How do you value interest in a personal holding company? A tale of three methods – Los Angeles Income Tax Planning & Income Tax Litigation Attorney Bruce Givner

by Bruce Givner on February 23, 2014

At the time of her death on December 10, 2005, Helen P. Richmond owned a 23.44% interest (consisting of 548 shares) in a family-owned personal holdings company called Pearson Holdings Company (PHC) which had a stipulated net asset value (NAV) of $52,114,041. Throughout its operations, PHC sought to provide a steady stream of income to the descendants of the company’s namesake, Frederick Pearson, by maximizing dividend income while minimizing taxes and preserving capital. Due to the tax on undistributed income under Code Sec. 541, to which PHC was subject, the company paid out most of the dividend income generated by the securities held in its portfolio at a reliable rate which, from the 1970’s through till 2005, had grown by around 5% per year.

When it came time to value Ms. Richmond’s gross estate, two conflicting values were proposed: one by the estate’s accountant and one by the IRS. The cause of these conflicting values resulted from the use of two different valuation methods. In the draft report he prepared, the estate’s accountant, Peter Winnington, used a capitalization-of-dividends method that valued the decedent’s interest in the company at $3,149,767, and the estate reported this value on the estate tax return. Conversely, the IRS’s expert, John A. Thomson, valued Ms. Richmond’s 23.44% interest in PHC at $7,330,000 using a discounted net asset method.

The Tax Court held that, while dividend capitalization is certainly one way to value a business, it is best used when a company’s assets are difficult to value. For PHC, though, a dividend capitalization method ignored the most reliable data available to determine the value of the decedent’s interest: the actual market prices of the publicly traded securities in PHC’s portfolio. Also, the dividend capitalization method of valuation assumed that a potential investor in PHC would only consider the present value of the dividend stream that the stockholder could expect to receive, when in reality any potential investor could calculate without controversy the value of PHC’s portfolio at $52 million, the company’s net asset value (before discounts).

Therefore, the Court determined that the NAV method must be used to determine the value of PHC. In doing so, the court valued Ms. Richmond’s interest in PHC by calculating PHC’s NAV ($52,159,430), subtracting from this amount PHC’s liabilities and reducing that value by a built-in capital gain tax discount, resulting in a NAV of $44,296,936. Calculating 23.44% of the NAV at $10,383, 202, the Court then applied a 7.75% lack of control discount as well as a 32.1% lack of marketability discount, leaving the value of the decedent’s interest in PHC at $6,503,804. The case was also penalized 20% for failing to hire a competent appraiser and, instead, relying on a CPA who was unskilled as a business appraiser.

Givner & Kaye focuses on sophisticated income tax planning and compliance, tax litigation and procedure, estate planning, and asset protection plans for individuals and businesses in Beverly Hills, Calabasas, West Los Angeles, Hollywood, and other areas of Los Angeles, Orange, Ventura, San Bernardino, Riverside and Santa Barbara Counties. Call Los Angeles Estate Planning and Asset Protection Plan Attorneys Givner & Kaye at (310) 207-8008 today.

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