell his shares in Agri to FABG. He received the following: n Book value for Agri shares (they were exchanged for FABG shares at book value also). n 5 year employment agreement at $218, 000 per year. n $314, 000 signing bonus. n Retirement of 1. 6 million in capital rates. Question – Which of the above items should be included in the purchase price? (Also note the Amlie shares had negotiated a come along agreement with Hill in 1991).

Conservator Agreement The conservator exchanged decedent’s Agri common stock at the offered ration for 6, 657 shares of FABG common stock on October 1, 1994, and negotiated an agreement (1994 Agreement) for the postdeath sale of decedent’s FABG stock to FABG for 1. 25 times book value, or $118. 23 per share plus 6 percent compounded annually until decedent’s date of death ($118 price). The 1994 Agreement was executed on October 31, 1994 (subject to approval by the district court).

Determination of $118. 23 Stock Prices Conservator hired an appraiser. Valuation was to include Hill’s rights. n Negotiations between all parties began. n Conclusion of Valuation: Agri was not worth an acquisition premium to FABG – therefore book n Value was appropriate. n In the appraisal the Hill rights included employment agreement, signing bonus, but not the 1. 6 million of capital notes forgiven of one of the other banks. n The end result was a price of 1. 25 times book or $118. 23 per share was fair based on the fact that the sale would be deferred until after death and capital gain tax would be avoided. n

Dispute With Rod When the conservator sought approval of the district court to enter into the 1994 Agreement, Rod (alone among the prospective heirs) filed formal objections in which he claimed, inter alia, that the proposed $118 price for decedent’s FABG stock failed to compensate adequately for the Hill Rights and could result in a potential loss to decedent’s estate of more than $500, 000.

1995 Agreement Estate would receive the $118. 23 per share preserving liquidity – Rod would guarantee payment. 1997 Agreement Rod Amlie would guarantee the $118. 23 per share to the estate. He would keep any upside. Rod and his trust negotiated a sale price of $217. 50 per share plus 4% per year – to be paid at death.

Payment of Stock – Decedent’s Death Decedent died on October 18, 1998, at the age of 96. On November 15, 1998, pursuant to the 1995 FSA, the Rod Amlie Trust exercised its call option to purchase all the FABG stock remaining in decedent’s estate after satisfaction of the bequests of such stock to the trust. On November 17, 1998, the FABG stock at issue was sold to FABG for $1, 489, 724. 93, the price derived under the formula in the 1997 Rod Amlie Family Agreement. Upon receiving the check for this amount from FABG, Rod endorsed it as executor of decedent’s estate and had the proceeds segregated into a check made payable to the estate for $993, 756. 96, the price for the FABG stock under the formula set forth in the 1995 FSA, and a second check for the balance of $495, 967. 97, which was eventually remitted to the Rod Amlie Trust. The IRS believed the $218. 00 per share should be reported. The estate believed $118. 00 as that was what they got paid per the agreement.

IRS Position The general rule of section 2703 is that any agreement to acquire property at less than its fair market value will be disregarded for Federal estate tax purposes unless the agreement satisfies the requirements enumerated in the statute. Those requisites include the requirements of preexisting law that the agreement be a bona fide business arrangement and not be a testamentary device, as well as a new requirement that the terms of the agreement be comparable to those of similar arrangements entered at arm’s length. Sec. 2703 (b).

Court Ruling 1. 2. 3. It is a bona fide business arrangement. It is not a device to transfer such property to members of the decedent’s family for less than full and adequate consideration in money or money’s worth. Its terms are comparable to similar arrangements entered into by persons in an arms’ length transaction.

Court Ruling - continued Respondent, with the hindsight knowledge that Rod secured an agreement some 2 years later for FABG’s purchase of the same stock at $217. 50 per share (plus 4 percent per year until decedent’s death, compounded semiannually), seeks to persuade the Court that the 1995 FSA provision to sell at the $118 price must have been a testamentary device to benefit Rod. The facts of this case do not fit that theory. The conservator, in an effort to fulfill fiduciary obligations, and the other prospective heirs, in furtherance of their own interests, accepted a price they believed (on the basis of professional advice) was fair at the time and in the particular circumstances. The purpose of the 1995 FSA, therefore, was not as a testamentary device to benefit decedent’s family members.

Farm Land IRS expert was not allowed to testify as they had not qualified him as an expert, nor did they offer an expert reporting compliance with rule (143 F)

Allowance of Fractional Discounts n n n Estate of Campanari Estate of Henry Estate of Baird Estate of Busch Estate of Pillsbury Estate took a 25 -30 fractional discount based on little supportive evidence. Court reluctantly allowed a 15% fractional discount.

Herbert Kohler, Jr. et al v. Commissioner TC Memo 2006 -152 Filed July 25, 2006 Judge Kroupa

Kohler Facts of Case Kohler is a private company. Established in 1887, it is one of the leading manufacturers of kitchen and bath products as well as power equipment. Kohler paid dividends, annually, from approximately 1900, with a stated policy of paying out 7%-10% of earnings and reinvesting at least 90%.

Kohler-Facts continued n Kohler developed two business plans: a) a management plan based on “realistic” projections of achievable targets b) an operations plan based on a “best case scenario” of theoretical projections

Kohler-Facts continued n 1996 n 1998 Kohler begins the process of taxfree re-organization under Section 368(a) Herbert Kohler died on March 4, 1998 Re-organization is complete on May 11, 1998

Kohler-Facts continued Goal of re-organization: to redeem 4% of the stock held by non-family members n Estate elects to use the alternate valuation date for determining the value of Herbert Kohler’s minority interest n

Kohler n Court Addressed These Issues: a) Burden of Proof b) Pre- or Post-re-organization Value for Stock c) Valuation Differences

Kohler Conclusions: IRS Report did not conform to USPAP standards relied on non-traditional valuation methods developed an unsubstantiated revenue structure IRS Expert – spent little time with Kohler management did not use the dividend method made significant errors in calculations

Kohler Conclusions (continued) Estate’s Reports were thorough and consistent with appraisal methodologies for closely-held companies were submitted in accordance with USPAP guidelines concluded value was supportable Estate’s Experts were “thoughtful and credible”

Overall Conclusion of Recent Cases n Experts are being rejected not only for lack of expertise, but for lack of due diligence. n Judges are being overruled for doing their own valuations.