Client Alert: Take-Aways from Gallagher v. Commissioner
In a tax court decision that came out in late June, Judge Halpern addressed the valuation of a closely-held business and addressed over a dozen valuation-related issues in the case. Estate of Gallagher (“Petitioner”) v. Commissioner (“Respondent”) concerned a 15% stake in a private newspaper company. While both Petitioner and Respondent offered competing expert opinions on value, it was the Petitioner’s opinion that received the most criticism. However, the Court’s finding of value was ultimately closer to that offered by the Petitioner’s expert. A summary table at the end of this article highlights many of the issues and how the Judge ruled on each issue.
Although the Court’s rulings on the merits of each issue is an important read for valuation professionals and lawyers whose cases involve valuation issues, the decision is also a good reminder of at least three important points when preparing expert reports or expert opinions: (i) opinions need explanations and support to convince a trier of fact, (ii) it’s important to know your jurisdiction, and (iii) it’s important to maintain focus on the key issues in the matter that have more of an impact on the outcome. We discuss these points further below, some of which often separate the winners from the losers in litigated valuation matters.
First, Judge Halpern’s ruling makes it clear that experts need to explain in detail and plain English each and every assumption, fact, decision, and theory that they use in coming to an opinion. An opinion, the court rightly held, has little or no weight without full and proper explanation. According to Judge Halpern, the Petitioner’s expert provided little or no support or analysis for half a dozen issues identified, causing the court to dismiss the Petitioner’s opinions on those issues. In addition, the Petitioner’s expert was criticized for not explaining sufficiently why he made certain capital structure and working capital assumptions based on comparable companies that he had previously maintained were not comparable enough for valuation purposes (i.e., a Market Approach). Without clear explanations as to why the comparable companies could be used for capital structure and working capital assumptions, Judge Halpern dismissed the Petitioner’s position entirely. In litigation, where you are often limited by the number of times you can explain your opinion, it is important to educate a judge or jury at each opportunity with clear and concise explanations for your opinions, assumptions and methods.
Second, the ruling on this matter reminds experts again that it’s important to know your forum and to understand the valuation standards and practices that are adhered to in that forum. In this matter, the Petitioner’s expert opined that no minority interest discount needed to be applied to the results of a Discounted Cash Flow (“DCF”) analysis. While this is generally consistent with rulings in the Delaware Chancery Court, other venues such as Financial Reporting generally do not permit minority interest discounts unless the cash flows can be demonstrated to reflect disproportionate returns to certain shareholders. In this matter, Judge Halpern believed that a discount should be applied to a DCF to reflect minority interest. With differing standards and practices among forums, understanding what methodologies are accepted or apply in a specific jurisdiction or forum is critical and up to the expert to adhere to.
Third, Gallagher v. Commissioner is a reminder that not all issues carry equal weight. It’s ultimately more important to focus on the issues in the matter that will have more of an impact on the outcome of the case. While the Petitioner’s expert failed to convince the court to accept most of his assumptions and conclusions, ultimately Judge Halpern’s valuation conclusion ($32.6 million) was closer to the Petitioner’s position ($28.2 million) than the Respondent’s position ($40.9 million). This was because the issues that the Petitioner’s expert did win on were more important than the ones they lost. For example, the Court agreed with the Petitioner’s expert that only one valuation method, a DCF analysis, could be performed. The Petitioner’s expert was able to convince the court to strike an entire valuation approach offered by the Respondent’s expert. Winning on the issue of valuation methods in addition to winning on certain assumptions (e.g., operating margins) ultimately resulted in a decision closer to the Petitioner’s initial opinion despite losing on more than a dozen specific issues (see table below).
While our discussion above did not include an analysis of the specific issues decided in Gallagher v. Commissioner, there is one issue addressed in the decision that will stoke an already lit fire. The ruling offers a perspective on the long disputed issue of whether to tax affect or not to tax-affect a pass-through entity such as an S corporation. There is significant finance literature addressing the issue, with many practitioners, including Duff & Phelps’ Roger Grabowski, maintaining that the tax-related benefits associated with pass-through entities should not be ignored in the valuation of these entities. In Gallagher v. Commissioner, the court was only provided with two alternatives: either (i) tax affect at a corporate tax rate, or (ii) do not tax affect at all. Judge Halpern found that a “fictitious corporate tax rate” is unreasonable for a company that does not pay corporate taxes, and concluded that the earnings of the subject company should therefore not be tax affected (thereby increasing the value of the business).
In summary, Gallagher v. Commissioner is one of those rare cases where numerous valuation-related issues are addressed in one opinion. The case is also a reminder to experts that (i) opinions need explanations and support to convince a trier of fact, (ii) it’s important to know your jurisdiction, and (iii) it’s important to maintain focus on the key issues in the matter that have more of an impact on the outcome.
|100% DCF (used Market Approach as check)||50% DCF, 50% Market |
Discount for Lack of Control
Discount for Lack of Marketability
Use information Available after the Valuation Date?
|Gain on divested subsidiary and life insurance policy, claim on self-insured life insurance, and overfunded pension fund|
Gain on divested subsidiary
|Only the gain on divested subsidiary|
Recurring Operating Margin
|Tax Affect Earnings|
Capital Expenditure (% of Revenue) data Stable based on
Increase over time
|Stable based on historical data|
Stable based on historical data
Working Capital (% of Revenue)
Variable without explanation
Stable based on Historical
Stable based on Historical
|Cost of Capital|
Cost of Capital – Capital Structure
Based on market values from guideline companies
|Based on market values from guideline companies |
Based on book value of subject company
|Based on book value of subject company|
Cost of Equity
Working Capital Deficit
Stock Options Outstanding
Subtracted all in-the-money stock option proceeds
Uses the treasury stock method
|Subtracted all in-the-money stock option proceeds|
The Court decision can be found at http://www.ustaxcourt.gov.
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