IRS: Valuation of Publicly Traded Stock Must Consider Anticipated Merger

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Office of Chief Counsel Internal Revenue Service Memorandum Number 201939002 (9/27/2019)

IRS: Valuation of Publicly Traded Stock Must Consider Anticipated Merger

Author: John H. Ramsey of Goulston & Storrs PC

On September 27, 2019, the Office of Chief Counsel (“OCC”) of the Internal Revenue Service released a Chief Counsel Advice Memorandum (the “Memorandum”)[1] addressing the valuation of stock of a publicly traded corporation for gift tax purposes, where the corporation was engaged in negotiating a pending merger at the time of the gift.

Background

The donor of the gift in question (the “Donor”) made a gift of shares of a publicly traded corporation, of which the Donor was both a co-founder and the Chairman of the Board, to a newly formed grantor retained annuity trust.  Prior to the gift, the corporation was engaged in exclusive negotiations with another corporation regarding a merger.  Sometime after the gift, the merger was announced and the price of the corporation’s stock increased substantially.

The OCC was asked whether, under such circumstances, the “hypothetical willing buyer and seller of shares in a publicly-traded company would consider a pending merger when valuing stock for gift tax purposes.”  The OCC concluded that yes, a hypothetical willing buyer and seller would consider a pending merger when valuing stock.

Section 25.2512-1 of the Gift Tax Regulations provides that the value of the property given as a gift is the “price at which such property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell, and both having reasonable knowledge of relevant facts.”  If there is a market for shares of stock given as a gift, the mean between the highest and lowest quoted selling prices on the date of the gift is the fair market value per share.[2] However, if it is established that quoted selling prices on the date of the gift do not represent the fair market value of the shares “then some reasonable modification of the value determined on that basis or other relevant facts … shall be considered in determining fair market value.”[3]

In the Memorandum, the OCC cited case law stating that hypothetical willing buyers and sellers are presumed to have “reasonable knowledge of relevant facts” and are presumed to have made a reasonable investigation into the facts, concluding that “reasonable knowledge includes those facts that a reasonable buyer or seller would uncover during the course of negotiations over the purchase price of the property.”[4] In addition, the OCC concluded that post-valuation events may be considered, if they are relevant to the question of value,[5] even if such events are unforeseeable as of the valuation date.[6]

Conclusion of the Office of Chief Counsel

The OCC concluded that the high and low quoted selling prices on the date of the gift did not represent the fair market value of the shares and that other relevant facts, including the pending merger, must be considered.

In support of this conclusion, the OCC cited two cases in particular.  In Silverman v. Commissioner, T.C. Memo. 1974-285, aff’d, 538 F.2d 927 (2d Cir.1976), cert. denied, 431 U.S. 938 (1977), the Tax Court rejected expert testimony regarding the valuation of shares of a corporation that was, at the time of a gift, in the process of reorganizing ahead of a public sale because the testimony failed to take into account the future public sale.  In Ferguson v. Commissioner, 174 F.3d 997 (9th Cir. 1999), aff’g 108 T.C. 244 (1997), a case involving the anticipatory assignment of income doctrine, the court concluded that transfers of stock prior to a planned merger “occurred after the shares had ripened from an interest in a viable corporation into a fixed right to receive cash” because “the surrounding circumstances were sufficient to indicate that the tender offer and the merger were practically certain to proceed.”

The OCC concluded that, through analogy to these two cases, the value of the stock of the corporation “must take into consideration the pending merger” because a hypothetical willing buyer and willing seller “would be reasonably informed during the course of negotiations over the purchase and sale of [the shares] and would have knowledge of all relevant facts, including the pending merger.”  The OCC went on to conclude that “to ignore the facts and circumstances of the pending merger would undermine the basic tenets of fair market value and yield a baseless valuation.”

While this final conclusion may be true in this case, as the Donor would, if the pending merger were not considered, have the opportunity to act on insider information to transfer shares by a gift at an understated valuation, it is unclear from the Memorandum how the hypothetical willing buyer and seller would have reasonably obtained non-public information regarding the pending merger, particularly because, as the OCC states, the hypothetical buyer and seller are not “specific individuals or entities, and their characteristics are not necessarily the same as those of the donor and the donee.”[7]

It will be interesting to monitor the application of the Memorandum in this case and to cases in the future, in particular its applicability to donors who are not privy to non-public information relating to the value of publicly traded companies.  In the meantime, donors may want to consider engaging in this type of planning early, before generalized appreciation potential is reduced to a specific and anticipated sale or merger.

[1] Office of Chief Counsel Internal Revenue Service Memorandum Number 201939002 (9/27/2019).

[2] Section 25.2512-2(b)(1).

[3] Section 25.2512-2(e).

[4] Estate of Kollsman v. Commissioner, T.C. Memo. 2017-40, aff’d, 123 A.F.T.R.2d 2296 (9th Cir. June 21, 2019).

[5] (citing Estate of Noble v. Commissioner, T.C. Memo. 2005-2, n.3)

[6] (citing Estate of Gilford v. Commissioner, 88 T.C. 38, 52-55 (1987))

[7] Citing Estate of McCord v. Commissioner, 120 T.C. 358 (2003), rev’d on other grounds, 461 F3d 614 (5th Cir. 2006); Estate of Newhouse v. Commissioner, 94 T.C. 193 (1990).