The Kress Case #1

United States District Court Strikes Blow against the Undead!
July 14, 2020

Sometimes things happenthat make one believe in Providence. There I was, musing on which rivetingaspect 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 caseof  James F. Kress and Julie AnnKress,  v. United States of America,  (Case No. 16-C-795, United StatesDistrict Court Eastern District of Wisconsin, March 25, 2019) – and what a caseit was! All singing, all dancing from a valuation perspective, it will provideme 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 ispaid on their profits. (Please note, by my use of the stake metaphor you shouldnot conclude that I am comparing the IRS to blood sucking creatures of theundead realm)

 

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

 

In the Kress case theIRS 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 cardboardpackaging. GBP was an S-corporation.

 

The taxpayers hadengaged two valuation experts to value the gifts – both effectively appliedtheir valuation methods to after tax cash flows.

 

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

 

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

 

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