The court reviewed the valuations of a 15% interest in a private company completed by experts for the estate and IRS. Key issues included the appropriate financial data, adjustments, valuation methods, and assumptions. The estate's DCF analysis projected higher growth but excluded pension adjustments. The IRS analysis relied more on market methods and lower projections. The court generally sided with the IRS experts but made some adjustments, such as constructing its own projections between the two. It applied discounts of 23% for lack of control and 31% for lack of marketability.

1. Key Estate & Gift Valuation Issues
A Review of Gallagher v Commissioner
July 27, 2012
Nickolas N. Sypniewski, ASA
nsypniewski@comstockadvisors.com
Newport on the Levee
1 Levee Way, Suite 3109
Newport, KY 41071
phone 859.957.2300
fax 859.957.2305

2. Gallagher v Commissioner
• Paxton Media Group, LLC (“PMG”)
• 28 daily newspapers
• 13 paid weekly publications
• Specialty publications
• Television station
• Financial Summary
• Revenue = $169.1 million
• Net Income = $48.2 million
• Total Assets = $357.5 million
• Book Equity = $73.8 million
• S Corp (1996) / LLC (2001) status protected by restrictions
2 on sale of stock

3. Valuations of PMG
• Date of Death: July 5, 2004
• Estate‟s interest: 15% of units
Value of
Decedent‟s
Source Comment Units .
David Michael Paxton (PMG CEO) Form 706 $34,936,000
IRS Notice of Proposed Adjustment $49,500,000
SMK Redetermination $26,606,940
Richard C. May Estate‟s Trial Expert $28,200,000
Klaris, Thomson & Schroeder IRS‟s Trial Expert $40,863,000
Tax Court $32,601,640
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4. Issues
• Date of financial information
• Adjustments to financial statements
• Market approach
• Discounted cash flow method
• Projections used
• Tax affecting income
• Cost of capital
• Discount for lack of control
• Discount for lack of marketability
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5. Date of Financial Information
Estate IRS Court
PMG 5/31/2004 6/27/2004 6/27/2004
Public Comps 3/28/2004 6/30/2004 6/30/2004
• Relatively minor issue/red herring
• Date of Death: July 5, 2004
• What was known or knowable
• June 2004 financials depict market conditions on the valuation date,
not that a willing buyer and seller would have relied upon the data
• Able to inquiries of PMG or of the guideline companies?
• Any intervening event between the valuation date and the publication
of the June financials?
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6. Adjustments to Financials
• Nonrecurring items
($000) Estate IRS Court
Gain on Divested Business ($7,900) ($7,895) ($7,895)
Gain on Life Insurance (700) 0
Positive Self Insurance (1,100) 0
Total ($9,700) ($7,895) ($7,895)
• Estate's expert did not explain why nonrecurring
• Pension Adjustment
• Estate's expert eliminated historical pension income & expense
• Estate's expert added $11.7 million overfunding of pension plan
• Estate's expert “failed adequately to explain” and court “fail[ed] to
understand”, so court disregarded
• Why not future benefit in DCF?
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7. Market Approach
Guideline Public Company Method
The basic steps of the guideline public company method are
as follows:
• Select comparable guideline public companies
• Compare the subject company to the guideline public companies
• Select appropriate valuation multiples based on the value of the
public companies‟ stock and their financial performance
• Apply the valuation multiples to the financial performance of the
subject company to arrive at an estimate of the value of the
subject company
• Deduct the value of capital debt
• Apply discounts and/or premiums as appropriate
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8. Market Approach
Comparison to Guideline Public Companies
• IRS's expert picked four & adjusted multiples down by 10%
• PNG slowing growth rate
• Size
• Private vs Public
• Court concluded that four guideline companies not similar
enough
• Size – 1/3 the revenue size & 1/4 the asset size
• Products – No internet component
• Growth – PMG greater revenue & EBITDA growth
• Liquidity – Similar
• Leverage – PNG more levered
8

9. Discounted Cash Flow
DCF Methodology
The basic steps to the DCF method are as follows:
• Forecast free cash flow over a period of time, including a residual
value of the company at the end of the projection period
• Determine a discount rate. This requires calculating the cost of
debt, the cost of equity and the mix of debt and equity in the
company‟s capital structure
• Discount the annual free cash flows and the residual value back to
their present value
• Deduct the value of capital debt
• Apply a discounts and/or premiums as appropriate
9

