Word. Tax Court reduces estate value of stock by executive’s “personal goodwill.” The courts have recognized that the value of a business depend on the contacts and reputation of a key executive — “personal goodwill.” That concept has enabled business owners to sell their goodwill separately from other business assets — handy in avoiding the double tax inherent in C corporations.
Yesterday the Tax Court applied “personal goodwill” in valuing stock in a decedent’s estate. Franklin Z. Adell died in 2006 owning all of the stock of STN.Com, a satellite uplink company. The company had one customer: The Word Network, a religious broadcaster set up as a non-profit and run by Mr. Adell’s son, Kevin.
The arrangement proved profitable to STN.Com, which generated nearly $16 million in revenues in 2006. That enabled company executives to travel in style, according to the Tax Court (footnotes omitted):
In addition to rent and compensation, STN.Com made several miscellaneous payments that were primarily for the personal benefit of Mr. Adell and Kevin. STN.Com leased luxury cars, including Bentleys and Rolls-Royces, used for personal and work purposes by Mr. Adell, Kevin, and its other employees. STN.Com also helped Mr. Adell and Kevin purchase and maintain real estate. For example, STN.Com gave money to Mr. Adell and Kevin to purchase a condominium in Los Angeles, California, and guaranteed the mortgage. STN.Com purchased high-end furnishings for the condominium and for Mr. Adell’s home in Michigan and paid all expenses, including the mortgage, interest, and insurance, related to Kevin’s second home in Florida. In 2002 STN.Com paid $300,000 toward Kevin’s home in Florida. From July 2002 through June 2003 STN.Com paid between $300,000 and $400,000 of Kevin’s personal legal fees for litigation involving a dispute with a home contractor. In 2006 Mr. Adell paid a $6 million judgment entered against Kevin using funds from Mr. Adell’s salary at STN.Com.
The estate filed a tax return showing a date-of-death value of $9.3 million. The IRS thought that number was slightly low, coming up with a value of $93.3 million. By the time of the trial, the IRS number had come down to $26,341,030, and the estate was arguing for a $4.3 million value. The trial came down to a duel of expert witness appraisers.
The main difference between the appraisals was the treatment of “personal goodwill” by the estate’s expert, a Mr. Risius. From the Tax Court decision:
Mr. Risius also adjusted STN.Com’s operating expenses to include an economic charge for Kevin’s personal goodwill. Mr. Risius explained that the adjustment was appropriate because the success of STN.Com depended heavily on Kevin’s personal relationships with the board of directors of The Word. Moreover, Kevin did not have a noncompete agreement with STN.Com, and as a result a potential buyer would acquire STN.Com only to the extent that the company retained Kevin. The economic charge for Kevin’s personal goodwill ranged from 37.2% to 43.4% of sales over the historical period and from 43.7% to 44.1% of sales over the projection period.
The IRS expert, Mr. Burns, admitted the importance of the son’s personal involvement, but took a different approach:
Instead of applying an economic charge for Kevin’s personal goodwill similar to the one found in Mr. Risius’ first valuation report, Mr. Burns concluded that a hypothetical investor would anticipate retaining Kevin as an officer of STN.Com and would need to compensate Kevin at an acceptable rate of 8.1% of sales. Mr. Burns noted that his assumed compensation level for Kevin of nearly $1.3 million in 2006 was significantly higher than Mr. Risius’ estimate of $528,000 in his first valuation report.
Tax Court Judge Paris found the estate’s approach more persuasive:
Kevin’s goodwill was personally owned independent of STN.Com. STN.Com’s success was heavily dependent on The Word because of their symbiotic relationship. To launch The Word, it was Kevin who contacted religious leaders in the Detroit area and Rev. Jackson in Chicago. Along with his notable contacts and his father, he went to Los Angeles to meet with DirecTV representatives about broadcasting The Word. His meeting was successful and it eventually led to the national broadcasting of The Word on cable television. Kevin was the face of the operation because he was the individual soliciting content and pursuing broadcast opportunities.
Yes, that Rev. Jackson.
Further, Kevin did not transfer his goodwill to STN.Com through a covenant not to compete or other agreement. Kevin was free to leave STN.Com and use his relationships to directly compete against his previous employer. If Kevin quit, STN.Com could not exclusively use the relationships that Kevin cultivated; thus, the value of those relationships should not be attributed to STN.Com.
Accordingly, Mr. Risius properly adjusted STN.Com’s operating expenses to include an economic charge of $8 million to $12 million for Kevin’s personal goodwill at an amount high enough to account for the significant value of Kevin’s relationships. Mr. Burns, on the other hand, not only failed to apply an economic charge for Kevin’s personal goodwill but also gave too low an estimate of acceptable compensation for Kevin, i.e., $1.3 million in 2006. This was especially so because Kevin had stepped into the position of Mr. Adell, who had previously made between over $2 million and $7 million of compensation in each of the five years before his death.
