Kardash v. Commissioner, 2015 Tax Ct. Memo LEXIS 69 (March 18, 2015)


A Tax Court memo resulting from a transferee liability case includes an informative discussion of the valuation methodologies the parties’ solvency experts used to determine the company’s fair market value at the point when various contested transfers of payment took place. The court’s analysis as to the merits of the valuations is short, but it suggests the court found the assessment of the IRS’s expert more credible. Even though the IRS failed to establish liability for all of its claims, it was able to show insolvency for three out of the five relevant years.

Pinpointing insolvency. The petitioners were two minority shareholders of a Florida concrete company that flourished during the home construction boom of the early 2000s but was insolvent by the end of 2007. The company was under the control of two majority shareholders, who, from 2003 to 2007, siphoned off most of the company’s cash. For 2003 and 2004, the company filed fraudulent federal income tax returns; for the subsequent three years, it filed none. Neither of the petitioners played a role in managing the finances of the company.

An eventual IRS audit found the company owed more than $120 million in taxes, penalties, and interest. Since the company could not pay, the agency agreed to an installment plan requiring monthly payments of $70,000 per month (for more than 150 years!). Under the Internal Revenue Code’s Section 6901, the IRS also went after the shareholders to recover as much as possible for alleged illegal money transfers. While the IRS reached agreements with the majority shareholders as to recovery under transfer liability, the petitioners challenged the agency’s claims in the United States Tax Court.

Section 6901 provides the Service with a remedy “for enforcing and collecting from the transferee of the property the transferor’s existing liability.” To establish the requisite liability, the IRS looks to applicable state law, in this case to the Florida Uniform Fraudulent Transfer Act (FUFTA). The IRS argued that several payment transfers to the petitioners represented actual and constructive fraud, but only the constructive fraud theory had any traction with the court. Under that theory, the IRS needed to show that the company received less than reasonably equivalent value for the transfers at issue and the company was insolvent at the time of transfer. Both sides retained solvency experts to determine the company’s enterprise value and by extension the point at which it was insolvent—a key issue in the case.

Disputed transfer payments. Two sets of transfers, amounting to $5 million in total, were under consideration. One set included 2003 and 2004 bonus “advances” to the petitioners. Specifically, after the company suspended its performance-based bonus program under which the petitioners received hundreds of thousands of dollars in addition to their salary, the majority owners gave the petitioners so-called “bonus advances” to enable the petitioners to keep up their standard of living. The majority owners told the petitioners they did not have to report the payments in their tax returns. When the IRS subsequently discovered the advances, it characterized them as dividends. The petitioners settled the disputes and paid tax on the advances.

The second set of transfers included dividends the company gave to all the shareholders based on the percentage of stock ownership, which the petitioners reported on their individual returns. The dividends were for 2005, 2006, and 2007.

Asset-based valuation. The IRS’s expert decided the best method to determine solvency was the “asset accumulation approach.” Under this method, he valued the company at the price at which a willing buyer would pay for the company’s tangible assets and land. As the expert saw it, any potential buyer would insist on reviewing the company’s tax returns and audited financial statements prior to buying it. Since the company could produce neither, no buyer would be willing to pay more than the value of the company’s tangible assets and land. The expert also said he did not believe the company had intangible assets of value.

The expert relied on a 2006 appraisal of the company’s assets, which indicated that the assets’ fair market value (FMV) at that time was 102% of the undepreciated book value of the company’s property, plant, and equipment. He simply applied this multiplier to the book value of the company’s assets on the relevant dates and concluded that the company was insolvent at all times during the five years at issue.

He also performed a backup analysis using the market approach to value the company’s assets. He said it was appropriate to use the revenue-to-sale-price ratio because “that is what most buyers use.” He found 13 sales of companies similar to the subject company. He explained that he adjusted the sales price for each company to account for the subject’s financial mismanagement and also applied a 25% key man discount (the court’s opinion includes no details on the reasoning behind it). For each company, he then divided the five-year average of revenues by the sales price. He determined that the median revenue-to-sale-price ratio was 0.9. Finally, he applied this ratio to the company’s average revenue for the five-year periods ending on each valuation date. He concluded that the value of the company’s income tax liabilities exceeded the FMV of the company’s assets by the end of January 2006 and that the company remained insolvent through the end of March 2007.

