Money Matters: Personal versus business goodwill distinction was key in a U.S. tax court business valuation case

By Anthony G. Sandonato
BridgeTower Media Newswires

What do these amounts have in common: $0, $4.3 million, $9.3 million, $26 million, and $92.2 million? Amazingly, they are all valuation estimates of the same company at the same point in time. And the cause of these wild swings in value? The estimate of personal goodwill, as a relatively recent estate case in Tax Court illustrates. The case is Estate of Adell v. Commissioner, 2014 Tax Ct. Memo LEXIS 155 (Aug. 4, 2014).

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Fact of the case

Franklin Adell owned 100% of STN, a company that provided cable uplink services to a single customer: The Word, a 24-hour religious broadcast network. The Word was a 501(c)(3) organization formed by Adell and his son, Kevin, who was made president of STN. The driving force of the entire operation-the network and the uplink business-was Kevin's personal relationships with churches and religious leaders. He had no employment contract with STN, and there was no non-compete agreement. The deal was that The Word would pay STN a "programming fee" equal to the lesser of: (a) actual cost; or (b) 95% of net programming revenue received by The Word.

When the elder Adell passed away, his estate reported on Form 706 that the 100% interest in STN was worth $9.3 million based on a valuation from an experienced financial analyst who used the discounted cash flow (DCF) income-based business valuation methodology. Almost four years after Adell's death, the estate filed an amended return that claimed the STN stock was worth $0. The IRS issued a notice of deficiency and determined that the value of STN was $92.2 million. The next stop was tax court.

At trial, the estate's expert submitted a revised valuation for STN of $4.3 million, based on liquidation value. The expert said his original valuation failed to account for the deal that put a limit on the programming fee, which prevents STN from being profitable. One problem with this approach, however, was that the deal seems never to have been enforced, as STN had healthy profits.

The IRS also revised its valuation, coming up with $26 million also using the DCF methodology. The IRS expert based his calculation on the assumption that a hypothetical buyer could retain the son by paying him $1.3 million a year.

The court noted the estate's "substantially inconsistent positions" but adopted the estate's original $9.3 million valuation. It discredited the estate's revised valuation in light of the company's historical profitability and expectations that it would make a profit in the future. At the same time, the IRS expert's goodwill approach also was inappropriate. He greatly undervalued the pivotal role the son played in operating both companies and his personal relationship with customers. Plus, if he quit, he could compete directly with the company, the court pointed out. (Postscript: Later on, the son actually did quit and took all of the business with him to a new company he formed.)

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Key takeaways from the Adell case

The tax court in the Adell case has made some very interesting determinations that will help in planning for the valuation of closely-held business interests. At the outset, it is important for tax attorneys, CPAs and other business advisors to be aware that facts are critically important to the tax effects of any proposed transaction, including business valuations to be used on tax returns, and that planners are in the unique position of helping mold the facts that will exist at any particular point in time. The Adell case also teaches us to be aware of both the pros and cons of buy-sell agreements and employment agreements, as well as the need to make sure that the business valuation appraisal you use for tax return filing purposes is the good appraisal, and not a cheaper one that you may not want to use if it is ever challenged.

In the Adell case, the estate won on the business valuation issue, but likely could have done even better. Here is what we learned:

The Adell case points out that "goodwill" involved in a business may, in fact, belong to the key employee and not to the business. In such a case, the business value would not include this goodwill, which would lead to a lower valuation. The value of personal goodwill, as distinguished from company value, is becoming a much more established concept and may have a very significant effect on valuation.

Who owns this goodwill can be affected by any existing buy-sell agreements and employment agreements. In this case, no such agreements existed, and the court determined that the business did not own the goodwill at issue, and therefore the value was significantly lower than the IRS appraiser had determined. The lesson here is that the effects of buy-sell agreements and employment agreements need to be considered, as either or both could have a valuation effect on a business. If the goodwill is owned by the business, the business value will be higher, and if the key employee owns the goodwill, the business value will be lower. The question for the planner is if you would rather the value be higher or lower for your intended planning purposes.

Another key takeaway is the importance of getting it right the first time. The court treated the first valuation, for the $9.3 million on its Form 706, as an admission by the estate (citing Estate of Hall v. Commissioner, 92 T.C. 312, 338 (1989)). When a taxpayer first admits a value-$9.3 million, in this case-a lower value "cannot be substituted without cogent proof that the reported value was erroneous." As to the ultimately determined value, the court went with the appraised value as stated on the originally filed Form 706. The estate had obtained a much lower appraisal after the IRS dispute arose, but the court determined that the amount on the Form 706 was an admission (against interest) and could not be lowered after the dispute arose. The lesson here is that it is better to spend the money on the front end to get the most appropriate appraisal than to go the cheaper route on the front end with the thought that a better (more expensive) appraisal can be obtained later if a dispute as to the value ever arises.

The U.S. Tax Court continues to review numerous business valuation cases each year. As new case law develops, the business valuation discipline continues to evolve. In summary, the key takeaway from the Adell case involves the dichotomy between personal versus business goodwill and the influence of buy-sell and non-compete agreements on this issue. An analysis of these factors will need to be thoroughly addressed in the future by accountants, attorneys, and business valuation professionals.

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Anthony G. Sandonato, CPA/ABV, CVA, Esq. is a tax and business valuation partner with Mengel, Metzger Barr and Company. He can be reached at 585-672-1838 or by e-mail at asandonato@mmb-co.com.

Published: Fri, Aug 11, 2017