Kohler has always been a privately held company, with a small number of shares held by individuals outside the Kohler family. Kohler stock has never been registered with the SEC or traded on a public exchange. Because of the closely-held nature of the company, since 1900 Kohler consistently paid 7%-10% annual dividends, even during recessionary times, because management was aware of the shareholders’ dependence on that stream of income and the shares would not be sold.
The company used two types of projections to plan its business: the Management Plan and the Operations Plan. The Management Plan consisted of achievable targets, reflecting real-world economic situations and management’s best judgment of the company’s position. This plan was shared with outsiders intending to do business with the company, such as lenders or insurers. The Operations Plan, on the other hand, represented the “best-case” scenario: what the company could achieve in the perfect environment, with maximum productivity and results.
Frederick died in 1998. Later that some year, the company went through a reorganization to get rid of non-family shareholders. In this 1998 reorganization, Kohler family members could exchange their old shares for either $52,700 cash per share or a package of new stock, while non-family shareholders’ only options were to either accept the cash-out or exercise dissenter’s rights. Frederick’s estate opted to receive new Kohler shares rather than cash. Some of the non-family exercised dissenter’s rights and eventually settled for differing amounts up to $135,000 per share, including settlement of claims for breach of fiduciary duty. The reorganization qualified as tax-free under the Internal Revenue Code, and was finalized on May 11, 1998, between the date of Frederic Kohler’s death and the alternative valuation date.
In this case, the IRS argued that the stock to be valued should be the pre-reorganization stock or, alternatively, that if the reorganization stock was used then the transfer restrictions should be disregarded. The Tax Court rejected both arguments. The Tax Court noted that the Code allows the executor of an estate to value estate property either on the date of the decedent’s death, or up to six months later (the alternate valuation date). Property disposed of within six months of the decedent’s death is to be valued as of the disposition. Stock exchanged for new stock of the same corporation in a tax-free reorganization, such as the Kohler stock in this case, is not treated as “disposed of” for the purposes of the IRC. Therefore, the Court found that the executor could elect to value the (new) Kohler stock as of the alternate valuation date.
Both sides used expert witnesses to establish the fair market value of the Kohler stock. At trial, the Tax Court granted the taxpayer’s motion to shift the burden of proof to the IRS after the taxpayer produced credible evidence to support its position. The Tax Court expressed “grave concerns” about the valuation presented by the IRS’s expert, Dr. Scott Hakala. The court questioned his credentials, noting that he was not a member of the American Society of Appraisers (ASA), and that he had not submitted his report with the customary certification required by Uniform Standards of Professional Appraisal Practice (USPAP). The Court also took issue with his “limited” background research into the company, consisting of less than three hours of meetings with Kohler management.
Dr. Hakala used two of the three usual approaches to valuation---the income approach and the market approach. All parties and the court considered the cost approach inappropriate since this was a going concern and not an asset-intensive business. For his income approach, Dr. Hakala used only a discounted cash flow analysis, not a dividend-based analysis. In his DCF analysis, he made his own assumptions about expenses instead of using the expenses in company projections. He did two DCF calculations, one based on the company’s Operations Plan (which he weighted 80%) and one based on the company’s Management Plan (which he weighted 20%). For his market approach, Dr. Hakala used the guideline company method (which he weighted 80%), and the transactions method (which he weighted 20%). He arrived at a valuation of $156 million for the value of the stock held by the estate.
The Tax Court criticized Dr. Hakala’s findings, noting particularly his decision to weight the Operations Plan at 80%, even though Kohler had emphasized that the Operations Plan was strictly a best-case scenario. Also significant was the failure to employ a dividend-based method in his income approach, even though dividends had been consistent for almost a century and were the primary vehicle for return on the stock. Ultimately, the Court placed “no weight on Dr. Hakala’s report as evidence of the value of the Kohler stock.”
The taxpayer retained Willamette Management Associates to value the Kohler stock. WMA has periodically appraised the company in the past. The appraisal was done in part by Robert Schweihs, who had written at least 50 articles on valuing a business, including serving as co-author of the book “Valuing a Business.” Mr. Schweihs was very familiar with Kohler prior to this assignment. WMA also used the income approach and the market approach. For the income approach, WMA used the DCF method, the discounted dividend method and the dividend capitalization method. For the market approach, WMA used the capital market (guideline company) method but not the transaction method. Unlike Dr. Hakala, he felt there were no other transactions of sufficient similarity to apply the transaction method.
WMA applied a 45% lack of marketability discount to the values determined with the DCF method and the capital market method, and a 10% lack of marketability discount to the values reached with the discounted dividend method and the capitalization of dividends method. WMA also used a 26% discount for lack of control with the value determined under the DCF method. WMA weighted the DCF method and the capital market method each 20%, with 30% to each of the dividend methods. This resulted in a valuation of $47,010,000 for the Kohler shares owned by the estate on the alternative valuation date.
The estate also presented testimony from Roger Grabowski, a managing director of Duff & Phelps. Mr. Grabowski had taught finance and valuation at Loyola University, and taught classes for the ASA. He spent 31/2 days interviewing 12 employees of the company. His valuation analysis was much more like that of WMA than that of Dr. Hakala, although he used different discounts and weights. His fair market valuation for the stock was $63,385,000.
The Tax Court was far more impressed with the opinions of the estate’s experts, according “significant weight to their reports.” The Court noted with approval that, because of their highly-developed familiarity with the company, they used correct projections to value the company and were aware of the importance of dividends to Kohler shareholders, making the dividend methods essential components of their analyses. The Tax Court adopted the WMA fair market value of $47,010,000, rejecting the entire tax deficiency assessed by the IRS. The Court also found that since the estate had correctly reported its value on the estate return, there could be no accuracy-related penalty.
|Plaintiff Lawyer(s)||Plaintiff Law Firm(s)|
|Peter Carter||Dorsey & Whitney LLP|
|Peter S. Hendrixson||Dorsey & Whitney LLP|
|Nathan E. Honson||Dorsey & Whitney LLP|
|Phillip H. Martin||Dorsey & Whitney LLP|
|John Rock||Dorsey & Whitney LLP|
|Mary J. Streitz||Dorsey & Whitney LLP|
|Defendant Lawyer(s)||Defendant Law Firm(s)|
|J. Anthony Hoefer|