10. DCF Forecast
Estate's Expert Year 1 Year 2 Year 3 Year 4 Year 5
Revenue Growth 4.60% 2.90% 4.90% 3.00% 4.90%
Operating Profit Margin 34.70% 34.10% 34.10% 34.10% 34.10%
IRS Expert Year 1 Year 2 Year 3 Year 4 Year 5
Revenue Growth 5.45% 1.50% 1.00% 1.00% 1.00%
Operating Profit Margin 39.50% 39.50% 39.50% 39.50% 39.50%
Court Year 1 Year 2 Year 3 Year 4 Year 5
Revenue Growth 5.45% 1.50% 1.00% 1.00% 1.00%
Operating Profit Margin 36.50% 36.50% 36.50% 36.50% 36.50%
• Court preferred growth & margins based on historical performance, & ultimately
constructed its own projections
• CIM not used by either appraiser
• Assumptions regarding future margins need quantitative support
• Use cash flow NOT EBITDA (Depreciation, CAPEX, Working Capital)
• Treatment of acquisitions
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11. Tax Affecting S Corps
Are S Corporations worth more than C
Corporations?
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12. Pros & Cons of Tax Affecting
• Two basic arguments against tax affecting are:
• S corporations do not pay income taxes (with some exceptions at the state
level). Therefore, the tax rate should be zero percent.
• If there is no value to being an S corporation, then why do so many companies
elect to be taxed as S corporations?
• Two basic arguments for tax affecting are:
• If the company is profitable, its income will be taxed, albeit at the shareholder,
rather than the corporate level. In fact, the typical company will make a
distribution to its shareholders to cover the tax, so the net cash flow of the S
corporation is similar to that of a C corporation.
• By applying a zero percent tax, the implication is that an S corporation is worth
67 percent more than a comparable C corporation. Under this logic, an
investor could purchase a C corporation, convert it to an S corporation and
resell the company for a 67 percent gain. This is not realistic.
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13. Tax Affecting
• Gross v Commissioner (1999)
• Wall v Commissioner (2001)
• Heck v Commissioner (2002)
• Adam v Commissioner (2002)
• Delaware Open MRI Radiology Associates, P.A. v Kessler,
et al (2006)
• Robert Dallas v Commissioner (2006)
• Bernier v Bernier (2007)
• Giustina v Commissioner (2011)
• Gallagher v Commissioner (2011)
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14. Disallowing Tax Affecting
• Potential substantial valuation understatement penalty for
taxpayer– greater than 35% difference (IRC 6662).
• Potential appraiser penalty (IRC 6701), and potential loss of
practice before IRS for up to three years (IRC 7408).
• Dramatically higher taxes due (67%) plus interest.
Tax Affect No Tax Affect
Pre-Tax Income $1,000,000 $1,000,000
Corp Tax Rate 40% 0%
Corporate Taxes 400,000 0
After Tax Earnings $600,000 $1,000,000
Multiple 6 6
Value $3,600,000 $6,000,000
Value Difference $2,400,000
Percent Difference 66.7%
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15. Cash Flow to Shareholder
C Corp S Corp
Pre-tax Income $1,000,000 $1,000,000
Corp Tax Rate 40% 0%
Corporate Taxes 400,000 0
Available for Dividend $600,000 $1,000,000
Federal Dividend Tax (15%) 90,000
Federal Personal Tax (34%) 340,000
Net Cash to Shareholder $510,000 $660,000
29.4%
• S Corps don‟t pay taxes, but a shareholders receive K-1s
• What CAN company distribute? What DOES company distribute?
• Increase in basis over time
• Avoidance of BIG tax
• Differences in compensation
• How long will S advantage last?
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16. Tax Affecting
Estate IRS Court
Tax Rate Applied 39% None None
S Corp Benefit $63.8 million None None
Cost of Equity Adjustment None 2% 2%
• Estate's expert adjusted to account for shareholder benefits:
• Added $12.8 million to account for “S shareholder tax savings on all future
projected distributions in excess of tax distributions”;
• Added $44.3 million to reflect the future value of the company‟s deductible
goodwill;
• Added $6.7 million to account for the company‟s extra marginal debt tax
shield.
• The Court disagreed, noting that the savings of an S election are
properly reflected through the imposition of a zero-percent corporate
tax rate in valuing S corporations under the DCF method.
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17. Cost of Capital
Estate IRS Court
Cost of Equity Method CAPM Build-Up Build-Up
Cost of Equity 13.5% 20.0% 18.0%
Cost of Debt 5.0% 6.60% 6.50%
Debt/Equity 15%/85% 75%/25% 75%/25%
WACC 12.3% 10.0% 10.0%
• IRS's expert Capital Structure
• Based on PMG‟s current capital structure
• Based on book value of debt & equity
• Estate's expert Capital Structure
• Based on guideline companies‟ capital structure
• Based on market value of debt & equity
• Court
• Agreed that the market value of debt and equity should be used, but
• Ultimately used PMG‟s own book capital structure
17

