Raley v. Brinkman

In a Tennessee buyout dispute involving a limited liability corporation organized as an S-corporation, the parties disagreed over whether it was appropriate to tax affect in calculating the fair value of the terminated member’s interest. The trial court declined to tax effect. In contrast, after explaining the concept of fair value, the Court of Appeals  said tax affecting was a consideration as it assisted the court “in determining the going concern value of the S-corporation to the shareholder or member.”

Citing to IRS job aid: In 2011, the plaintiff (seller) and defendant (buyer) formed an LLC that owned and operated a “Wurst-Burger Joint,” in Nashville. Each member had a 50%interest. The LLC had S-corp status. While the restaurant blossomed, the members’ business relationship soured and litigation between the members ensued.

Eventually, the trial court terminated the plaintiff’s membership interest in the LLC, finding his wrongful conduct adversely affected the business. The defendant opted to buy out the plaintiff’s interest under the applicable statute, which required the court to determine the fair value of the plaintiff’s membership interest. Both sides offered valuation expert testimony.

The buyer’s (defendant’s) expert applied discounts for lack of control and marketability (the use of discounts was another contested issue) and tax affected. Specifically, he used a 38% tax rate, which, he said, “was entirely appropriate and comports with generally accepted valuation standards and methods.” The appeals court opinion notes the expert explained “in considerable detail” his reasons for applying this rate to the income stream in his income-based model. Among other things, he said, because “all of the components of the Capitalization Rate are based on after-tax values or after-tax income data, the income stream to which the Capitalization Rate is applied in the Income Approach must also be an after-tax amount to be comparing apples to apples.”

The plaintiff objected to the use of discounts and tax affecting. In arguing against tax affecting, he referred to a job aid for IRS valuation analysts that said, “no entity-level tax should be applied in the valuation analysis for a non-controlling interest in an electing S-corporation, absent a compelling demonstration that independent third parties dealing at arms-length would do so as part of a purchase price negotiation.” He also cited the landmark Gross case, in which the U.S. Tax Court rejected tax affecting in a gift tax dispute.

The trial court agreed with the plaintiff. It said its decision not to permit tax affecting “rests primarily on the reasoning that the LLC elected to be taxed as an S-corporation.” The court said, “to a lesser extent,” it was also guided by gross. It noted that Gross was “not on point but only analogous,” as it dealt with a fair market value determination done in a different context.

Correlation issue: The Court of Appeals noted the applicable statute required the trial court to consider all relevant evidence for the valuation. Tax affecting was relevant evidence, the appeals court said. It said the trial court, in rejecting tax affecting, “applied the fair market value standard, as the Gross court did.” This was the wrong standard here, the appeals court found. A more persuasive case was Delaware Open MRI, in which the court of Chancery determined the going-concern value of an S-corp. Citing Delaware MRI, the Court of Appeals said tax affecting was relevant to determining “what the investor ultimately can keep in his pocket,” assuming he maintains his investment position.

It added the statute required the court to consider the “recommendations of any of the appraisers of the parties to the proceedings.” Here, the defendant’s expert stated tax affecting was a generally accepted factor in the fair value calculation of an S-corp, Also, the court said, in the recent gift tax case, Estate of Jones, the U.S. Tax Court noted the importance of treating the cash flow and the discount rate consistently by using after-taxor pretax values for both. “Therefore, we find that, for correlation, tax affecting was relevant to the fair value determination of [the company],” the Court of Appeals said. It remanded “to allow the parties to present evidence relative to tax-affecting.”

Additional note: This court’s decision, which references the recent key gift tax cases, Kress and Estate of Jones, contrasts with R.D. Clark & Sons, Inc. v. Clark, a January 2020 buyout decision from a Connecticut appellate court that upheld the trial courts decision not to tax affect when valuing the departing shareholder’s interest.