When Superman was trapped in “Bizarro World,” he found everything was the opposite of its earthly counterpart. Or, as Jerry Seinfeld observed, for an inhabitant of Bizarro World, “Up is down, down is up, he says ‘hello’ when he leaves, ‘goodbye’ when he arrives.”1 Several long-standing valuation issues were subject to a type of “up is down” treatment in 2011.

Tax-affecting S Corporation Earnings

The Tax Court continues to say “no” to tax-affecting the value of S corporation earnings (that is, discounting the value of those earnings on the basis of assumed future tax burdens imposed on them) and the valuation community just as persistently says “yes” to tax-affecting the earnings. This conflict in approaches has existed for more than a decade. In the 1999 ruling Walter L. Gross, Jr. et al. v. Commissioner,2 the court determined that a Cincinnati-based soft drink distributor was properly valued by not tax-affecting its S corporation earnings and applying a market-derived multiple. Since Gross was decided, valuation professionals have devoted considerable efforts to assessing the valuation impact of tax benefits derived by S corporation shareholders — avoiding a double layer of taxes on distributions received and getting a stock basis step up on earnings retained by the corporation. The general consensus among professionals is to value an S corporation by tax-affecting its earnings as if it were a C corporation and then make an upward adjustment to its shares by the incremental value associated with the specific tax benefits received by the S corporation shareholder.

The Tax Court has remained steadfast in its treatment of S corporation valuations over a string of cases3 since 1999. During 2011, the Tax Court revisited the issue in two cases involving pass-through tax entities and held to their S corporation stock position that pass-through equity interests are appropriately valued by not tax-affecting pre-tax earnings.

The first case was Estate of Natalie Giustina v. Comm'r,4 which involved an operating timberland business that was a limited partnership. The expert for the estate prepared a discounted cash flow analysis and reduced each year's cash flow by 25 percent to account for pass-through income taxes. Citing Gross, the court stated, “An appraiser should not reduce cashflows by income tax while simultaneously using a pretax rate of return to discount the cashflows to present value.”5 Whether the court's conclusion that the appraiser used a pre-tax rate of return in his calculation is an accurate representation, the relevant outcome is that the court dismissed as inappropriate the tax-affecting of pass-through entity income.

Less than one week after Giustina, the Tax Court decided Estate of Louise Paxton Gallagher v. Comm'r6 with a similar outcome on the tax-affecting issue. In Gallagher, the pass-through entity was a limited liability company that published daily newspapers and weekly publications, as well as owned and operated a television station. A noteworthy aspect of Gallagher is that it was heard before the same Tax Court judge, Judge James S. Halpern, who decided Gross in 1999. While it found that tax-affecting corporate earnings wasn't justified, the court implied it was open to persuasion on the issue. The court wrote:

Absent an argument for tax affecting [the Company's] projected earnings and discount rate, we decline to do so. As we stated in Gross …, the principal benefit enjoyed by S corporation shareholders is the reduction in their total tax burden, a benefit that should be considered when valuing an S corporation. 7

Tax-affecting pass-through earnings and incorporating the incremental value from tax benefits received by an S corporation shareholder appear to be consistent with the court's stated desire that S corporation stock values consider the benefits of a reduction in their total tax burden. Can the valuation community persuade the court that such an approach to valuing the stock is more appropriate than treating the S corporation as a tax-free entity by not tax-affecting its earnings?


The Gallagher opinion also took aim at two foundational tenets of corporate finance — the weighted average cost of capital (WACC) and the capital asset pricing model (CAPM), questioning their application in valuing closely held corporations. Quoting from Estate of Hendrickson v. Comm'r, the court stated that, “We have previously held that WACC is an improper analytical tool to value a ‘small, closely held corporation with little possibility of going public.’”8 WACC reflects a business' cost of capital for cash flows available to all investors (debt and equity) based on a blending of the cost of equity capital and debt capital. The company at issue in Gallagher had $169 million in revenue and $48 million in net income. This media company wasn't the typical model for “small, closely held” businesses. The experts for both the estate and Internal Revenue Service used WACC as the rate of return in their respective valuation analyses and neither party raised the issue to the court. The court grudgingly accepted WACC in Gallagher, but observed, “we shall adopt it, although we do not set a general rule in doing so.”9

WACC is such a long-standing and pervasive concept in financial analysis, it's difficult to understand the court's distinction that WACC is applicable to public companies but not private ones. WACC is calculated by weighting the required returns on interest-bearing debt and equity in proportion to their estimated percentages in an expected capital structure. Management of both private and public companies seeks to maximize corporate value by using the lowest cost of capital available. Employing lower cost debt in a capital structure rather than higher cost equity capital should be management's objective whether the business is public or private. If a private company can prudently employ a percentage of debt in its capital structure, its shareholders will benefit. The court is likely to have difficulty locating a valuation expert who agrees with its position that use of WACC in an analysis is exclusive to public company equity interests.


