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Tax-affecting income OK’d for gift tax valuation

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Tax Hot Topics newsletterThe Tax Court recently held in Estate of Aaron U. Jones v. Commissioner, T.C. Memo. 2019-101 that a taxpayer may tax affect the earnings of an S corporation and a limited partnership when using the income method in valuing the business interests for gift tax purposes.

In 2009, Aaron Jones made gifts of interests in an S corporation and a limited partnership to his three daughters and to trusts for their benefit. These transfers were part of a succession plan that was started in 1996. The business was a 55-year-old family-owned lumber and timber business. Mr. Jones filed a gift tax return for 2009 reporting gifts of about $21 million. Upon examination the IRS issued a notice of deficiency valuing the assets at $120 million and a gift tax deficiency of a little less than $45 million. Mr. Jones died about five years after the gift. The Tax Court agreed with a subsequent appraisal by the taxpayer that the value of the gift was about $24 million.

There were two key findings in the Tax Court’s opinion. The first was that the business interests should be valued under an income approach, such as the discounted cash-flow method used by the taxpayer’s appraiser, not the net asset method used by the IRS. Of more general impact was the second finding -- that the discounted cash-flow method used by the taxpayer’s appraiser correctly tax-affected the income from the business.

The court found that the taxpayer’s appraiser took into account the tax consequences to the businesses’ flow-through status in determining the value of the gift. The adjustments included imputing the burden of the current tax that an owner might owe on the entity’s earnings and the benefit of the avoidance of the tax on future dividends. This methodology allowed the income of the businesses to more closely approximate the income from a C corporation in applying the discounted cash flow method.

The court distinguished the recent group of valuation cases rejecting the taxpayer’s attempt at tax-affecting the earnings of flow-through entities. Crucial to the taxpayer’s victory in this case were favorable facts and a detailed appraisal that explained both the appraiser’s rationale and the use of the facts the appraiser relied on in reaching his conclusions. 

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