It is said that the famous Greek tragedy playwright Sophocles once proclaimed: “the long unmeasured pulse of time changes everything.” When it comes to valuing the shares of closely held companies, the passage of time can indeed change everything. A recent decision in U.S. Tax Court involving media magnate Sumner Redstone is an example of just how relevant--and perhaps more importantly, irrelevant--reference transactions can be when used to value closely held companies. Specifically, the timing of the reference transactions was the key facet on which the court drew an important distinction in its decision. The Sumner Redstone v. Commissioner of Internal Revenue1 tax dispute (“Redstone v. Commissioner”), decided December 9, 2015, is a good example of the potential pitfalls of referencing transactions occurring after the transaction date in valuations of stock transfers of closely held companies.
The history of Redstone v. Commissioner is lengthy and involves a rather complicated set of facts, including a dispute dating back to 1971 that served as the nexus for this tax dispute. Sumner’s father Mickey Redstone had founded the closely held company National Amusements Inc. (“NAI”) in the 1930s. His sons Sumner and Edward later joined him in senior management. Upon incorporation as a holding company, class A stock was issued to Mickey, Sumner, and Edward. By 1968 their father Mickey planned to retire gradually and transfer some of his stock to his grandchildren, the children of Sumner and Edward. Mickey therefore established a trust for the benefit of his four grandchildren.
In 1971, Edward decided he no longer wanted to work with his father and brother, left employment with NAI, and sought to sell his NAI stake, initiating a dispute over the value of Edward’s shares. Litigation ensued and a June 1972 settlement agreement resulted in 1/3 of the class A shares that were initially awarded to Edward were placed in a trust for the benefit of Edward’s two children with the balance going directly to Edward.
Immediately following the litigation settlement, Sumner executed irrevocable trusts in July 1972 and transferred NAI stock benefiting his two children. Sumner and his wife never filed a gift tax return for the July 1972 time period. Subsequently, in 1984, NAI redeemed class A shares from the trust established by Mickey and trusts created as a result of the settlement with Edward, all for the benefit of Mickey’s grandchildren. The collective redemptions totaled $21,428,571.
Fast forward to 2010 and the IRS commenced a gift tax examination of Sumner covering the 1972 calendar year focused on his July 1972 NAI stock transfer to his children. On January 11, 2013 the IRS issued a “Notice of Deficiency” and Sumner subsequently petitioned the U.S. Tax court on April 10, 2013. The tax dispute centers around whether the July 1972 transfer by Sumner to his children’s trusts was a “gift” according to gift tax law.
While other important tax and legal questions were at issue in this case, the focus of this article is the ultimate valuation of the shares. In estate and gift tax disputes such as this, Fair Market Value (“FMV”) is the pertinent Standard of Value.2
The tax court’s expert relied primarily on the “merger and acquisition” method3 to value the Sumner July 1972 transfer. Specifically, the expert used the $5 million price NAI agreed to pay Edward, which took place three weeks prior on June 30, 1972 as a comparable transaction. The June 30, 1972 $5 million payment yielded a value of $75,000 per NAI common share. The expert argued that the settlement payment amounted to an arm’s length transaction and occurred at essentially the same point in time. Further, the expert highlighted that each party to the settlement payment in June 1972 had opposing goals; that is, Mickey and Sumner wanted to pay Edward as little as possible to settle the long-running and painful litigation and Edward wanted to maximize the payment. Finally, the expert asserted that the valuation of the Sumner transfer in July 1972 should reflect a minority non-controlling stake in NAI just as the June 1972 settlement payment to Edward reflected Edward’s “minority, non-marketable interest basis.” Given the $75,000 per share reference costs, the expert valued the shares Sumner transferred at approximately $2,500,000.
