If you own the family business and perhaps your children and grandchildren are working with you as well, I am sure you all once in a while wonder how much your business is worth? Did you know there is someone else who is interested in how much your business is worth. No, it’s not a potential buyer; it’s the IRS! If you read my last article on Family LLC Discounts you know exactly why the IRS is interested in the value of your business. But did you also know that the expert witnesses working for the IRS will compute “personal goodwill” as part of your business valuation? If you are curious as to why personal goodwill is important to the Government then keep reading this article to learn about how personal goodwill will come into play in the likely event of an IRS audit of your estate tax return, perhaps many years after you are long gone.
Goodwill brings us smack into the walls of the US Tax Court where just a few weeks ago Judge Paris decided the case ofT.C. Memo. 2014-155 ADELL vs IRS. Franklin Adell founded STN.Com’s, a cable uplinking company, with his Son Kevin. STN.COM sole business purpose was to broadcast an urban religious program channel named “The Word Network” (The Word). When Adell died in 2006 his estate included the entire ownership of STN.Com and numerous other assets. Adell‘s estate valued STN.Com, with a reported date-of-death value of $9.3 million in the Form 706 Estate Tax return filed in late 2007. Estate tax was owed of approximately $15 Million on STN and all the other assets. The STN.Com stock’s reported value was based on a valuation report prepared by and certified by J Stout Risius Ross, Inc. (Ross).
Just so you know, I thought it interesting that the Estate filed almost back to back amended tax returns in 2008 and 2010 which reduced the estate tax paid from $15 Million to $8 Million. As you see it, if you file a first tax return wrong under penalty of perjury and then file another one wrong and then another, would you think, the IRS might show some interest? At any rate, the tax returns were indeed audited by the IRS. As the end of the audit, the IRS determined that the STN.Com stock was worth not $9 Million as reported on the original Form 706, but more like $92 Million. The increase in valuation resulted in over $60 Million in additional tax liability, penalties and interest to the estate.
During the Tax Court trial, the IRS retained Mr. Burns (Burns) as their expert witness. Adell retained expert witness Ross, who computed the original valuation on the original tax return filed November 2007. Ross argued that STN.Com was worth $4 Million and Burns argued that STN.Com was worth $92 Million. Surprisingly Burns, used the same discounted cash flow analysis of the income approach that Ross used. In addition, Burns substantially relied on the Ross determinations including his projected sales for STN.Com, which were based on the company’s historical performance and on conversations with management. So while Burns and Ross used the same methods their conclusions were dramatically different. How could this be?
The Court found that “Goodwill” was valued very differently by Burns and Ross. Goodwill not from the business or the brand, but Goodwill from Kevin Adell, his personal goodwill. Kevin developed thousands of relationships with The Word and its customers nationwide. Because personal goodwill does not belong to the company, the valuation of STN.Com had to be adjusted downward after Kevin’s personal goodwill was recognized. Both experts recognized that Kevin himself personally created this Goodwill, but Ross valued Kevin’sgoodwill at $12 million while Ross only valued Kevin’s goodwill at $1 million. As a result, Ross valued the company almost $90 Million less than Burns. After a thorough review, the Court sided with Ross but not entirely. Judge Paris gave Adell the 9 Million valuation of STN.Com as per the original tax return filed but not the 4 Million that Adell had asked for on the back to back amended tax returns. Either way, this was a huge victory for Adell, Ross and American taxpayer.
What does this mean for all you small business owners? What can we learn from Adell? First make sure you consult with your tax attorney and tax advisors regarding how they are recording and computing and annually valuing your small business. Have your estate planner teach you, your family and kids the techniques of valuation for estate tax purposes, including the discounted cash flow method of income approach. Second ask your CPA best practice on how to recognize the value of goodwill created by the owners and operational partners and their children. Finally, suggest to your CPA to disclose your business valuations including the personal goodwill to the Government in your annual business tax returns to show contemporaneous and extemporaneous valuations. Better for you to do it now than have the IRS do it later!
Thank you for joining Chris Moss CPA on TaxView. Happy Valuations.
Kindest regards Chris Moss CPA