Sales of closely held stk judged best reference for the valuation of shares. Carsten Hoffmann is a managing director of FMV Opinions, a valuation and financial advisory services firm.

Overview

In Michael W. Huber, et ux. et al., v. Commissioner; T.C. Memo. 2006-96 (9 May 2006), the Tax Court was faced with having to inspect various transactions from all sides to determine if they occurred "at arm's length." The gift-tax dollars at stake were significant because the audit had to do with gifts made by various family members over a four-year span, 1997 through 2000, and at a 50% marketability discount.

In legal parlance, the term "arm's length" refers to the bargaining position of two parties that are unrelated to one another and whose mutual dealings are influenced only by the independent interest of each. The term is used to describe a standard of dealing that reflects no motivation other than those normally to be expected on the part of two unconnected parties transacting in good faith in the ordinary course of business.

Joseph Maria Huber, a German immigrant, founded the J.M. Huber Corporation, a paint and pigment manufacturer, in the 1880s. In a familiar story of hard work paying off, Huber's business grew to over $500 million in annual revenue by the time frame in question. The company had over 250 shareholders, mostly Huber family members.

The company hired Ernst and Young (E&Y) in 1993 to appraise the company shares every year. E&Y valued the company stock based on a publicly traded market comparable model and applied a discount of 50 percent for the lack of a liquid market. The share price determined by E&Y was used for gifts to family members, transfers to non-family members, charitable gifts, company stock redemptions, stock option grants, and fixing compensation for board members.

The Internal Revenue Service (IRS) agreed with the valuation of the marketable value of the underlying stock, so the only question was whether there were arm's-length sales of Huber shares that supported the 50% marketability discount.

The facts

There were about 90 transactions of Huber shares between shareholders from 1994 through 1999. The shareholders were not obligated to use the E&Y value to sell shares. The relationships between those involved in the transactions were in some cases close, as between parents and their children, and in other cases more distant -- as in a share sale to, in one case, a trust, and in another, the spouse of a second cousin. Still other transactions involved nonprofit organizations.

To support the premise that transactions occurred at arm's-length using the E&Y determined price, the taxpayer had several parties that relied upon the stipulated price testify at court. One of those individuals was a Mr. Brooke.

Mr. Brooke purchased shares in 1997 from an estate that needed the funds. Mr. Brooke was a distant relative of the decedent. Mr. Brooke testified that he regularly received and reviewed the company's 5-year plan, yearly budgets, monthly financial reports, and annual reports. Considering that Mr. Brooke held an M.B.A. from Stanford and ran a private equity firm, the court figured he was a credible judge of value and would not enter into a non arm's-length transaction.

The court found that the IRS was attempting to focus on isolated sales between family members, and thereby disregarding the 90 sales transactions that took place between parties that were hardly related or unrelated. As the court put it: "We view the variety of relationships among the shareholders in Huber as a positive indicator of the existence of arm's-length sales."

The court found further support for this view in two other considerations: the fact that the same price was used for charitable transactions, and that the acceptance of an artificially low value for Huber stock would be against the best interest of shareholders, board members and senior management.

Nice try

In a last ditch effort to dispute the value, the IRS suggested that the Huber shareholders, by not offering their shares for sale to the public, failed to obtain the optimum price. The court rejected this notion, observing that the courts have long recognized the rights of shareholders in closely held companies to remain private. The court further noted that the assumption that a public offering would have garnered a higher value for the stock was purely hypothetical.

Summary

The court wrapped up its findings with, "We reject respondent's suggestion that almost 250 shareholders would harmoniously accept an artificially low valuation of the Huber stock so that a few people who may or may not be related to them can pay less estate tax."

The court concluded that the sales of Huber stock established in the record were arm's-length sales that demonstrated the best reference for the valuation of Huber shares on the petitioners' gift-tax return.

Conclusion

There really isn't much to add this case description. When you have 250 shareholders and more than 90 transactions between related and non-related parties for a plethora of different purposes, some benefiting from a high value and some benefiting from a low value, many of them very well informed, it isn't really all that surprising the court found the transactions to be arm's-length and thereby the fair and accurate indicators of value. -FWR

This is not intended or written to be used by any taxpayer or advisor to a taxpayer for the purpose of avoiding penalties that may be imposed upon the taxpayer or advisor by the IRS. This writing is not legal advice, nor should it be construed as such.

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