Valuation

The Kress Case #1

United States District Court Strikes Blow against the Undead!
November 4, 2022

Sometimes things happen that make one believe in Providence. There I was, musing on which riveting aspect of business valuation practice to regale you with this month and, frankly, having a bad case of writers block. Then from the blue I received ane-mail from a business valuation publication highlighting the recent case of  James F. Kress and Julie Ann Kress,  v. United States of America,  (Case No. 16-C-795, United States District Court Eastern District of Wisconsin, March 25, 2019) – and what a case it was! All singing, all dancing from a valuation perspective, it will provide me with material for two (maybe three) of these e-mails!

 

Where to start? Well, the case may have put a stake through the heart of the contention held dear bythe IRS that S corporations should be valued effectively assuming no tax is paid on their profits. (Please note, by my use of the stake metaphor you should not conclude that I am comparing the IRS to blood sucking creatures of the undead realm)

 

No tax means more cashflow and more cash flow means higher values. In a line of cases starting with Gross v. Commissioner (1999) the IRS contended and the Tax Court accepted the application of a zero percent tax rate to pass-through entity earnings resulting in a large valuation premium.

 

In the Kress case the IRS challenged the values of gifts made by Mr. and Mrs. Kress from 2007 to 2009of stock in Green Bay Packaging (“GBP”), a very large manufacturer of cardboard packaging. GBP was an S-corporation.

 

The taxpayers had engaged two valuation experts to value the gifts – both effectively applied their valuation methods to after tax cash flows.

 

And then the twist –the expert engaged by the IRS also applied C-corporation tax rates to the company’s cash flow, a position contrary to the zero percent approach previously advocated by the IRS. Granted, the IRS’ expert then adjusted the company’s value upwards to reflect tax advantages associated with the company’s S-corporation status. Whether the adjustment is warranted or not, the key point is that the IRS appeared to accept that tax-affecting was appropriate.

 

The court also accepted tax-affecting and rejected the S-corporation adjustment. It opined that “GBP’s subchapter S status is a neutral consideration with respect to the valuation of its stock. Notwithstanding the tax advantages associated with subchapter S status, there are also noted disadvantages, including the limited ability to reinvest in the company and the limited access to credit markets.”

 

There is no indication yet whether the no-tax affecting argument will stay dead after this assault or re-animate through an appeal – like all good vampire movies there may yet be a sequel.