TAX COURT VALUATIONS

BVRI appraisers have testified in numerous U.S. tax court cases on a broad range of valuation issues, including reasonable executive compensation, discounts for lack of control/marketability, noncompete covenants, patents, licensing agreements, trademarks, secret formulas and other intangible assets.

BVRI has been retained in approximately half of these disputes by the taxpayer and half by IRS district counsel. More than 75% of these disputes were settled after the exchange of expert reports.

A representative profile of these cases is presented below.

Software Firm v. C.I.R., U.S.T.C. Docket Nos. 8265-00 and 8266-00, Boston, MA. J. Chiechi.

Issues: Value of minority shares; allocation of value to stock and noncompete and royalty/consulting contracts; minority interest discount.

Summary. Taxpayer-petitioner (P), a manufacturer of digital voice dictation/transcription software and related equipment, redeemed the stock of two minority shareholders for $500,000 and also entered into noncompete and royalty/consulting contracts with both shareholders. In valuing the redeemed shares, P applied an 80% discount for lack of control and marketability, and allocated substantially all the purchase price to the noncompete and consulting contracts. One year later, P sold the entire business to a large manufacturer for $5,000,000. Prior to the redemption, one of the minority shareholders served as the senior software engineer and was solely responsible for developing a Windows™ version of P's DOS software, a role which he resumed after the redemption under the terms of his royalty/consulting agreement. The second minority shareholder was not a key person in the business and was not replaced after his departure.

The IRS challenged P's allocation of the purchase price and valuation of the redeemed shares.

BVRI was retained by the IRS to determine the reasonableness of P's valuation of the stock and the noncompete and royalty/consulting contracts. We valued the noncompetes based on their economic reality and other factors cited in Thompson v. C.I.R., TCM 1997-287, and other relevant case law. We determined the discounts for lack of control and marketability based on factors cited in Mandelbaum v. C.I.R., TCM 1995-255.

The case settled after the exchange of expert direct and rebuttal reports.

Heavy Equipment Mfr. v. C.I.R., U.S.T.C. Docket No. 25671-95, Portland, OR. J. Beghe.

Issues: Value of trademark license and covenant not to compete; allocation of purchase price; §1060.

Summary. Taxpayer-petitioner (P), a manufacturer of logging and other heavy equipment, purchased substantially all the operating assets of a division of a large public company that manufactured and distributed heavy industrial equipment used primarily in the logging and pipeline industries. The assets purchased included all inventories, manufacturing drawings, specifications, blueprints, technical information and all copyrights related thereto, most production equipment and all open sold orders. P retained all the seller's key personnel. The seller agreed to a five-year noncompete and provided P a three-year license to use seller's trademark. P allocated the entire purchase price to the tangible assets, the noncompete and the trademark license (all Class III depreciable or amortizable assets) and nothing to goodwill. The values of all tangible assets were stipulated.

BVRI was retained by the IRS to determine the values of the noncompete, the trademark license and all other identifiable (Class III) intangible assets, as well as their remaining useful lives. Our investigation included a detailed review of all drafts of the purchase documents; financial and management information of the buyer and the seller; all correspondence of the buyer, the seller and their agents; offers to purchase by other suitors; and the seller's SEC filings. We also inspected competing products, interviewed competitors and former employees of the seller, analyzed the domestic and foreign markets for the products, and assisted in the deposition of management.

Our valuation of the noncompete was based on its economic reality and other factors cited in Thompson v. C.I.R., TCM 1997-287, and other relevant case law. Our valuation of the trademark license included analysis of advertising, marketing and sales methods used by the seller, alternative marketing methods, distribution methods, sales of new units and replacement parts, fair royalty rates and other relevant factors.

This case settled after the exchange of expert direct and rebuttal reports.

Grocery Chain v. C.I.R., U.S.T.C. Docket No. 10905-97, Washington, D.C. J. Chiechi.

Issue: Reasonable executive compensation; §162(a)(1).

Summary. Petitioner (P) was a closely held grocery chain which also owned and operated a rock quarry, an insurance agency and miscellaneous other businesses in the Mid-Atlantic region. The parent company also owned, developed and managed numerous commercial retail properties. P was owned and managed by three shareholder-officers (father and two sons) who were semi-active in the business and whose roles varied over the years. Most corporate policies and key management decisions were jointly made by the three shareholders.

BVRI was retained by the IRS to determine reasonable compensation for the three shareholder-officers. We developed our valuation based on the factors cited in Mayson Mfg. v. C.I.R., 178 F.2d 115 at 119 (6th Cir. 1949); Elliotts, Inc. v. C.I.R., 716 F.2d 1241 (9th Cir. 1983); Rutter v. C.I.R., 853 F.2d 1267 (5th Cir. 1988); and other relevant cases. We researched numerous sources of market compensation data for senior executives in the grocery, rock quarry and real estate management industries. We also relied on disclosures in SEC filings of several peer companies, as well as our valuations of similar businesses.