18. CAPM & WACC
• Capital Asset Pricing Model (CAPM)
• “The special characteristics associated generally with closely held
corporate stock make CAPM an inappropriate formula to use in
this case.”
• Weighted Average Cost of Capital (WACC)
• “We have previously held that WACC is an improper analytical
tool to value a „small, closely held corporation with little
possibility of going public‟.”
• “Neither party has indicated the likelihood of PMG‟s becoming a
publicly held company; however, because both experts used
WACC as the rate of return in their analyses, and neither party
otherwise raised the issue, we shall adopt it, although we do not
set a general rule in doing so.”
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19. Valuation Discounts
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20. Levels of Value
Total Equity Value (Controlling Shareholder)
Financial Buyer of a Company
Control Premium Discount for Lack of Control
Marketable Minority Interest Value
Publicly Traded Equivalent Value
Discount for Lack of Marketability
Non-Marketable Minority Interest Value
Non-Controlling Shareholder of a Private Company
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21. Prerogatives of Control
• Change management or • Sell or acquire treasury shares
directors • Do an IPO
• Declare & pay dividends • Change the articles of
• Set operational and strategic incorporation/bylaws
policy • Decide what products to offer
• Acquire, lease or liquidate assets • Decide what markets to enter
• Liquidate, dissolve, sell or • Select vendors, suppliers and
recapitalize subcontractors
• Set compensation
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22. Discount for Lack of Control
• Income Approach
• If cash flows represent “minority interest cash flows”, an explicit discount
might not be necessary
• Guideline Company Method
• Generally considered to result in a minority interest value, so an explicit
discount may not be required
• However, like the income approach, consideration should also be given to
the nature of the underlying profits
• Merger & Acquisition Method
• Results in a control value, so an explicit discount for lack of control is
required.
• Asset Approach
• Results in a control value, so an explicit discount for lack of control is
required.
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23. Control Premiums Paid
No. of Average Median
Transactions Premium Premium
2002 326 59.7% 34.4%
2003 371 62.3% 31.6%
2004 322 30.7% 23.4%
2005 392 34.5% 24.1%
2006 454 31.5% 23.1%
2007 491 31.5% 24.7%
2008 294 56.5% 36.5%
2009 239 58.7% 39.8%
2010 348 51.5% 34.6%
2011 321 54.1% 37.8%
Control Premium
5-Year Weighted Average 48.1% 33.4%
10-Year Weighted Average 45.4% 30.1%
Implied Minority Discount
5-Year Weighted Average 32.5% 25.0%
10-Year Weighted Average 31.2% 23.1%
Source: Mergerstat Review, 2012.
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24. Discount for Lack of Control
• Court acknowledged that both a discount for lack of
control and a discount for lack of marketability are
appropriate
• Estate's expert indicated that DCF already represented
minority value, so no additional minority discount
• IRS's expert applied a 17% discount to the DCF
• Based on the inverse of a 20% control premium
• 10% less than Mergerstat - all industries
• 20% less than Mergerstat – PMG‟s industry
• Court applied a 23% discount to DCF, based on the inverse
of a 30% control premium
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25. Discount for Lack of Marketability
• Both experts primarily relied on restricted stock studies
• Estate's expert used 30%. IRS's expert used 31%. Court
used 31%.
• The Court cites Furman v. Commissioner in stating its
dislike for the use of the restricted stock studies:
“finding the taxpayer‟s reliance on the restricted stock studies in
calculating a lack of marketability discount to be misplaced since
owners of closely held stock held long term do not share the same
marketability concerns as restricted stock owners with a holding
period of 2 years.”
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26. Summary of Issues
Estate IRS Court
Financial Data What's Available As of Val. Date IRS
Earnings Adjustments ($9,700,000) ($7,895,000) IRS
Pension Adjustment Yes No IRS
Guideline Company Method Minimal Weight Used Estate
Projections Higher Lower IRS
Capital Expenditures 2.3% - 3.1% of revenue 2.8% of revenue IRS
Working Capital Fluctuating Negative 2.5% of revenue IRS
Tax Affecting 39% & S Benefit 2% Ke Adjustment IRS
Cost of Capital (WACC) 12.3% 10.0% IRS
Discount for Lack of Control None Applied 17% to DCF 23% to DCF
Discount for Lack of Marketability 30.0% 31.0% IRS
Stock Options Diluted & Proceeds Diluted Estate
Value $28,200,000 $40,863,000 $32,601,640
• Despite agreeing with IRS‟s expert on most issues, the
conclusion of value was closer to Estate‟s value (65%/35%)
26

27. The Attorney & the Appraiser
• Explain & Support
• How will they be addressed & documented
• Get explanations in the initial report (vs rebuttal)
• Know your audience
• Valuation Issues to Watch
• Guideline company comparisons
• Projections
• Tax Affecting
• CAPM
• WACC
• Valuation Discounts
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28. Thank you
Any questions?
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