In Estate of Louise Paxton Gallagher v. Commissioner (T.C. Memo. 2011-148), not only did the Internal Revenue Service lose very badly, but also it did so even though it seemingly had both very good facts and past Tax Court opinions on its side. It wasn’t a great day in court for the government. In fact, the court’s own “appraisal” came in below the original valuation claimed by the estate. The case is a must-read for anyone interested in current Tax Court thinking on valuation issues.

Louise Paxton Gallagher passed away on July 5, 2004, holding 15 percent of Paxton Media Group, LLC (PMG), which owned 28 local newspapers throughout the South and Midwest. PMG’s president valued Louise’s interest for the estate tax return at approximately $34.9 million. Initially, in audit, the IRS proposed a value of $49.5 million. By the time the case made its way to the Tax Court, the estate had lowered its value to $28.2 million and the IRS had itself come down to approximately $40.9 million. Experts who testified at trial backed both valuations.

Gallagher is a pure business valuation case: the only question for the court is the valuation of the decedent’s units in PMG. Further, rather than adopting one of the experts’ opinions or “splitting the baby,” the court instead writes its own valuation report. The court reviews the two appraisals, their methods and inputs and chooses among the inputs provided. And sometimes the court rejects both appraisers’ inputs and generates its own. The result is a fascinating overview of current Tax Court approaches vexing valuation problems.

The Market Approach

The court rejects the use of the “public guideline companies” method (that is, comparing the subject company to publicly traded companies). The IRS’ expert chose four guideline companies. Yet PMG was smaller than the median of the guideline companies and many of them had a broader range of publications, as well as more of an online presence. In addition, PMG had seen faster growth in the recent past than the guideline companies. The only company held to be “of sufficient similarity to PMG” was McClatchy Co.

Tax Affecting

Haven’t we seen this movie before? The taxpayer goes to court with a simple plea: pass-through entity status doesn’t make us immune from paying taxes – it just means we pay the taxes at a different level. Should it really matter whether the company or its owners pay income taxes? Then the taxpayer slams face-first into the wall called Gross v. Comm’r (T.C. Memo. 1999-254). As paraphrased in Gallagher, Gross held that “the principal benefit enjoyed by S corporation shareholders is the reduction in their total tax burden (…).” In Gallagher, the estate’s appraiser had explicitly accounted for these tax savings (primarily, the avoidance of double taxation of distributions). And yet, the court finds that the estate’s appraiser had “advanced no reason” to deviate from the Gross analysis. In a string of opinions, it seems the Tax Court wants to treat the pass-through earnings technique used in Gross as something akin to “settled law.” Appraisers who want to tax affect in court need a very thoughtful critique of the Gross method – clearly a much better one than anything the court has seen until now.

Discount Rate

The court arrives at a weighted average cost of capital of 10 percent, which is identical to the IRS’ appraiser’s estimate. Tax affecting and different capital structure assumptions made up most of the difference between the two. The court rejects the capital asset pricing model in favor of the “build-up” method for calculating the cost of equity capital.

Financial Projections

The court clearly feels that the IRS’ appraiser supported his inputs the best. When projecting revenues, for example, the court holds that the low growth rates the IRS’ appraiser used are more reasonable because they were based on an analysis of PMG’s historical growth. Also, the court adopts the operating margins estimated by the IRS’ appraiser. By 2004, newsprint costs were increasing dramatically, which in retrospect is a clear detriment to newspaper profits and valuations. Unfortunately, the estate’s appraiser didn’t supply enough evidence on this point. (Terms like “fails to explain,” “fails to convince,” etc., are common throughout the court’s discussion of the taxpayer’s analysis.)

Other Inputs

Space doesn’t permit analyzing them all, but Gallagher pronounces on myriad other issues, including: overfunded pension plans, projecting capital expenditures, adjusting for future working capital needs, estimating the correct capital structure, restricted stock data and the proper date of financial information. Take it from me: it’s a smörgåsbord of valuation techniques.

Market Approach Rejected

So, even with inputs mostly based on the IRS’ appraiser’s, the court arrives at a market value of invested capital (MVIC) of approximately $667.5 million, a total equity value before discounts of $408.7 million and a final value of the estate’s 15 percent of $32,601,640, which is about $2.3 million below the Form 706 (federal estate tax return) valuation.

To me, the most disappointing aspect of Gallagher is the rejection of the market approach. While in retrospect, more guideline companies probably should have been included (Media General, Inc., for example), these were in truth very good comparables. The appeal of the market approach is the discipline it can add to the analysis. For example, the court arrived at an MVIC here that’s more than four times PMG’s revenues, a multiple more often seen for high-flying technology stocks. The outlook for newspaper stocks was already darkening as of mid-2004. And if there’s any consolation here for the government, it might be that the estate, unless it sold out immediately, probably did worse. Today, the media industry is a shadow of its former self. Just as one example, The New York Times Company, which owns what’s generally regarded as the premiere brand in the business, is currently trading at about 0.7 times revenues. Clearly, while a disappointment, the result for the IRS in Gallagher could have been even worse.