Our formulation of reasonable compensation, which included allowances for base salaries, annual bonuses, long-term incentives, benefits and perks, was based on the actual services performed, the size and financial performance of P, compensation paid to nonshareholder-employees, and other factors generally recognized by tax courts and other executive compensation consultants.

Our opinions were documented in four volumes describing P's corporate and management structures, each subsidiary, store openings and closures, job descriptions of each officer, management services and training provided by P's major supplier, significant competitors, the compensation market data upon which we relied, and our formulation of reasonable compensation for each officer for each year in question.

This case settled after the exchange of expert direct and rebuttal reports.

LabelGraphics, Inc. v. C.I.R., TCM 1998-343. J. Parr. Affirmed: 86 AFTR2d Par. 2000-5137;
No. 99-70164 (9th Cir.).

Issue: Reasonable executive compensation; §162(a)(1).

Summary. Taxpayer-petitioner (P) was a job shop printer of pressure-sensitive custom labels which were sold primarily to high-tech electronic equipment and software companies. The subject executive founded the business in 1980 and served as the CEO. P quickly established a niche in the emerging market for such labels with leading electronics manufacturers in its region. In 1987, P hired a vice president to take over many of the general management duties formerly performed by the CEO. The VP was the only employee with a college degree and supervised all department managers. P was highly profitable throughout the mid-1980s. However, in the late 1980s, sales stalled when competition intensified.

The CEO owned 100% of P's stock, was well seasoned in the printing industry and oversaw all phases of the business, including marketing, sales, production and all financial matters. From 1986 to 1989, the CEO's annual salary and bonus totaled approximately $400,000. In 1990, the year in question, his compensation rose to $879,000, which included a bonus of $723,000 and triggered a corporate loss for the year. The next highest-paid employee was the VP, who received a salary and bonus totaling $117,000. The CEO's son, who was in his late 20s and had no college education, served as the production manager and was paid $104,000.

P retained three experts, all of whom characterized P as a high-tech company similar to its customers, and opined that the CEO's compensation should total at least $879,000, including an allowance for stock options which is common in high-tech companies.

BVRI was retained by the IRS to determine reasonable compensation for 1990, which we concluded was $230,000. This consisted of a salary of $120,000 and a bonus of $110,000 which were formulated on the basis of P's size, financial performance and returns on investment during the relevant period. We considered the CEO's role in the business, actual services performed, investment risk of P's stock, the roles and compensation of nonshareholder-managers, the compensation of other executives in the printing industry, and what a hypothetical investor would be willing to pay for the CEO's services.

The Court ruled that reasonable compensation totaled $406,000, citing the CEO's established salary of $150,000 and his previous annual bonuses of approximately $250,000. The Court's ruling was affirmed by the 9th Circuit Court.

Freres Lumber Co., Inc. v. C.I.R., TCM 1995-589. J. Colvin.

Issues: Value of noncompete and goodwill; allocation of purchase price; §1060.

Summary. Taxpayer-petitioner (P) purchased lumber and veneer plants, USFS timber contracts, and certain other assets, including a covenant not to compete, from the sellers, who had vigorously competed with P for public timber. P allocated a certain value to the noncompete but no value to goodwill, which the IRS contested. At trial, the IRS's expert valued the noncompete at approximately 25% of P's allocated value and assigned a substantial value to goodwill. BVRI was retained by P to value the noncompete, which we valued at the approximate allocated value, and goodwill, which we valued at zero.

The Court held that goodwill had no value and that the noncompete was worth approximately 60% of P's allocated value. As a result of the Court's ruling, P incurred no additional tax. See TCM 1995-589 for full text of Court's decision.

Estate of Ralph E. Lenheim v. C.I.R., TCM 1990-403. J. Gerber.

Issue: Value of investment and operating companies.

Summary. Decedent made numerous gifts of stock in the subject corporation and sold an operating company to his son at a bargain price.

Valuation issues. Discounts for lack of control and marketability and for corporate ownership of assets; value of real estate and operating enterprise; value of purchase contract; accounting methods applied in business acquisition; provisions of decedent's will; reasonable executive compensation; nonrecurring and nonoperating expenses; goodwill and other intangible assets; prior redemption of stock; and restrictive stock agreement. See TCM 1990-403 for full text of Court's decision.

Estate of Yeager v. C.I.R., TCM 1986-448. J. Goffe.

Issues: Values of preferred stock and control block of common stock held by decedent and wife.

Summary. Subject corporation was a real estate holding company with three subsidiaries, each of which held reciprocal stock interests in the parent company and sister subsidiaries.

Valuation issues. Existing form of corporate structure; discounts for lack of control and marketability; fiduciary duty to minority shareholders; contingent liabilities against corporation involved in construction lawsuit; value of real estate contracts, notes, mortgages, and other assets and liabilities of parent company and subsidiaries; key-man discount; and closed-end investment company discount. See TCM 1986-448 for full text of Court's decision.