The second basic finance principle that the court objected to in Gallagher was the use of the CAPM formula to derive the cost of equity capital. It stated that, “The special characteristics associated generally with closely held corporate stock make CAPM an inappropriate formula to use in this case.”10 Without elaborating on its position, the court agreed with the IRS' expert that an alternative methodology — the buildup method — is the appropriate method by which to calculate the company's cost of equity capital.

Since CAPM is an established methodology that has been vetted by substantial financial research, it's difficult to understand the Tax Court's rationale that CAPM is only appropriate for public companies and not closely held entities.

IRS Job Aid on DLOM Released

Although not falling in the “up is down” category, a study by the IRS, “Discount for Lack of Marketability Job Aid for IRS Valuation Professionals”11 (the Job Aid) was published last year. The study was commissioned to assist IRS personnel in dealing with discount for lack of marketability (DLOM) issues, but wasn't intended for public consumption. However, the study was leaked during the summer and the IRS officially released it on its website. The 112-page document reflects substantial research by the IRS into past and present approaches to establishing DLOM. The Job Aid reviews long-standing methods and models for estimating DLOMs and provides insights into the IRS' view of the strengths and weaknesses of the 18 models and approaches surveyed. The IRS emphasizes that the Job Aid is “not meant to provide a cookbook approach to evaluating a marketability discount;” however, it nonetheless draws back the curtain somewhat to reveal some of the IRS' views. Perhaps the most telling instruction in the Job Aid is the basic question an IRS reviewer should pose: “Under the prevailing facts and circumstances and considering the nature of the interest to be valued, why is the DLOM not zero?”12

Interest Rates

Last year brought unusually low interest rates. No one can comfortably predict how long low interest rates will last, but we know that the rates in late 2011, as measured by Internal Revenue Code Section 7520, were at their lowest since 1989. (See “Section 7520 Rates,” this page.)

The current applicable federal rate (AFR) and Section 7520 rates provide the estate-planning community with significant opportunities with respect to intrafamily loans, grantor retained annuity trusts (GRATs), charitable lead trusts and sales to defective grantor trusts. In August 2011, the Federal Reserve announced its intention to maintain low interest rates until mid-2013. The Federal Reserve's stated policy may provide an extended period in 2012 to take advantage of planning techniques that benefit most from a low interest rate environment. Estate-planning strategies that take advantage of these historically low rates are particularly appealing.

Looking Forward

It's hard to believe that anyone would fail to note that this is a presidential election year. Such years have many characteristics, but one of the more benign is that new legislation grinds to a halt. It's likely that Congress won't be concerned with 2013 estate and gift tax rates until the lame duck session after the November presidential election. Today, we know interest rates are low, two-year GRATs are valid, valuation discounts are available, the top gift and estate tax rate is 35 percent and the exemption amount is $5.12 million. With estate and gift tax rates seemingly locked in for 2012 and AFR and Section 7520 interest rates at unusually low levels, it's difficult to foresee when conditions for transferring assets to loved ones will be as favorable as they are now.

This year may present taxpayers with a unique “Bizarro World” of record low interest rates, record high exemptions and a 35 percent estate and gift tax rate. The question without an answer is: When will these favorable conditions snap back to earth?


  1. See www.seinfeldscripts.com/TheBizarroJerry.htm.
  2. Walter L. Gross, Jr. et al. v. Commissioner, T.C. Memo. 1999-254 (July 29, 1999), aff'd, 272 F.3d 333 (6th Cir. 2001).
  3. Estate of Richie C. Heck v. Comm'r, T.C. Memo. 2002-34 (Feb. 5, 2002); Estate of William G. Adams, Jr. v. Comm'r, T.C. Memo. 2002-80 (March 28, 2002); Richard Dallas v. Comm'r, T.C. Memo. 2006-212 (Sept. 28, 2006).
  4. Estate of Natalie Giustina v. Comm'r, T.C. Memo. 2011-141 (June 22, 2011).
  5. Ibid., at p. 14.
  6. Estate of Louise Paxton Gallagher v. Comm'r, T.C. Memo. 2011-148 (June 28, 2011).
  7. Ibid., at p. 32.
  8. Ibid., at p. 35.
  9. Ibid., at p. 35.
  10. Ibid., at p. 36.
  11. www.irs.gov/pub/irs-utl/dlom.pdf.
  12. Ibid., at p. 74.

Radd L. Riebe is a managing director in the Cleveland office of the Valuation and Financial Opinions Group, Stout Risius Ross, Inc.