Three-pronged valuation approach. The petitioners’ expert used three methods, weighting them evenly at 33.3%, to compute a weighted market value of invested capital. From that value, he subtracted debt and liability to arrive at an equity valuation.

The first approach was performing a discounted cash flow (DCF) analysis. The petitioners’ expert based the cash flow projections on three sources. For Year 1, he used management’s forecast; for Years 2 through 4, he used industry growth statistics capturing expectations as to the growth of the residential construction market in the U.S., inflation expectations, and the historical relationship between growth in Florida residential construction and U.S. residential construction. For Year 5, he used industry statistics capturing expectations of inflation in the U.S. and projections of Florida’s population growth.

He explained that a willing buyer and willing seller would have relied on the available management forecasts and used estimated revenue growth or a long-term growth rate forecast when there were no management forecasts. He did not account for fraud in his estimates. He found that EBIT in 2002 was just over $7 million and nearly $59.8 million at the end of 2006. He calculated the rate of return on equity capital using the modified capital asset pricing model (MCAPM) and used the Gordon growth model to determine the terminal value of the company. He capitalized the projected cash flows beginning in the terminal period into perpetuity. First, he normalized depreciation, capital expenditures, and working capital requirements to match long-term expectations of revenue. Then, he normalized available cash flows (The court’s opinion does not give further specifics.)

The IRS’s expert rejected this approach because the company did not have reliable historical cash flow information on which to base cash flow projections. According to the expert, no prospective buyer would value the company using a DCF analysis.

The petitioners’ expert also performed a guideline public company analysis based on six publicly traded companies that operated in a similar line of business. The multiples he used included enterprise value divided by revenue and enterprise value divided by EBITDA.

Finally, he conducted a guideline company transactions analysis, comparing the subject company to similar businesses that had been acquired in private transactions, including mergers and acquisitions. He said he searched for similar transactions based on business descriptions. The multiples again included enterprise value divided by revenue and enterprise value divided by EBITDA. (The court’s opinion is short on detail as to the comparative analyses.)

The petitioners’ expert concluded that the company was not insolvent at year-end 2006 or any date before but was insolvent at year-end 2007. This conclusion led the petitioners to argue that the company did not become insolvent until after they had received the last of the contested transfer payments.

Both experts largely agreed on the value of the company’s debts.

Mixed solvency ruling. In terms of establishing fraud by first showing lack of reasonably equivalent value, the IRS argued the 2003 and 2004 bonus advances to the petitioners were loans that were never repaid. Consequently, the company did not receive reasonably equivalent value for the transfers during those two years.

The Tax Court disagreed, finding these advances were compensation that the petitioners received instead of the suspended bonuses. The company never expected repayment. Since the petitioners gave reasonably equivalent value for the transfers during 2003 and 2004, insolvency for those years was not an issue. The transfers were not constructively fraudulent. Moreover, the court found that, even with the 2003 and 2004 advance payments, the company’s assets then exceeded the FMV of its debts. Therefore, it was not then insolvent.

In terms of the IRS’s fraud claim pertaining to transfers in 2005, 2006, and 2007, the court found the company “likely did not receive reasonably equivalent value” for payments to the petitioners. Under the state’s fraudulent transfer act, “a distribution of dividends that is not compensation or salary for services rendered is not a transfer in exchange for reasonably equivalent value.” Therefore, there was constructive fraud assuming the company was insolvent at the time of the various transfers that occurred during those years, the court said.

Without providing a detailed discussion of the expert testimony, the court in effect found the company was insolvent on all of the transfer dates starting in 2005, that is, once the company made dividends to the four shareholders. These large payments and the accumulation of tax liability stripped the company of its assets and rendered it insolvent, the court said. Consequently, the petitioners were liable as transferees for 2005, 2006, and 2007, the Tax Court held.