Sumner’s expert pointed to the per share price of a March 1984 NAI transaction whereby NAI redeemed shares for the trusts benefiting Mickey’s grandchildren. Sumner’s expert claimed that this transaction, almost 12 years following the establishment of the Sumner’s children’s trusts in July 1972, needed to be taken into account. Under a valuation method described as “the engrafting method”4 of valuation, Sumner’s expert pointed out that events occurring after the valuation date “may be taken into account as evidence of fair market as of the valuation date.”5 Relying on the transaction from 1984, Sumner’s expert concluded that the Sumner transfer shares should be priced at $22,079 per share or $736,000 as of 1972.
Importantly, Sumner’s expert did not provide the court with any examples of other matters in which guideline transactions were relied on where the date of the transaction was long after the valuation date. Further, no adjustments were made to account for macro-economic or industry factors that changed over time (e.g., changes in inflation, industry outlook, changes in entertainment practices and technology, changes in NAI product or business lines).
Decision and Takeaway
The court ruled that the Sumner July 1972 transfer was indeed a gift according to gift tax law and found Sumner deficient of $737,625 for the calendar quarter ending September 30, 1972.6 While there were several court conclusions, with regard to the valuation issues the court found little merit in Sumner’s expert’s “engrafting method” arguing in particular that citing a reference transaction from 1984 was not particularly relevant to a valuation date of July 1972. The court found that not only had too much time passed in general, but too much had changed for NAI and the industry as a whole in the interim 12 years for reliance on a redemption price from 1984. The court agreed with the tax court’s expert opinion that the June 1972 settlement agreement was the more relevant transaction.
Referencing appropriate transactions is a critical facet of the Market Approach7 to valuations. Particularly when valuing the stock of closely held companies, guideline transactions can shed useful light on the value of the subject company. There is established legal precedent in the tax court for valuation practitioners to take into account certain events taking place following the valuation date;8 however, in such cases the amount of time that has passed matters. The decision in the referenced Noble v. Commissioner case stated that “in determining the value of unlisted stocks, actual sales made in reasonable amount at arm’s length, in the normal course of business, within a reasonable time before or after the basic date, are the best criterion of market value.”9
There are numerous factors and variables to consider with valuations of closely held companies. But when considering reference transactions occurring over a decade after the valuation date (such as the 1984 NAI redemption), a healthy dose of skepticism is warranted. Failure to recognize Sophocles’ wisdom that “the long unmeasured pulse of time changes everything” can lead to your own valuation case version of a Greek tragedy.
1.Docket No. 8097-13
2.AICPA Forensic & Valuation Services Practice Aid – Business Valuations for Estate and Gift Tax Purposes at page 23. For legal precedent see Morrissey, et al. v. Commissioner, No 99-71013 [9th Circuit Court of Appeals, March 15, 2001].
3.The merger and acquisition method (“M&A method”) is one of two methods associated with the Market Approach to valuation. The Market Approach takes a market oriented view of the subject company by looking for reference transactions to estimate a value of the subject company. The M&A method (or guideline transactions method) looks for transactions involving similar businesses to the company in question. Another common method of valuation associated with the Market Approach is the guideline public company method. The guideline public company method looks to similar public companies to estimate a value of the subject company.
4.Sumner’s expert argued this valuation method most closely resembles the direct capitalization method, a form of the income approach to valuation. The tax court’s expert argued that it was an error to reference a transaction 12 years later, and Sumner’s expert failed to make other needed adjustments rendering Sumner expert’s valuation unreliable. Thus there was no need to separately determine whether the so-called “engrafting method” was an appropriate or reasonable valuation method to consider.
5.Sumner’s expert cites Estate of Jung v. Commissioner, 101 T.C. 412, 431.
6.See T.C. Memo 2015-237at 2. There was also a finding in favor of the Petitioner (Sumner), namely that the Petitioner was not liable for “additions to tax”, i.e. Sumner was not fraudulent in his failure to file a gift tax return in 1972.
7.See footnote 3 for a description of the Market Approach.
8.Estate of Helen M. Noble, v. Commissioner (Noble), T.C. Memo 2005-2 (January 6, 2005)
9.Id at 10.