At the time of Josephine Thompson’s death in 1998, she owned approximately 20% of the common shares of Thompson Publishing Co., Inc., a closely-held business, which was a publisher of business-to-business directories. At the time of Thompson’s death, the company was profitable, but faced significant challenges from the market due to the growth of Internet-based directories. The taxpayer’s estate calculated the value of Thompson’s common shares at approximately $1.75 million, using a capitalization rate of 30.5%, which included a 12% management and Internet-component risk. After determining that the company’s total value was $25.3 million and the estate’s share of the company was $5.3 million, the estate applied discounts for minority interest and marketability of 40% and 45%, respectively, or 85% in the aggregate.
Conversely, the IRS determined that the total value of the company was $225 million, by comparing the company to public companies and also by reference to discounted cash flows (similar to capitalization of income). The estate’s share of the total value was $46 million, to which the IRS applied no minority interest discount and a 30% marketability discount to arrive at the final value of $32 million.
The Tax Court, however, found no basis for the estate’s 12% management and Internet risk component of the capitalization rate, and determined the minority interest and marketability discounts were too aggressive; and also disagreed with the IRS’s valuation, indicating that the public company “comparables” were too dissimilar to be of any use in the valuation and that there were significant errors in the IRS’s discounted cash flow analysis.
The Tax Court used the estate’s capitalization rate of 30.5% less the 12% management and Internet-component risk, or 18.5%, and applied it to the company’s average earnings to which it added the value of non-operating assets. The estate’s share of this amount was $22.7 million, to which the Tax Court applied a minority interest discount of 15% and a marketability discount of 30%, or an aggregate discount of 45%, resulting in the final value of $13.5 million. The positions of the taxpayer, the IRS, and the Tax Court are summarized in the following table:
Party Estate Tax Capitalization Minority Marketability Final
Value Rate Interest Discount Value
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Taxpayer $5,300,000 30.5% 40% 45% $1,750,000
IRS $46,000,000 3.5% 0% 30% $32,000,000
Tax Court $22,700,000 18.5% 15% 30% $13,500,000
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The lesson for taxpayers is that the Tax Court is willing to apply relatively high capitalization rates and minority and marketability discounts aggregating 45% to arrive at an estate tax value for a company.
A substantial part of our practice is dedicated to assisting business owners and families of significant wealth with respect to issues such as those raised in the Thompson case. Please do not hesitate to telephone us if you have any questions regarding valuation issues in your estate plan.