The court went with the $9.3 million value on the original tax return: “…the Court concludes that Mr. Risius’ first valuation report on the STN.Com stock included with the original estate tax return was the most creditable because it properly accounted for Kevin’s personal goodwill and appropriately used the discounted cashflow analysis of the income approach to value the STN.Com stock.”
The moral? Appraisers working with closely-held businesses need to look closely at important customer and vendor relationships and determine whether they actually belong to the corporation, or if they instead belong separately to executives. The case also is more support for taxpayers wanting to sell personal goodwill separately from corporate assets.
Cite: Estate of Franklin Z. Adell T.C. Memo 2014-155.
Robert D. Flach offers fresh Tuesday Buzz! Robert has also started a new monthly newsletter, The Tax Professional. “The purpose of THE TAX PROFESSIONAL is to discuss and debate issues of interest and importance to the profession of preparing income tax returns – such as certification and credentials, dealing with the IRS and state tax agencies, due diligence requirements, ethics and obligations, regulation, representation, tax law complexity, etc.” While I often disagree with Robert, he’s a smart and entertaining guy, and both his blog and the newsletter are worth regular visits.
Kay Bell, August to-do list: Vacation, shopping, school and taxes
Peter Reilly, Homeowner Association IRS Ruling Highlights Schizophrenic Nature Of Associations. “Unless they have vast reserves earning significant investment income, homeowners associations can avoid any significant tax liability by filing Form 1120H, which allows the organization to exclude assessments. Despite that option,
Annette Nellen, Marijuana businesses and ethical issues for tax practitioners. Can you get in trouble for helping a pot store pay its taxes?
Frank Agostino, a veteran Tax Court litigator, guests posts in Procedurally Taxing with Procedural Challenges to Penalties: Section 6751(b)(1)’s Signed Supervisory Approval Requirement. “In view of the fact that the IRS (and the Tax Court) have so strictly adhered to the Code’s substantiation requirements, one is hopeful that a similar strict compliance standard will be applied when interpreting a statutory provision clearly intended to protect taxpayer’s procedural due process rights.”
Jack Townsend, Williams Yet Again – Court Bows Deeply to Government Claims of Expansive Discretion for FBAR Willful Penalty
The current diversionary panic about corporate inversions has reached its illogical conclusion, reports J.D. Tucille at Reason.com: With Loyalty Oath Demand, Crusade Against Corporate Inversion Gets Even Creepier.
Leave it to Jonathan Alter to jump the already laughably overblown “problem” of corporations seeking friendlier tax jurisdictions elsewhere right past parody. Forget any discussion of why businesses are relocating. At the Daily Beast, Alter wants potential “corporate deserters” to take…wait, I have to check this again…yep…loyalty oaths.
The post quotes Mr. Alter’s argument:
For those companies less able to act as Americans or recognize their real interests, there are two ways to make this work. The president should issue an executive order that says any company that wants to keep its federal contracts must sign a new-fangled [non-desertion agreement]…
But other companies with few or no federal contracts might be tempted to desert anyway.
That’s where the rest of us come in. Under my scheme, companies that sign non-desertion agreements would embed a tiny American flag or some other Good Housekeeping-type seal in their corporate insignia for all to see, just as companies during the Great Depression that agreed to Franklin Roosevelt’s recovery plan hung an emblem of a blue eagle in their windows with the legend, “We Do Our Part.”
Mr. Tucille observes:
To make it clear where this all goes, the National Recovery Administration once boasted, “The Fascist Principles are very similar to those we have been evolving here in America.” Its head, Hugh Johnson, noted about the adoption or rejection of the blue eagle symbol and its code, “Those who are not with us are against us.”
There’s a good book about this sort of thing.
Corporations have entirely legitimate purposes other than funneling cash to the IRS. They have to make payroll, supply desired and needed goods to customers, and provide a return to their owners. They have no more obligation to pay un-owed taxes than you, me, or Mr. Alter. Unless Mr. Alter declines to itemize and forgoes his personal exemption in the name of economic patriotism, no blue eagle for him either.
Kyle Pomerleau, Everything You Need to Know About Corporate Inversions (Tax Policy Blog). “The most obvious benefit is that most countries do not have a worldwide corporate income tax system. The United States taxes income earned by U.S. corporations no matter where they earn that income, domestically or abroad.”
Martin Sullivan, Don’t Count on Tax Reform to Stop Inversions (Tax Analysts Blog)
Rebecca Wilkins, Wall Street a Major Player in Current Wave of Corporate Inversions (Tax Justice Blog). Maybe because investors like companies that don’t incur unnecessary expenses.
Renu Zaretsky, Online Taxes: Searches, Storage, and Sales. The daily TaxVox headline roundup covers, among other things, an insane attempt to tax websites that link to Spanish newspaper association stories. “Note to Spanish tax authorities: buena suerte.”